Our First Model-The Circular Flow diagram

Circular flow diagram

A visual model of the economy that shows how dollars flow through markets among house holds and firms

The economy consists of millions of people engaged in many activities – buying selling, working, hiring manufacturing and so on. To understand how the economy works we must find some way to simplify out thinking about all these activities. In other words we need a model that explains in general terms, how the economy is organized and how participate in the economy interact with one another.

Figure presents a visual model of the economy called a circular flow diagram.


Firms: Produce and sell goods and services. Hire and Use factors of production –

Markets for goods and services: Firm sell. Households 

Households: Buy and consume goods and services. Own and sell factors of production 

Markets for factors of production: Households sell. Firms buy.

In this model, the economy is simplified to include only two types of decision makers – firms and households. Firms produce goods and services using inputs such as labor land and capital (buildings and machines). These inputs are called the factors of production. Households own the factors of production and consume all the goods and services that the firms produce.

Households and firms interact in two types of markets. In the markets for goods and services, households are buyers and firms are sellers. In particular households buy the output of goods and services that firms produce. In the markets for the factors of production households are sellers and firms are buyers. In these markets, household provide the inputs that firms use to produce goods and services. The circular flow diagram offers a simple way of organizing all the economic transactions that occur between households and firms in the economy.

The inner loop of the circular flow diagram represents the flow s of inputs and outputs. The households sell the use of their labor, land and capital to the firms in the markets for the factors of production. The firms then use these factors to produce goods and services which in turn are sold to households in the markets for goods and services hence, the factors of production flow from households to firms, and goods and services flow from firms to households. The outer loop of the circular flow diagram represents the corresponding flow of dollars. The households spend money to buy goods and services from the firms. The firms use some of the revenue from sales to pay for the factors of production such as the wages of their workers. What’s left is the profit of the firms owners who themselves are members of households. Hence, spending on goods and services flows from households to firms, and income in the form of wages rent and profit flows from firms to households.

Let’s us a tour of the circular flow by following a dollar bill as it makes its way from person to person through the economy. Imagine that the dollar begins at a household, say in your wallet. If you want to buy a cup of coffee, you take the dollar to one of the economy’s markets for goods and services such as your local Starbucks coffee shop. There you spend it on your favorite drink. When the dollar moves into the Starbucks cash register, it becomes revenue for the firm. The dollar doesn’t stay at Starbucks for long, however because the firm uses it t buy inputs in the markets for the factor of production. For instance Starbucks might use the dollar to pay rent to its landlord for the space it occupies or to pay the wages of its workers. In either case the dollar enters the income of some household and once again is back in someone’s wallet. At that point, the story of the economy’s circular flow starts once again.

The circular flow diagram is one simple model of the economy. It dispenses with details that, for some purposes are significant. A more complex and realistic circular flow model would include, for instance the roles of government and international trade. Yet these details are not crucial for a basic understanding of how the economy is organized. Because of its simplicity this circular flow diagram is useful to keep in mind when thinking about how the pieces of the economy fit together.