2.5 The Circular Flow Model

Notes

The circular flow model shows how money, goods and resources move through a market economy.

• Households own the factors of production and buy goods and services. Firms buy factors of production and make goods and services.
• In the product market, households buy goods and services from firms. Money (spending) flows to firms; goods flow to households.
• In the factor market (resource market), firms buy land, labor, capital and entrepreneurship from households. Money (rent, wages, interest, profit) flows to households; resources flow to firms.
• Money flows one direction around the circle, and goods and resources flow the opposite direction.
• Government joins the flow: it collects taxes from households and firms, buys goods in the product market, hires workers in the factor market, and provides public goods and transfer payments.
• Worked example: a teenager is paid $120 for a week's work at a grocery store (factor market) and spends $30 of it on a phone case (product market).