The Circular Flow Model

The Circular flow model is about how households and firms interact with each other in the economy. While Households trade factors of production to receive income from firms in the Factors of Production market. On the other hand, Firms produce Goods and Services by utilizing those Factors of Production. Such Goods and Services are sold to Households for Revenue in the Goods and Services Market.

The Circular Flow Diagram

Circular Flow Diagram

The Circular flow model explains how money is moved between Households and Firms in a loop. Land, Labor, Capital, and Entrepreneurship are the four factors of Production.

We start with the Factors of Production Market first. Here, Households sell Land, Labor, and Capital to Firms in exchange for income (wages, rents, and profits) paid by Firms. The Firms then use the Factors of Production to produce Goods and Services. The Goods and Services produced are sold in the Goods and Services Market.

In the Goods and Services Market, Households spend money to buy Goods and Services. While Firms sell Goods and Services to Households for Revenue. And, this goes on in a loop. In the Goods and Services Markets, Households are the buyers while Firms are the sellers. The opposite happens in the Factors of Production Market.

It is relatively easier to explain the economic interaction between Households and Firms through Circular Flow Diagram.

Circular Flow Model with an example

Now, understand it with the help of an example. To buy an iPhone, one has to go to the Goods and Services Market, the place where Firms sell their Goods and Services. We spend money in the Goods and Services Market to buy an iPhone. On the other side, we have firms that receive, the money we spend, as revenue.

The firms use revenue received to pay rent, wages, etc. for utilizing factors of production. The factors of production, which are traded in the Factors of Production Market, help them make an iPhone.

The income received by Households is used to spend again on other Goods and Services. And, all of this works in a loop.

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