Click to add text The Circular Flow of Income By David Anthony Siddall

Circular Flow Model Economists use the circular flow diagram to illustrate the basic mechanics of an economy and to illustrate the basic function of markets. For simplicity, we will first look at the circular flow model for a closed economy (one that is not trading with other economies).

Circular Flow Model

A household may be a person or a group of people that share their income. A firm is an organisation that produces goods and services for sale.

Factor Markets The points of exchange when individuals sell their resources (land, labour, capital, and entrepreneurial ability) to firms for money. Firms will demand these resources to produce goods and services. Prices paid for the use of resources are determined in this market, and will create the flow of rent, wages, interest and profit income to the households. Example: firms hiring workers

Markets for Goods and Services The points of exchange when firms sell their goods and services to households in exchange for revenue. Households demand these goods and services in order to maximise utility. Prices paid for goods and services are determined in this market, and will create the flow of revenue (income) for firms. Example: households purchasing televisions (goods) or meals in restaurants (services)

Each Group Both Buys and Sells Individuals or households function as both providers of resources and as consumers of finished products. Businesses function as buyers of resources and sellers of finished products.

Circular Flow Model: Open Economy The model we have just looked at is very simplified, assuming a closed economy. In reality, there are 'leakages' – some money will be saved, some taxed and some spent on imports. There is also additional spending – by government and by foreigners purchasing the economy's exports.

Circular Flow Model: Open Economy

Limitations of the Circular Flow Model Intra-household and intra-business exchanges are ignored. The model implies a constant flow of output and income – the reality is that these flows are changeable over time.

Questions In which market do individuals sell their resources (such as labour) to firms? The factor market Can you give an example of something that might be bought in the market for goods and services? Televisions (an example of a good) or meals in a restaurant (an example of a service)