Living Economics: Basic Circular Flow Diagram

*The game referenced in this article is ‘The Tribez‘ offered by Game Insight UAB.

Each country’s economy is a cycle ~ a system of steps forming a self-repeating flow of activity.

Companies are attracted by the potential for profits to produce new goods. ➞ They hire workers and input capital needed ➞ New goods and services are designed that meet customer needs ➞ The new resources are offered for sale on the market to consumers ➞ Consumers take the money from their jobs to purchase resources and offer companies profits ➞ Companies are attracted by these profits to continue producing goods or to develop new goods ➞ They hire workers and input capital needed ➞ New goods and services are designed to meet customer needs ➞ The new resources are offered for sale on the market to consumers ➞ Consumers take the money from their jobs to purchase resources and offer companies profits ➞ and so the circle continues.

When any single part of the circle ceases to operate properly, trade may cease and the economy will collapse. For example, if consumers cannot find jobs, they will not have the money to purchase goods and services. Companies will cease production, laying off even more workers in a downward spiral of collapse.

The survival of each economy is dependent on careful resource management — ensuring that resources (labor, land, raw materials, money) are available when and where they are needed.


We can break the Resource Management cycle is divided into four stages, each containing the possibility for disruptions to arise and each having its own issues and concerns.


Create

We have discussed the types of resources previously. Limited or Unlimited, Natural or Man-made. . . . each variety incurs its own issues and needed strategies for resource production.

1) Is a resource ethically moral to produce? ➞ Production may be possible, but is it proper?

“Now, I am become Death, the destroyer of worlds.”

― Robert Oppenheimer (Father of the atomic bomb)

There are some resources that are both highly profitable and highly demanded, but are unethical and dangerous for society to produce. Examples might include prostitution, illegal narcotics, new diseases, and weapons such as the nuclear bomb.

2) Should the creation of the resource be legal?

Piano keys used to be produced with ivory overlays which are generally preferred to modern plastic keys. However, by the 1970s the creation of ivory was more or less illegal due to the impact on the elephant population. Today, although not many prefer them — most pianos are produced using the plastic keys.

Not all resources can be produced legally — either because of bans on the raw materials or the finished good. Generally these bans are the result of ethical interests or concerns over unnecessary consumption of limited / scarce resources.

3) Is creation in the current situation efficient or even possible?

Should Saudi Arabian government invest in the development of the forestry industry given that trees are a limited resource with high production costs? The island of Fiji does not have any diamond mines and are unlikely to find the creation of raw diamonds possible.

Consider the following: Spain is considering the production of Swords (⚔️ ) but has discovered that four other countries have lower costs of production (Italy, Japan, and Mozambique). Should the Spanish companies continue to produce swords even though they are less efficient than the competition?


Gather

Gathering involves collecting the resources and transporting either to manufacturers who will develop man-made materials or to retailers who will sell them to consumers. This is where Economics may readily overlap with Supply Chain Management decision-making procedures

1) How difficult or costly is it to gather the resources logistically?

National infrastructure offerings vary by country, the main alternatives are:

  • By Train or Railway
  • By Automobile
  • By Airplane
  • By Ship

Not all options are available in every country; for example, some countries have no railways and land-locked countries may find shipping impossible.

Nor are all options equally convenient or priced. . . . shipping tends to be relatively cheap but slow and with limited destinations available; flight tends to be faster but is more expensive and again has limited destinations.

2) Is it safe to gather or transport the resources?

Some materials require special strategies and plans for safe transportation and storage (e.g. dangerous chemicals, weapons, items not appropriate for exposure to children).

Where the materials need to be imported from abroad, it becomes even more complex as long term transportation becomes necessary and trade barriers arise.

3) Is the transport or gathering of these resources legal?

International supply chains can be particularly difficult due to national differences in shipping and distribution laws. Resources that are legal and available for use in one country may be illegal to transport across international borders. Even domestically, some resources are legal to create and own, but cannot be easily transported (e.g. China bans the shipment of knives or batteries in domestic shipping systems).


Trade

Trade is the exchange of one resource for another, and it is here that governments spend the majority of their focus.

Countries need to ensure that necessities and good resources are efficiently and properly traded, but also that dangerous or undesired resources are successfully prohibited.

The line between resources that are desirable for trade and those that are undesirable is not always as simple as legal versus illegal goods. There are many situations where a resource is both useful and legal, but is not necessarily a resource governments with to trade domestically or internationally. Examples might include the trade of weapons to underage minors or the sale of key national resources to foreign consumers.

In _____, mainland China experienced a major business scandal when a dangerous chemical (Melanine) was found inside the baby formula of Chinese producer Sanlu. Consumers rapidly shifted to purchasing formula from Hong Kong distributors instead, but this left Hong Kong with a growing shortage for local parents. In response, the HOng Kong government established a quota lim


Divide


The first economics model is the Circular Flow Diagram which depicts the national economy — the parties, the markets, and how they interact.

The Circular Flow Diagram

Although exceedingly complex as all the nuances are analyzed, the economy of a country is impressively simple when broken down to its fundamental elements.

In its most basic form, there are two key actors within an economy.

  • Households (producers of Factors of Production)
  • Firms (producers of Finished Goods)

There are two markets where goods and services are sold:

  • Market for Factors of Productionwhere inputs are sold.
  • Market for Goods and Services – where finished goods are sold.

In theory, the economy works in a circular structure:

  1. Households (workers & investors) offer labor and capital ($, Resources) in the market for factors of production.
  2. Firms purchase these inputs and produce finished goods and services.
  3. Finished products are offered for sale in the market for goods & services
  4. Households (buyers) purchase the finished goods.
  5. In order to finance their purchases, households offer labor and capital for sale.
  6. The circle continues

One can see how the circular flow develops. . . . and naturally, each of these transactions is a trade or exchange. Households give inputs in exchange for wages, income, and dividends. Firms give products in exchange for revenue.

In older economies, Bartering was popular where households and firms traded one resource for another non-monetary resource of similar value (Eggs for Milk; Goats for a Cow; A Haircut for a Shoe Polish).

This still exists in several countries where money remains an unreliable means of exchange; however most developed countries (and many undeveloped countries) have shifted to a system trading resources for a monetary currency (Dollars, Yuan, Yen, Pounds).

Therefore, the circular flow diagram has two circles each revolving in opposite directions to reflect the “exchange” aspect of the movement of resources.

  • 1) Money (internal circle)
  • 2) Resources (external circle)

Resources come; Money goes
Money comes; Resources go.

Two actors — Households and Firms

Two markets— Factors of Production; Goods & Services

Two circles— Resources & Money (Moving in opposite directions).

The Importance of the Circular Flow Diagram

The circular flow diagram demonstrates several key concepts for economists:

1) Trade is Necessary for the Economy

Trade is not just important to the economy – it is the lifeblood of the economic system. Where trade in one of the markets halts, it negatively effects all other factors.

E.g. When labor is no longer purchased from the market for factors of production, the households no longer have the money to buy resources from the market for finished goods.

Where firms cease purchasing factors of production; households cannot afford the finished goods

It is possible for the circular flow to collapse — when this happens, it can result in a recession or depression (broken economies):

  • Jobs decline in the market for factors of production.
  • Households have less money to purchase products and firms have fewer inputs
  • Firms eventually decrease production of finished goods
  • They need fewer workers, so jobs decline further.
  • As jobs decline, households decrease their spending.
  • First decrease production; which means fewer jobs.

Macroeconomics deals substantially which how to handle these types of situations.

2) Four Key Targets for Improved Efficiency

There are four places where resource management can be improved within the economy:

  • Decrease costs and improve value creation within the Market for Finished Goods and Services
  • Decrease costs and improve value creation with the Market for Factors of Production
  • Increase the population and welfare of households offering inputs and purchasing goods
  • Increase the population and welfare of firms offering goods and purchasing inputs

It is the economist’s job to identify which of these can be improved in any given economy and how.

3) The Market is Self-Sufficient

The economy is internally-driven as the actors and markets will drive the creation of necessary resources and incentives without outside influence.

One very important person is missing in the basic circular flow diagram – the government. The economy can (and has in the past) operated in areas and amongst parties that acknowledged no formal governmental institutions. The inhabitants of the “wild west” and the lawless ports thriving in the exploration age developed entirely valid economies often independent of the weak or absent governments.

The black and grey economies of the modern world are raking in billions of dollars annually in an entirely illegal system.

When a new need arises amongst buyers, the businesses (out of self-interest in profits) will naturally (without force) begin to create new goods to meet the social demand. When the interest fades, businesses again will decrease production naturally.

As companies increase production (to increase revenue), they hire more workers. This puts more money into the households who in turn purchase more products. Together firms and households can cycle upwards to success.

4) The Market is Self-Regulating

On a related note, the market is also self-regulating when operating properly.

That is to say, the market itself will drive out bad actors. Theoretically, when consumers are unsatisfied with a company, the households will cease to work for or buy from that company. It will eventually either adapt or go bankrupt. Either way, the undesirable behavior disappears from the system. The same is true for workers who fail to work satisfactorily or problematic buyers.

There are however three important caveats to the self-regulatory nature of the market:

A) Where the market is operating within a monopoly (few substitutes), the power of consumers to control a bad actor can be limited.

B) Where the actors collude to act as one monopoly, the power of the market may be limited.

C) The self-regulatory nature of the market depends on active, ethical consumption. Where consumers disregard unethical or illicit behavior in the market and continue to support bad actors, the market may fail to regulate such firms. Thus, most markets thrive in competitive situations where consumers have options and consumers are actively encouraged to use the power of a boycott.

In 1990s, the Southern Baptist Convention as well as other conservative institutions called for boycotts of Disney based on what they deemed unethical behavior. Other famous consumer boycotts include those against companies involved in child or low-paying labor; companies utilizing animal resources (e.g. furs); companies supporting certain charities; and more.

EconomyA country’s unique system of combining governmental, corporate, and individual factors in managing its resources
Circular Flow DiagramThe model depicting the relationship between households and firms and the trade of resources throughout the economy.
TradeThe mutual exchange of one item for another.
Market for Goods and ServicesThe market where goods and services are sold and moved into the economy
Market for Factors of ProductionThe market where inputs and maufacturing materials are sold to firms.
Factors of ProductionVaries, but generally includes land, labor, capital, and human capital
Self-RegulatingThe market regulates and controls the behavior of firms and households internally without the need for outside forces.
Self-SustainingThe market provides its own series of incentives driving firms and households to trade without the need for outside forces.
BarteringAn economy wherein one resource is traded for another (usually non-monetary) resource of similar value.
BoycottConsumers refuse to purchase or financially support companies or parties that they deem to be behaving improperly.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s