Understanding the Circular Flow Model in Economics

Let’s face it, the economy is complex and can be difficult to understand. Luckily, economists have developed models to help us learn and understand how the economy functions. One of the most useful is the circular flow model.

The circular flow model highlights the “flows” within the economy―the flow of economic resources, goods and services, and the flow of money. To demonstrate the usefulness of the circular flow model, let’s follow a few dollars through

a cycle. Imagine you are a hungry consumer who hears the homemade fries at the diner down the street calling your name. You take your money to the diner for a tasty meal.

When you pay your check, you are buying goods and services. But the money doesn’t remain in the cash register for long. Alice, the diner owner, uses the money to purchase resources. She buys homegrown potatoes

from a farmer; pays the server, who took your order, his wages; and makes a payment on the loan she got to buy new equipment for the diner. All of these are costs of production. After she has paid her costs of production, the remaining revenue is her profit—the

income she earns as an entrepreneur owning and operating her diner. Let’s say your money goes to the farmer, and that for him is income. That money won’t remain in his wallet forever, though. Before you know it he will spend it, and the cycle

will begin again. The circular flow model shows the interaction between two groups of economic decision-makers―households and businesses―and two types of economic markets―the market for resources and the

market for goods and services. While the real economy is much more complex, the simple circular flow model is useful for understanding some key economic relationships. Let’s start with the two groups of economic decision-makers.

On one side of the model are households. Households consist of one or more persons who live in the same housing unit, such as a family. Households own all the economic resources in the economy. The economic resources are land, labor, capital, and entrepreneurial ability.

Land resources are natural resources. For example, these could be actual land owned by a farmer or other natural resources such as oil, water, and trees. Labor is just what it sounds like―work for which you are paid.

Capital resources are goods used to produce other goods and services. For example, think of a hammer used by a carpenter or a computer used at a business. Finally, entrepreneurial ability is the human resource that combines the other resources

to produce new goods and services and bring them to market. So, an entrepreneur might combine land, labor, and capital in new ways―taking risks along the way―to bring a good or service to market.

On the other side we have businesses. A business is a privately owned organization that produces goods and services and then sells them. Businesses can be large, such as an automobile manufacturer, or small, such as a diner. And, businesses may produce goods, such as computers and bicycles,

and services, such as haircuts and car repairs. But households and businesses are not isolated, they interact in markets. At the top of the model we have the market for resources. The market for resources is

where households sell and businesses buy economic resources―land, labor, capital, and entrepreneurial ability. Notice that it is households who own all the economic resources. You might think of capital, say a delivery truck, as being owned by a business. But who

owns the businesses? You guessed it―households. Whether a small diner owned by an individual, a partnership owned by several individuals, or a corporation owned by stockholders, all of these businesses are owned by people who are also members of a household.

Let’s look at some transactions in the market for resources by a business. A diner:it uses a mix of economic resources, such as land―potatoes for fries; labor―cooks and wait staff, and capital ―kitchen equipment; and cash register resources to produce goods and services―in

this case cheeseburgers, fries, and milkshakes. The business buys these economic resources from households. For example, let’s say you work at the diner. You are selling and the diner is buying your

labor resources. Those homemade fries come from potatoes―a natural resources―bought from a local farm, which is owned by a household. The new milkshake machine and french fry cutter―capital resources―were bought from a business three states over and the stockholders of that business

are members of households. Finally, the diner itself is owned by Alice, who is a member of a household and an entrepreneur who has turned her skill of making the best homemade fries in town into a successful business.

In exchange for their resources, households earn income. Each resource has its own income category. Households receive wages for their labor, rent for use of their land, interest for use

of their capital, and profit for their entrepreneurial ability. For working at the diner, for example, your income would be wages paid in the form of a paycheck at the end of the month. So, in the market for resources, households sell resources and businesses buy resources.

The resources flow one way (counter-clockwise) and money flows the other (clockwise). At this point in the cycle, households sell resources to businesses. So, households are holding income and businesses are holding resources. But, what do households do with

the income? What do businesses do with the resources? To answer these questions, let’s focus on the bottom of the model, the market for goods and services, where the goods and services produced by businesses are bought.

Let’s start with businesses. Businesses use the economic resources they buy in the market for resources to produce goods, such as computers and bicycles, and services, such as haircuts and car repairs.

Businesses sell these goods and services to households in the market for goods and services. For example, the diner produces cheeseburgers, fries, and milkshakes. Households use part of their incomes to buy goods and services. The payment businesses

receive is called revenue. For example, at the diner, revenue comes from customers paying for their food. In short, the market for goods and services is simply where the goods and services produced

by businesses are bought. So, in the markets for goods and services, businesses sell goods and services and households buy goods and services. Products flow one way (counter-clockwise) and money flows the

other (clockwise). Let’s step back a bit and notice a few things about the circular flow model. First, it shows how businesses and households interact in the two markets―the market for

resources and the market for goods and services. Notice that households and businesses are both buyers and sellers. Households are sellers in the market for resources. Households sell land, labor, capital, and

entrepreneurial activity in exchange for money, which in this case is called income. Households are buyers in the market for goods and services. Households exchange income for goods and services.

Businesses are sellers in the market for goods and services. Businesses sell goods and services in exchange for money, which in this case is called revenue. Businesses are buyers in the markets for resources. Businesses exchange the revenue earned in

the market for goods and services to buy land, labor and capital in the market for resources. In this case, the money spent is called the cost of production. Second, the model shows the flow of money in exchange for goods and services and resources.

Money flows clockwise, while goods, services, and resources flow counter-clockwise. The circular flow model is a simple tool for learning about the economy. It shows the relationship between households and businesses and how these different decision-makers in the economy

fit together. Plus, it shows how money keeps economic resources and goods and services moving around and around and around the economy. And that’s something Alice appreciates.