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Free market circular flow diagram12/26/2023 ![]() ![]() “ 1.3 How Economists use Theories and Models to Understand Economic Issues” in Principles of Economics 2e by OpenStax is licensed under Creative Commons Attribution 4.0 International License.The circular flow diagram 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. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports). This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labour markets work in the economy. ![]() The inner circle shows this and represents the two sides of the labour market in which households supply and firms demand. Households sell their labour as workers to firms in return for wages, salaries, and benefits. The outer circle shows this, and represents the two sides of the product market (for example, the market for goods and services) in which households demand and firms supply. In the diagram, firms produce goods and services, which they sell to households in return for revenues. The circular flow diagram simplifies this to make the picture easier to grasp. There are many different markets for goods and services and markets for many different types of labour. Arrows “C” and “D” represent the two sides of the factor market. In return, firms pay for the inputs (or resources) they use in the form of wages and other factor payments. land, capital, raw materials) firms need to produce goods and services in the market for inputs (or factors of production). Where do households obtain the income to buy goods and services? They provide the labour and other resources (e.g. 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 labour market, households provide labour 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. The Circular Flow Diagram The circular flow diagram shows how households and firms interact in the goods and services market, and in the labour market. 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 labour market in which households sell labour to business firms or other employees.įig 2.1 “ Circular Flow Diagram” by OpenStax, CC BY 4.0. A good model to start within economics is the Circular Flow Diagram (Fig 2.1). ![]()
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