Circular Flow
| Author | Roger Luft |
| Pages | 115-117 |
Page 115
Circular flow describes how a market economy works. A market economy is one in which individuals influence directly what is produced, marketed, and consumed. Individuals do this by spending money on what they want. This then directs producers to produce goods and services that individuals will consume. The amount of goods and services that are made available is related to the laws of supply and demand.
A model that best depicts how goods and services flow in exchange for money is called the circular flow model, shown in Figure 1.
The primary participants in the circular flow of goods and services are businesses and households. Households are made up of individuals who both spend money and are the recipients of money. Businesses do the same—they spend money and also receive money from households. It is important to note that the flow of goods and services is in one direction in Figure 1, while the flow of money expenditures is in the opposite direction. Both flows make a complete circle—hence, it is called the circular flow of goods and service.
There are two types of markets in the circular flow of goods and services. The resource market is where businesses purchase what they use to produce goods and services. Resources are in the form of labor, natural resources, capital, and entrepreneurship, all of which are supplied by households.
If, for example, a business wants to build a small plant to produce electronic equipment, it must have land on which to build the plant. In the process of building the plant, it uses human laborers who in turn use natural resources to construct the building. Capital to complete the building comes ultimately from households, usually by means of some type of financial institution that lends money to the entrepreneurs (who also come from households) to construct the electronics plant.
Product markets are where goods and services are sold. In the case of the plant that produces electronic equipment, the outlets for its products might be retail stores. Members of households purchase the equipment for their own use in the household. Pieces of electronic equipment are purchased by the households that also provided the resources that made it possible to build the product. The outside circle of the process shown in Figure 1 has been completed.
In the reverse direction is the flow of spending. Beginning...
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