The Circular Flow

1. The Circular Flow The simple circular flow model of the economy is designed to have us understand the basic operations of the economy

2. 8 Markets for factors of production (resources) 5 1 2 Households Businesses 4 3 Markets for good and services 7 6

3. The simple circular flow In the simple circular flow model we have two players of the economic game: Households and Businesses. Households are: sellers of all inputs, or factors of production (the resources land, labor, capital and entrepreneurial ability), and buyers of all output of good and services. Businesses are: Buyers of all inputs and sellers of all output. On the next slide I jump into the circular flow in a somewhat arbitrary place because the system is operating in all places, but we have to start our discussion somewhere.

4. Starting at the box with households, let’s follow flows 1 through 4 in a counterclockwise fashion. Flow 1 – Households sell their land , labor, capital, and entrepreneurial ability in the market for resources. Flow 2 – Businesses buy these factors of production and use them to make goods and services. Flow 3 – Businesses sell the goods and services made. Flow 4 - Households buy the goods and services. So, when we start at the households and go counterclockwise from 1 to 4 we will follow the flows of what are called “real” things – the resources and the goods and services made. These are what are really important in the economy because these are the items used to create our standard of living.

5. Roundabout production – the making of capital goods. The simple circular flow here is a simplification of the economy. While it is true that people own resources, much of the capital accumulation is done at the corporate level. Here is a simple story to make a point. Think back to primative man. How did they catch fish? I am speculating that primative man first crouched by the water and tried to catch fish with bare hands. Pretty hard job. Later, primative man figured that if nets or rods were first made, then later more fish could be caught than if just caught by hand. Making a net is an investment in a capital good and is a roundabout method of production. Today, firms undertake a great deal of this investment because it enhances productivity.

6. Next we look at flows 5 through 8 and these are financial flows and we see a connection between spending, revenues, and income. Flow 5 – The households payment after selling resources in the factor markets is called income. Flow 6 – When the households buy stuff they pay for it and the term used in the national economy sense to represent this buying is spending or consumption expenditure. The households buy from businesses in the markets for output of good and services. Flow 7 – When the businesses sell goods and services to household the businesses collect revenue. (So, if we ignore government for now, expenditure = revenue).

7. Flow 8 – When businesses take in revenue from sales then they use the money to pay for the resources they have purchased in the markets for factors of production. Here we talk about costs of business. So the flows 5 through 8 are the financial flows that correspond to our “real” flows. The simple circular flow model is a simple model of the day to day operations of the economy. Much of the rest of the course will be filling out more realistic parts of the story.

8. Flows 1 through 4 are flows of inputs (resources) and output (goods and services). Flows 5 through 8 are flows of money. The flow of money is one way we account for the flow of resources and goods and services. Analogy – A grocery store We look at the revenue of a grocery store to get a feel for the output amount – but we know the output is made up of items like milk, cheese, steak, etc… We look at expenses to get a feel for amount of inputs used – but we know the inputs are hours of labor, watts of electricity used, and so on.

9. The last idea I would have you think about here is that while resources are turned into output 1) The output, or production, has a dollar value, 2) The resources used get paid income, and 3) The dollar value of production = income of resources. In other words, someone must earn an income when production occurs. The two values are equal in dollar amount.

10. Final thought Our economy is large and complex. Each individual business has a pretty decent grip on what resources are being used and can probably make a list of what those resources are on a sheet of paper – you know, labor, cash registers, and on and on. Each individual household knows what goods and services are being bought and can probably make a list of those items on a sheet of paper – you know, cookies, milk, and on and on. In our large complex economy it would be difficult to get these lists from businesses and households. But we have come up with ways to get at the money flows. Often our focus will be on money flows when we really want to talk about the lists.