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As you have learned, an economy is a complex system of interacting parts used to coordinate decisions about the use of scarce resources. In an economy that relies on markets for the coordination of decisions, economic activity can be grouped into three main types:
EXAMPLE
Have you ever been in a situation where you felt overwhelmed by all the responsibilities you carry? You have to take care of your family and your home, work every day so you can pay the bills and keep a roof over your head and food on the table. If so, at some point you probably wished there were two of you. With two of you, the load would become lighter and you would be able to catch your breath. There is value in recognizing you can’t do it all. This same conclusion is true for households, firms, and governments. If businesses will make the stuff we want, then households are willing to trade time to earn a paycheck. And with a healthy paycheck, we buy the services of others to make our life easier. Depending on one another makes life easier.One way to visualize the interaction and the economic activity connecting sectors and markets is to use a diagram. A circular flow diagram is a simplified model that shows the basic economic relationships in a market economy. The diagram provides an overview of how households, firms, and governments interact in different markets as they exchange resources, goods and services, and money.
Let’s begin our review of the circular flow diagram by examining the makeup of the resource markets, and then move on to the product market before we put it all together in the complete circular flow diagram.
As you learned in Unit 1, markets are any arrangement that brings buyers and sellers together to exchange goods and services for money. The exchange of resources occurs in the resource markets. Resources are sometimes referred to as factors of production. The factors of production are the economic resources an economy has available to produce goods and services, including land, labor, capital, and entrepreneurship. A resource market is any place where the factors of production are bought and sold. It brings together the owners of resources together with the business firms that produce goods and services. We will refer to businesses as firms. A firm is an economic institution that transforms factors of production into goods and services.
EXAMPLE
Walmart and FedEx are business firms, as are your local dentist, plumber, store owner, and the neighborhood school. Each is a firm that produces a good or service. Each firm needs to purchase factors of production in the resource market, such as hiring workers, buying capital equipment like computer systems and software and vehicles for transporting products, or buying raw materials derived from nature, such as petroleum products, minerals, and water.Each factor of production is bought and sold in its own market. There is a market that brings together buyers and sellers of land, of labor, of capital, and of entrepreneurship and involves a payment as compensation for its use.
The following table describes the four types of resources (or the factors of production used by firms) and identifies the form of payment received by the seller.
| The Four Factors of Production | |
|---|---|
| Land | Land refers to nature’s gifts, such as trees, water, mineral, and wildlife resources that can be used for the production of goods and services. When land is used, payment is in the form of rent. |
| Labor | Labor is human effort. When labor is used, payment is in the form of wages. |
| Capital | Capital consists of man-made resources that can be used to produce goods and services as well as human capital, which is the accumulated knowledge, skills, and experiences of workers. When capital is used, payment is in the form of interest. |
| Entrepreneurship | Entrepreneurship is a form of labor but unlike labor it involves the creation of a business. Payment for entrepreneurship is in the form of profit. |
In the economy households are the owners of resources. Like a firm, a household is an economic institution. A household is a group of individuals (such as a family) living together and making joint decisions. Households are suppliers of land, labor, capital, and entrepreneurship to the economy. Collectively, the members of households make decisions about what resources will be made available to firms or governments that produce goods and services. They do this through decisions such as determining which members of the household will sell their labor in the labor market and for how many hours, or deciding how to spend the income earned. Households’ decisions about providing labor will determine how much labor businesses will have available to employ. Households’ decisions about land resources will determine how much land will be brought into cultivation for crops. Collectively, households own all resources; land, labor, capital, and entrepreneurship in an economy.
When households transfer the use of or sell resources in one of the resource markets, they are then compensated with payment. If a household sells labor time to a firm or government, then the household earns wages. If a household creates a business of any type using its entrepreneurial skills, then the household is compensated in the form of profit (or loss). Having earned income, households then create the demand for goods and services when they spend the income they earned. Household spending decisions will determine what business firms will be able to sell. In doing so, households impact the success or lack of success of businesses in the economy.
A household's income will depend on both the quantity of the resources it owns and the value society places on those resources.
EXAMPLE
Suppose that the Jones household owns a set of high-quality resources. Ms. Jones has a master’s degree in engineering and Mr. Jones has a bachelor’s degree in mathematics. The market for engineers and the market for mathematicians value both skills highly, so the Joneses will be compensated well at their respective workplaces, and their household income will tend to be high.The portion of the circular flow diagram below illustrates the interactions of buyers and sellers in the resource market.
The diagram above shows that in the resource market, households selling land, labor, capital, and entrepreneurship are compensated by firms. Firms purchase those resources to make their products.
If you seek a job, you are participating in the labor market. If you own land, you can rent or sell it in the land market. Capital and entrepreneurial skills are for sale in their respective markets, too. We will delve more deeply into each of these four types of resource markets in Unit 4.
Firms transform the factors of production purchased into goods and services. These goods and services are sold in product markets. A product market is any place where goods and services are bought and sold. Product markets are as varied as the goods and services offered for sale. There are auto repair markets, housing markets, shoe markets, and so on.
EXAMPLE
Consider grocery shopping as an example of the product market. When you shop for groceries you physically take goods home with you after shopping. The product market includes both goods and services. When you get a haircut at a salon, you do not bring a physical good home with you, but you purchase a service in the product market.The diagram below is the portion of the circular flow diagram that relates to the product market.
The diagram above shows that in the product market, households purchase goods and services made by business firms and that firms, in turn, earn income from the sale of their products.
Governments also purchase factors of production in the resource market, which enables them to provide goods and services such as the following:
In microeconomics, our focus is mainly on the interaction between households and business firms. When you study macroeconomics, you will consider the broad economy and learn about the important role played by the government.
As you have learned, the circular flow diagram is a tool that helps learners visualize the interdependencies between economic agents and markets in a complex economy. So far, we examined the interactions of households and firms with respect to product markets and resource markets.
The diagram below is the portion of the circular flow diagram that shows the flows of physical transactions as they move through the economy.
Notice that in the diagram above, the arrows move in a clockwise direction. The diagram traces the flow of physical transactions through the economy, which begins in the resource market. It shows that households sell land, labor, capital, and entrepreneurship in the resource market. Firms enter the resource markets to purchase the factors of production (land, labor, capital, and entrepreneurship). The interactions continue in the product market. Firms create goods and services to sell in the product market. Households in need of goods and services enter the product markets to purchase goods and services.
EXAMPLE
Next, we will study a portion of the circular flow diagram that maps the flow of payment transactions through the economy.
Notice that in the diagram above, the arrows move in a counterclockwise direction. The diagram shows that the flow of payment transactions through the economy begins in the resource market. Firms compensate the owners of resources by paying rent for the use of land, wages for the use of labor, interest for the use of capital, and profits to entrepreneurs. Households, having earned income, then enter the product markets and buy goods and services. Firms selling goods and services earn revenue on each sale.
EXAMPLE
When you study macroeconomics, you will discover that when the relationship between firms and households becomes unbalanced, troubling problems emerge. Unemployment of workers may appear in the labor market. Or unstable price changes may occur in the product markets. These problems will require the introduction of the government sector because it is responsible for addressing such problems.
The complete circular flow diagram below pulls together all of the partial diagrams we have reviewed, mapping the complete flow of both physical stuff and the monetary transactions. Notice that there is a small circle in the middle of the diagram. This circle represents government. You will learn more about the relationship among government, firms, and households if you study macroeconomics.
We began this lesson by explaining that the economy is a complex system of interacting parts. Now that you have learned about the circular flow of economic activity, you might recognize that the economy is like a living organism, in that it is highly organized with different interdependent parts filling different roles and completing different tasks. Each part has a specific purpose and activity to complete. If you choose to study macroeconomics, you will learn more about the circular flow diagram from the macroeconomic perspective.
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