Living Economics: Basic Circular Flow Diagram

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

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

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.

This image has an empty alt attribute; its file name is image-28.png
Notice the two circles.

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.

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