Participants in the circular flow: households and firms

Households are all the people who live together and who make joint economic decisions. Your family is a household, and a person living on his or her own is a household. Communes of friends who live in one house and share their expenses also form a household.

In a market economy, households are the biggest owners of the factors of production. They own all the labour and entrepreneurship as well as the capital and natural resources (land).

Even though businesses own the capital goods (buildings, factories, tools and machines), these businesses are, in turn, owned by households through the shares they have in them. Some households may own only a few hundred rand worth of shares, while others may own thousands or millions of rand worth of shares in a company. The point is that businesses are legal entities that are owned by people (households). These households own a firm's capital goods and have a right to its profit in the form of dividends.

Households make these factors of production available to the economy, where they are used by firms to produce goods and services. In exchange for the use of the factors of production, households receive an income from firms in the following forms:

• salaries or wages in return for their labour services
• interest on their capital
• rent from the ownership of natural resources such as agricultural land
• profit from entrepreneurial activities

The most important source of income for households in South Africa is the wages and salaries they receive in return for their labour services. To earn an income, households must therefore take part in the production of goods and services. This is a vital decision that households have to make. They have to decide to whom they will make their factors of production available, how many of these factors of production and at what price. The more factors of production a household owns, and the more valuable these factors are, the higher the income of the household will be. This all happens in the factor market.

Households are therefore active participants in the factor market as suppliers of factors of production.

The primary aim of households is to maximise their satisfaction with their limited income. Households try to maximise their satisfaction by using their income to buy consumer goods and services that satisfy their needs and wants. These goods and services are bought on the goods market. Households are therefore active participants in the goods market as the demanders (buyers) of goods and services. They are the consumers in our society and responsible for consumption spending, which is spending on consumer goods and services.

If you think back to the basic economic questions of what, for whom and how to produce, you will immediately recognise the importance of households. It is the households, through their income and consumption expenditure, that the questions of what to produce and how much of it and for whom, are answered. What households (consumers) want and can afford (their demand) determines what firms will produce. A change in their behaviour (even a small one) has a significant impact on the flow of production, income and spending.

The characteristics of households may be summarised as follows:

• They are owners of production factors.
• They are sellers of production factors.
• They are consumers of goods and services.
• They are buyers of consumer goods and services.

In a market economy, business enterprises or firms are responsible for the production of goods and services in the economy. The bulk of the goods and services in South Africa are produced by privately owned businesses and they are therefore one of the key decision makers in our economy.

Firms combine and transform factors of production to produce goods and services. They are therefore active participants in the factor market as buyers of the factors of production that are owned by households. In return for the use of the factors of production, firms pay households wages and salaries for labour, interest for capital, rent for land and profits for the entrepreneur. This is part of the cost of production for the businesses.

Businesses do not only produce the consumer goods and services that households demand. They also produce capital goods (factories, machines and tools) that are used in the production of consumer goods and services. This creation of capital goods is known as real investment.

There are different types of firms. Sole proprietorships are owned by a single individual who makes all the decisions. All the profits in a sole proprietorship go to that single owner. There are close corporations which are not publicly traded on any stock exchanges. They are a closed investment and are generally small. There are also partnerships, which are not that different from sole proprietorships. A partnership usually involves two or more individuals who bring together the money, skills and other resources and share the profit made. And then there are companies. According to the law, these are a type of business whose identity is separate from the owners of the business.

While households try to maximise their satisfaction from their limited income, firms try to maximise their profits. Profit is the difference between revenue and expenditure. Revenue is earned from the selling of goods and services to households in the goods market. Firms are therefore active participants as supplier (sellers) in the goods market. Firms strive to keep their revenue as high as possible and their expenditure – which is determined by their cost of production – as low as possible.

Looking back at our economic problem of what, how and for whom to produce, firms are responsible for "how to produce" and they continuously search for ways to make the production of goods and services more efficient. This is important, because our resources are scarce and we cannot afford to waste them.

The general characteristics of firms may be summarised as follows:

• They are buyers of factors of production.
• They are producers of goods and services.
• They are sellers of goods and services.