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Microeconomics

Learn the toughest concepts covered in Microeconomics with step-by-step video tutorials and practice problems by world-class tutors

Basic Principles of Economics

Circular Flow Diagram

The circular flow diagram shows the interaction between households and firms (producers).
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Households and Firms

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Alright, so now we're gonna look at a diagram that helps us simplify the inner workings of an economy. The circular flow diagram, it's a model that illustrates the relationship between firms households, goods and services and the factors of production. So let's go ahead and define what the household and the firm are, and then we'll move down into the diagram first we have households and households we define as a person or a group of people that share income, they don't necessarily have to be related, they just have to share income. And a quick note, I want to say, is that the households Mhm. Own the factors of production, households. Excuse me, households own the factors of production, they own the resources, I'll put resources. Okay, and you might think, hey there's firms that I know um companies that own the land that they're building is on. Well, the idea is that in the end the households own those companies, right? It's actually people who own the companies that own the land. So in the end the households own all the factors of production, they own the resources. Uh So next we have the firm and the firm is an organization that produces goods and services. Pretty simple. Uh They take the factors of production, they take the resources that are sold by the households and they turn it into goods and services. So let's look at this on the diagram
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The Circular Flow Diagram

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So here we have an empty circular flow diagram um and we're gonna fill it in now. Mine didn't totally fit on the screen, but I think we're gonna be okay. Um Let's start by putting the households and the firm's here on our circular flow diagram. So here we'll put the households on the on the right and remember that the households own the factors of production, right? They own those resources. And on the left will put the firms and they're gonna interact in two marketplaces. Up here, I'm gonna put the market for goods and services. Um I'm just gonna put market for goods. But that includes services as well. And down here we'll have the market for resources, right? The factors of production, market for resources and these resources, right? This includes not only the labor that the households are going to provide to the firms, but also includes things like the land, right? They own all the factors of of production and they're selling it to the firm's here. So let's start with the interaction of the household with the market for goods. Okay. So they go to the market for goods and they buy they buy goods, right, households, you go you buy cereal, you buy a tutoring service, right? Anything you're buying goods in the market for goods and services. Um And in return for that, they spend money, they're gonna spend their money, right? We're gonna use this green to represent the flow of money, so they spend their money, maybe the earnings that they have and they spend it there in the market for goods and let's look at the firm's interaction with the market for goods. So firms um they they produce the goods and services and they bring them to the market for goods for sale, so they actually sell their goods and services in the market for goods, let's go to our green and what do they get in return? So in return for selling the goods and services, they get revenue right, they get money from the households in that sense. Now let's see how the households interact with the market for resources. So like I said the households own the resources. So when they go to the market for resources, they are selling their resources. So you can kind of see how this goes back and forth here. I'm gonna knock myself out of here for a second, just so I'm not in the way. Um And for selling those resources, they are going to receive let's say income, right? They could get wages, they could get rent for their land, something like that, so that's the flow of money right there in green. And let's do the final part, let's do firms and the market for resources. So firms go to the market for resources uh to buy the inputs for their production. So they're actually buying resources here uh there by resources and they are going to be paying money for this. So we'll draw the arrow this way, the money going this way and we can say they're paying, let's say in the form of wage wages or rent, right? Um And that's kind of how you can see the flow right, The inner circle is flowing clockwise, so the household sell their resources that get bought by the firm and the firm produces the goods that it sells to the to the households, just like the other way. You see the money flowing in the opposite direction, right? So let's summarize back up here. If you go back to the top of the page, let's summarize all this information real quick. So we have the households that are buying goods and services and selling the resources. I'm gonna put here, resources and firms are buying resources and selling goods and services. So there is your circular flow diagram.
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