Let’s take a tour of the circular flow by following a dollar bill as it makes its way from person to person through the economy. Hence, spending on goods and services flows from households to firms, and income in the form of wages, rent, and profit flows from firms to households. What’s left is the profit of the firm owners, who themselves are members of households. The firms use some of the revenue from these sales to pay for the factors of production, such as the wages of their workers.

The households spend money to buy goods and services from the firms. The outer loop of the circular-flow diagram represents the corresponding flow of dollars. Hence, the factors of production flow from households to firms, and goods and services flow from firms to households. The firms then use these factors to produce goods and services, which in turn are sold to households in the markets for goods and services. The households sell the use of their labor, land, and capital to the firms in the markets for the factors of production. The inner loop of the circular-flow diagram represents the flows of goods and services between households and firms. The circular flow diagram offers a simple way of organizing all the economic transactions that occur between households and firms in the economy. In these markets, households provide firms the inputs that the firms use to produce goods and services. In the markets for the factors of production, households are sellers and firms are buyers. In particular, households buy the output of goods and services that firms produce. In the markets for goods and services, households are buyers and firms are sellers. Households and firms interact in two types of markets. Households own the factors of production and consume all the goods and services that the firms produce. These inputs are called the factors of production. In this model, the economy has two types of decisionmakers-households and firms.įirms produce goods and services using inputs, such as labor, land, and capital (buildings and machines).

Above Diagram presents a visual model of the economy, called a circular flow diagram.

Circular flow model example