In an economic system, people’s self-interest is manifested in markets and through the political process. Both are intertwined and affect each other; an economist would be unlikely to look at any part of the political process without considering how it affects markets. An economic model called the circular flow model shows the relationship between households, firms, governments, and the foreign sector as they all interact in product (e.g., goods), factor (e.g., labor), and financial (e.g., stock, bond) markets. These markets are also interrelated, as you no doubt have concluded from the previous discussions of them, but this theory helps show and describe this interrelationship.
The starting point for understanding the entire economy is a very simple model that illustrates how households and firms interact in the product market and the factor market. The private sector is nothing more than the households and businesses in an economy. Households buy goods and services from firms in the product market.
Where did the households get the money to buy the goods and services?
Firms employ land, labor, capital, and entrepreneurship in order to provide goods and services.
There are two sets of flows between households and firms. Flowing in one direction are goods and services in the product market, and land, labor, capital, and entrepreneurship in the factor market. Consumption spending flows in the opposite direction of the goods and services. Flowing opposite the factors of production are factor payments, which include rent, wages, interest, and profits.
Notice that the simple model of the private sector overlooks everything the government does. So we have to consider the public sector of the economy as well as the private sector. The public sector refers to all levels of government, from local to federal. The public sector interacts with households by purchasing some of the factors of production (such as land or labor) in exchange for the factor payments (such as wage, rent, or interest). Government also interacts with firms by buying goods and services in the product market.
Government combines the factors of production with the goods and services it buys from firms in order to provide public goods and services to the private sector. National defense, police, fire protection, schools, libraries, and roads are examples of the types of public goods and services provided by the public sector.
Where is the government getting the income with which to buy the factors of production from households and goods from the firms? Taxes, in both the factor market and the product market, are the source of governments’ income. Taxes on personal income and corporate profits are collected in the factor market. Sales tax is an example of a tax collected in the product market. Sometimes the government subsidizes firms, which represents a flow of money from government to firms. Like firms that receive subsidies, many households receive transfer payments like Social Security and welfare.