MGT Notes

Reference, ‘Principles of Economics,’ by N. Gregory Mankiw, 3e, Pg 24

Since there are numerous activities going on in an economy at the same time, there is a need for a model to simplify the understanding of these activities. A Circular Flow Diagram conceptualizes the organization of an economy and how its participants interact. This diagram assumes just two decision makers – firms and households. Firms produce goods and services using Factors of Production (land, labor, capital). Households own the factors of production and consume the outputs of firms.

Two types of markets are hypothesized in the above model. In the markets for goods and services, households are buyers and firms are sellers while in the markets for factors of production, the households are sellers and firms are buyers.

The circular nature of the diagram comes from looking at the flow of inputs & outputs and the flow of dollars. Outputs flow from the markets for the factors of production to the firm, who sell products in the markets for goods and services. These goods are consumed by households who then provide inputs into the markets for the factors of production through employment and investment. Dollars flow from households into the markets for goods when they purchase items. These dollars then move to firms, who then pay for expenses and then the rest go to households of business owners.

This is a very simplified form of understanding the economy. This does not include the role of other parties such as the government and international trade.