The Circular-Flow Diagram of Economics

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 our thinking about all these activities. In other words, we need a model that explains, in general terms, how the economy is organized and how participants in the economy interact with one another.

Figure 1 presents a visual model of the economy called a circular-flow diagram. 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 laser, 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 are 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, households 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.

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