This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy. The inner circle shows this and represents the two sides of the labor market in which households supply and firms demand. Households sell their labor as workers to firms in return for wages, salaries, and benefits. The outer circle shows this, and represents the two sides of the product market (for example, the market for goods and services) in which households demand and firms supply. In the diagram, firms produce goods and services, which they sell to households in return for revenues. The circular flow diagram simplifies this to make the picture easier to grasp. Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. Arrows “C” and “D” represent the two sides of the factor market. In return, firms pay for the inputs (or resources) they use in the form of wages and other factor payments. land, capital, raw materials) firms need to produce goods and services in the market for inputs (or factors of production). Where do households obtain the income to buy goods and services? They provide the labor and other resources (e.g. Arrows A and B represent the two sides of the product market. Households pay for goods and services, which becomes the revenues to firms. In the labor market, households provide labor and receive payment from firms through wages, salaries, and benefits.įirms produce and sell goods and services to households in the market for goods and services (or product market). The direction of the arrows shows that in the goods and services market, households receive goods and services and pay firms for them. The Circular Flow Diagram The circular flow diagram shows how households and firms interact in the goods and services market, and in the labor market. It pictures the economy as consisting of two groups-households and firms-that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees. Companies often build models of their new products, which are more rough and unfinished than the final product, but can still demonstrate how the new product will work.Ī good model to start with in economics is the circular flow diagram ( ). We use models to test theories, but for this course we will use the terms interchangeably.įor example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Strictly speaking, a theory is a more abstract representation, while a model is a more applied or empirical representation. Sometimes economists use the term model instead of theory. A good theory is simple enough to understand, while complex enough to capture the key features of the object or situation you are studying. If done well, this enables the analyst to understand the issue and any problems around it. The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. A theory is a simplified representation of how two or more variables interact with each other. These assumptions tend to be different than the assumptions an anthropologist or psychologist might use. They analyze issues and problems using economic theories that are based on particular assumptions about human behavior. Watch this video about John Maynard Keynes and his influence on economics.Įconomists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline.
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