Circular Flow Of Labor & Capital

In the study of economics, one learns the circular flow of the economy between firms and households. This post however presents another circular flow model based on capital and labor. (It is a closed economy with no government for simplification.) There are 4 pools within this circular flow related to the income and utilization of labor and capital.

In the center of the model is the percentage of national income from production that goes to owners of capital. We do have a capitalistic economy. The control of capital is at the center of the economy. Capital income is central to determining the pools around it… the percentage of national income going to labor and the percentage utilizations of labor and capital.

This circular model is different because we do not see money going back and forth between entities. Instead we see dynamics of utilization and distribution between one pool and another.

Share of Income between Capital & Labor

At the top of the circular flow is the relationship between how much of national income goes to capital and labor. For the most part, this is determined by owners of capital because they control the equipment, investment funds and other capital used for production. Then they hire labor to work with the capital.

There is a historical power struggle between capital and labor for sharing the income from production. Strikes, walk-outs and killings define the history. When labor loses bargaining power, labor share of income tends to fall. What effect then do changes in labor share affect the utilization of labor and capital?

Relationship between Labor Share & % Utilization of Labor (Green linein model)

In production, labor needs to be hired. The amount of available labor supplied depends on labor’s share of income from production. Here are some graphs to show this relationship.

As the labor index rose to over 112 in the 1950?s and 1960?s, unemployment increased. The utilization rate of labor looked to be limited by capital owners.  Since then, labor share has fallen. Now it looks as though labor is limiting its supply. The implication is that labor is less willing to supply its labor when its share of income is low.