ECS 1501
Topic 5 – Circular flow model
Content
There are many sectors in an economy,
however one sector cannot work without
being affected by others
In this study unit we will examine how the
goods and factor markets work together
Introduction
The circular flow model is a simplification of how the
economy works.
In a complete circular flow model, the interaction
and interdependence between the major
participants (households, firms, government and the
foreign sector) in the various markets (factor, goods
and financial) are captured.
The three major flows
Production,
income and
spending Spending
are all
flows Production
Income earned in the
production process is spent
to purchase products
Production
creates
income
Income
Stocks and Flows
Stock (stock variable) Flow (flow variable)
Has no time dimension and Has a time dimension and
can only be measured at a can only be measured over
specific moment a period of time
Eg. A shopkeeper who takes Eg. The water flowing out of
stock a dam is measured over a
certain period
Markets
Goods Market Factor market
• Market for goods and • Market for various factors
services of production
• In macroeconomics we • Factor markets include the
treat the goods market as if labour markets and markets
there were only one market for capital goods
for all goods in the • In macroeconomics we
economy (aggregation) aggregate the factor
• In microeconomics, markets markets
are analysed individually • In microeconomics markets
are analysed individually
Households and firms
Households
• Household = All the people who live together and make joint economic
decisions or who are subjected to others who make such decisions for them
• Households are the basic decision making unit in an economy
• Members of households consume goods and services to satisfy their wants,
they are consumers
• Consumption (C) = the act of consuming goods and services
• Households/consumers largely determine what should be produced in a
market economy
• Households sell their factors of production to firms who combine them to
create goods and services
• They receive income from the firms in the form of wages, interest, profit etc.
Firms
• Firm = unit that employs factors of production to
produce goods and services that are sold in the
goods market
• Firms are engaged primarily in production
• Firms always aim to achieve a maximum profit.
• Profit is the difference between revenue and cost
• Capital is one of the factors of production purchased
by firms
• The act of purchasing capital goods is called
investment or capital formation (I)
Factor market and goods market
Goods and Goods and
Services Services
Goods Market
Firms sell consumer goods in Households purchase
the goods market consumer goods in the
goods market Households
Firms
Firms combine factors of
production and produce
consumer goods
Firms purchase factors Households sell their
of production in the factors of production
factor market in the factor market
Factor Market
Factors of Factors of
production production
Real and nominal flows
Income Spending
Goods Market
Income of firms Households purchase
represent the spending goods and services in
of households the goods market
Firms
Households
Income of the households
Firms purchase factors of represents the spending of
production in the factor the firms
market
Factor Market
Spending Income (wages;
profit etc)
End