Lesson 9: Circular Flow Model
Objectives: Students will analyze who resources flow through a market and between the major decision
makers of the market.
Materials Required: none
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Welcome back students. Today we are going to apply the last two lessons to this lesson. In this lesson,
we are going to reference back to the major economic decision makers and resources and see how all of
these things flow through a market. Before we being, answer the following two questions:
1. What are the four resources in a market?
2. Who provided these four resources?
Ready?
To answer the first question, it is land, labor, capital, and entrepreneurial ability. These are for major
resources in any market and they are used to produce goods and services. To answer the second, all
resources are provided by households in the market. Households are the most important group in any
economy, and that’s primarily because resources are provided by them. Without them, there can be no
production.
So now to understand their role, and the role of others in the economy, we are going to discuss the
Circular Flow Model. The “Circular Flow Model” is the flow of resources, products, income, and revenue
among economic decision makers. It is the way economists show how all things flow throughout the
economy. See Figure A below. As we can see, on the top and bottom of the graph are the resource and
product markets. We have to understand what these two markets are before we move forward. A
resource market is the place were resources are bought and sold. A product market is where goods and
services are bought and sold. So let’s begin with the inner orange ring of the cycle.
In the orange cycle, it starts with the Households. Households sell their resources to the resource
market, where it is bought by firms (business) as resources. Firms buy these resources and convert them
into goods and services, which are brought to the product market. At the product market, households
buy goods and services.
This is where the outer ring starts. In the green ring, we see that for those goods and services,
households engaged in “consumption expenditure” (buying goods they want). From there, the firms
received revenue for the goods and services they bought. However, we know nothing is free, and to
produce those goods and services,
the firm had to pay for the
resources, which is shown by
“costs”. These costs were the
result of the firm buying resources
from the household. These costs
to the firm translate into income
for the household, which is shown
by the top right arrow on the
cycle.
What this model shows is that as
resources flow the market and
turn into goods and services,
money flows in the opposite
direction. It is a constant flow of
resources and money in the
economy.
Figure A
Now while this is the general circular flow model used in most basic classes, there is another form of this
model that includes the government as well. See Figure B below.
Figure B- Note, this graph is flipped upside down, with the product market on top and the resource
market on bottom.
Since you have an idea of how to read the original circular flow, I will not go too deep into the details.
What you need to understand is that the government does have a role to play in the model, primarily
through the use of taxes. The government taxes both firms and households and uses that money in
several ways:
1.
2.
3.
4.
To provide grants to business to try and stimulate economic growth
Provide welfare to the households, such as food stamps, Medicare, Social Security, and more.
To buy resources from the resource market and use them to make products for government use
To buy goods and services from the product market
Note that the role of the government here is outside of the flow. The flow of resources and money
happens regardless of government interference (assuming that they are not the sole firm, such as in a
communist regime). The government simply uses taxation as a means to fund their own activities and
activities that benefit the economy, such as redistributing money or ensuring the placement of social
safety nets, among other things. Again, as mentioned before, we will discuss in more detail the role of
the government in future lessons.
Closure: the most important thing to take away from this lesson is understanding how resources in a
market flow. As we saw in Figure A, money flows in the opposite direction of resources, because money
is used to purchase those resources or pay for those resources. It’s also important to understand the
implications of an uninterrupted flow of resources, because if the flow of resources is broken, we as a
nation can see the large scale problems that follow, such as recessions and depressions in the economy.