![]() ![]() Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve. Rather, they use the graph of the theory to help them figure out the answer. In this course, we will mostly use graphs.) Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Economists express theories as diagrams, graphs, or even as mathematical equations. Then they use the theory to derive insights about the issue or problem. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports).Įconomists carry a set of theories in their heads like a carpenter carries around a toolkit. 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. land, capital, raw materials) firms need to produce goods and services in the market for inputs (or factors of production). Arrow “C” indicates this. In return, firms pay for the inputs (or resources) they use in the form of wages and other factor payments. Arrow “D” indicates this. Arrow “B” indicates this. Arrows A and B represent the two sides of the product market. Where do households obtain the income to buy goods and services? They provide the labor and other resources (e.g. 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 shows how households and firms interact in the goods and services market, and in the labor market. The third line shows imports that the home country receives the fourth line shows the payments that the home country sent abroad in exchange for these imports. The top line shows exports of goods and services leaving the home country the second line shows the money that the home country receives for those exports. 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.įlow of Investment Goods and Capital Each element of the current account balance involves a flow of financial payments between countries. ![]() A good model to start with in economics is the circular flow diagram. ![]()
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