THE FLOW OF A MARKET:
CIRCULAR FLOW CHART
Explain the circular flow of economic activities &
how interactions determine the prices of goods &
services
GETTING THE IDEA
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It is common to hear that there is
a circular flow of economic
activity
This means economic activity is
an ongoing, two-way relationship
between:
o The factor market (individuals)
o The product market (business)
THE FACTOR MARKET (HOUSEHOLDS)
THE FACTOR MARKET (HOUSEHOLDS)
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The factor market is where
businesses buy two factors of
production:
o Labor to do the work
o Capital to buy the things needed
to create the service or product
Households are the source
(supply) for both of these factors
of production
HOUSEHOLDS
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Provide labor in the form of
household members
Provide capital in the form of
savings available to invest in
capital in the form of:
o Land
o Trucks
o Machines
o Raw materials
o Other things needed for
production
HOUSEHOLDS
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The amount of money available
to pay for capital & labor
determines how much the firm
can produce
The amount of money a
household earns selling the
factors of production determines
how much it can consume &
save
HOUSEHOLDS & LABOR
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The price of labor is
determined in the market
Households offer their
labor to firms for a price
and firms offer a price for
labor
HOUSEHOLDS & LABOR
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When a household & a business agree on a
price for labor & the amount of labor to be
provided then the household member agrees to
work for the firm
o This agreement is a contract
o The price may not be determined on the
first round of offers
o It may take a series of offers & counteroffers to arrive at a price that both sides
agree upon
HOUSEHOLDS & CAPITAL
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The price of capital (interest)is
the rate of return that
households require firms to pay
to get the households to invest
in the firm
The investment can be:
o A loan (also called a bond)
o Equity (also called stock)
HOUSEHOLDS & CAPITAL
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A base interest rate is usually set by each country’s central
bank
o That is the lowest interest rate that any household would accept
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on a loan
o Usually loans to businesses are at higher interest rates than the
rate set by the central bank
The rate of return on equity is the amount of profit available to
each owner divided by the owner’s investment
If a firm does not offer a high enough rate of return, then
households will not invest in the firm
THE PRODUCT MARKET (BUSINESSES)
THE PRODUCT MARKET
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Is where firms supply
goods & services for
sale to households
Households buy the
goods & services they
need or want to
consume & do not
buy the others
THE PRODUCT MARKET
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If the firm can sell its product for
more than the cost of producing
the products, the firm has a profit
o The profit is paid out to the owners
(equity holders)
If the firm does not make a profit,
there is nothing to pay the owners
o This type of firm will not be able to
get more equity to buy capital & will
go out of business
THE CIRCULAR FLOW OF ECONOMIC ACTIVITY
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The households return the money either by purchasing
goods & services or by investing in the firm
Money is flowing one way for products; factors of
production are flowing the other way
These flow require both firms & households
o Also create the economic interdependence of the participants
in the economy
o Households & firms need each other to keep the economy
going
THE CIRCULAR FLOW OF ECONOMIC ACTIVITY
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Is the flow of money from
firms to households as
wages & salaries
Households either spend
the money on products
for consumption or save
the money to generate
income in the future