Circular Flow Diagram
Buying goods is a necessity for everyone. Some of those goods are groceries, while others are clothing for an important event. A functioning economy depends on the purchase of goods, no matter what they are. Every time we buy a good, we contribute to the economy. We’ll examine how those purchases were just one piece of a bigger economic puzzle in this article. An economy works in circles, which is referred to as the circular flow diagram in economics. The circular flow diagram is a basic model used in economics to explain the operation of an economy. It examines primarily the flow of money, goods, and services throughout the economy. There are two main characters in the diagram: firms and households, where households represent consumers and firms represent producers.
- This diagram shows how households and firms interact in two markets: the goods and services market where firms sell to households and households buy from business firms, and the labor market where household workers sell to firms.
- This circular flow diagram shows how households and firms interact on the goods and services market, as well as the labor market. The arrows indicate that households receive goods and services and pay firms for them in the goods and services market.
- As part of the labor market, households provide labor and are paid by firms through wages, salaries, and benefits.
- Goods and services are produced and sold by companies to households in the market for goods and services (or product market).
Indications of Different Arrows
- Households purchase goods and services, and companies earn revenue from that. This is indicated by the arrow “A”.
- The two arrows A and B represent the two sides of the product market. From where do households obtain income to purchase goods and services? Labor, capital, raw material, and other resources are provided by them for firms to produce merchandise and services in the market for inputs (or factors of production). This is indicated by the arrow “B”.
- In return, firms pay wages and other factors of production for the inputs (or resources) they use. This is indicated by the arrow “C”.
- The two arrows “C” and “D” represent the two sides of the factor market. In the real world, there are many different markets for goods and services, as well as markets for many different types of labor. This is indicated by the arrow “D”.
Outer and Inner Circle in Circular Flow Diagram
- The circular flow diagram simplifies this to make the picture easier to understand. Companies produce goods and services that they sell to households to earn revenue. An outer circle shows this, and represents the two sides of a product market (for example, the market for goods and services) in which households demand and firms provide. In exchange for wages, salaries, and benefits, households sell their labor to firms.
- In the inner circle we see this and represent the two sides of the labor market, households and firms.
- In its simplest form, the circular flow model explains how the product and labor markets in an economy work, but does not contain all of the features of the model. There is no problem adding details to this basic model if we wish to introduce more real-world elements, such as financial markets, governments, and interactions with other countries (imports and exports).
- An economist carries a set of theories in their head like a carpenter carries a toolkit. The first thing they do when they see a problem or issue in economics is to go through the theories they know to see if one fits. Using the theory, they derive insights about the issue.
- Theories are expressed by economists in the form of diagrams, graphs, or even mathematical equations. We will mostly be using graphs in this course.) Economists don’t figure out the answer to a problem and then draw a graph to illustrate it. Instead, they use the graph of the theory to figure out the answer.
- Though you can sometimes figure out the right answer without using a model at the introductory level, if you continue to study economics, before long you will run into issues and problems that you will need to graph. Microeconomics and macroeconomics are explained based on theories and models. The most well-known theories are probably those of supply and demand, but you will also learn a number of other theories.
Circular Flow Diagram Quiz
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