Circular Flow DiagramsEconomists use the circular flowdiagram to show the high degree ofeconomic interdependence in oureconomy.Money flows in one directionwhile goods, services, andthe factors of production flowin the opposite direction.
Circular Flow DiagramsThis simplecircular flowmodel showstwo groups ofdecisionmakers —households(orindividuals)andbusinesses.(Latergovernmentwill beadded).Thecoordinatingmechanismwhich bringstogether thesedecisions isthe marketsystem.HouseholdsBusinessesResource or factor MarketProduct Market
• Operate as the points of exchange when individualssell their resources (land, labor, capital, andentrepreneurial ability) to businesses in exchange formoney incomes.Resource (or factor) markets• Exampleshiring of workers by a business firmsavings and investments in stocks andbonds.• Prices paid for the use of resources aredetermined in this market, and will create the flowof rent, wages, interest and profit income to thehouseholds.• Businesses will demand these resources toproduce goods and services.
Resource Money PaymentsLand, Labor, Capital and EntrepreneurshipHouseholdsBusinessesResource or factor MarketProduct Market
Productmarkets• Operate as the points of exchangebetween consumers who use moneyincomes to buy these goods and servicesproduced by businesses.• Money income itself does not havevalue, since money must be used inexchange for the goods and services thatsatisfy our wants.
Resource Money PaymentsLand, Labor, Capital and EntrepreneurshipGoods and ServicesMoney PaymentsHouseholdsBusinessesResource or factor MarketProduct Market
Examplesretail stores and other outlets forproductsHouseholds create the demand for goods andservices, while businesses can fill the demandwith the supply that they produce with theresources sold.The flow of consumer expendituresrepresent the sales revenues or receipts ofthe businesses.The interaction of demand for goods andservices with the supply of availableproducts determines the price for theproducts.Why a circular flow?
Individuals or households functionas both providers of resources andas consumers of finished products.Each group of economic unitsboth buys and sells.Businesses function as buyers ofresources and sellers of finishedproducts.Resource MarketProduct MarketResource MarketProduct Market
Scarcity plays a role in this modelbecause households will only possess alimited amounts of resources to supply tobusinesses, and hence, their moneyincomes will be limited.This limits their demand forgoods and services.Because resource are scarce,the output of finished goods andservices is also necessarilylimited.
√ Intra-household and Intra-businesstransactions are ignoredLimitations to Circular Flowmodel√ Production expendsresources and human energyand can cause environmentalpollution.√ The model implies constantflow of output and income; thefact is that these flows areunstable over time.√ Government and the financialmarkets are ignored.
Resource Money PaymentsResource or factor MarketProduct MarketLand, Labor, Capital and EntrepreneurshipGoods and ServicesMoney PaymentsHouseholdsBusinesses