Arrows A and B represent the two sides of the product market. Households pay for goods and services, which becomes the revenues to firms. In the labor market, households provide labor and receive payment from firms through wages, salaries, and benefits.įirms produce and sell goods and services to households in the market for goods and services (or product market). The direction of the arrows shows that in the goods and services market, households receive goods and services and pay firms for them. It pictures the economy as consisting of two groups-households and firms-that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees.įigure 1.7 The Circular Flow Diagram The circular flow diagram shows how households and firms interact in the goods and services market, and in the labor market. Companies often build models of their new products, which are more rough and unfinished than the final product, but can still demonstrate how the new product will work.Ī good model to start with in economics is the circular flow diagram ( Figure 1.7). We use models to test theories, but for this course we will use the terms interchangeably.įor example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Strictly speaking, a theory is a more abstract representation, while a model is a more applied or empirical representation. Sometimes economists use the term model instead of theory.
A good theory is simple enough to understand, while complex enough to capture the key features of the object or situation you are studying. If done well, this enables the analyst to understand the issue and any problems around it. The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. A theory is a simplified representation of how two or more variables interact with each other. These assumptions tend to be different than the assumptions an anthropologist or psychologist might use.
They analyze issues and problems using economic theories that are based on particular assumptions about human behavior. Here's a fun video explaining this concept more.Watch this video about John Maynard Keynes and his influence on economics.Įconomists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline. Like businesses, the government provides (sells) goods and services to businesses and households in return for money (taxes). The government hires companies through the goods and services market, just like households. The government goes to the factor market to hire its workers, just like the private sector. Fortunately, some of Sandra's payment is left over as income to Ben.Ī simple model excludes the government, but when the government is added the flows are altered, but income still equals expenditures. His purchase is an expense to Ben, but income to the auto parts store. Ben also purchases parts from a local auto parts store. George's wages are income to George, but an expenditure to Ben. Ben uses some of Sandra's payment to pay George. In other words, one person's expenditure is another entity's income. The circular flow model illustrates how in an economy income must equal production. Figure 1 illustrates how households and businesses interact in the goods and services and factor markets in exchange for money. The goods and services market is anywhere businesses sell goods and services to the final consumer. These factors include entrepreneurs, land, natural resources, labor, and capital. The factor market is where businesses go to purchase the items needed to produce goods or services. They trade with each other in two markets-the factor market and the goods and services market. The two major actors in the circular flow model are households and businesses.
This diagram depicts how goods and services flow in exchange for money. The circular flow model is a model that depicts how goods and services flow in exchange for money.Įconomists use the circular flow model to show the interdependent relationships between households, producers (businesses), and government.
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