THE CIRCULAR FLOW MODEL

Economic activity in a market economy is based on the free flow of products and resources in free markets. A simplified circular flow model illustrates how goods and services are exchanged in free markets. Like any economic model, the circular flow model is a simplification of reality. The circular flow model shown in Figure 2.3 illustrates exchanges in two markets, the product market and the factor market. The primary actors in the circular flow model are households and business firms—the two main components of the private sector in the U.S. domestic economy. More detailed circular flow models sometimes include the role of government, financial institutions, and foreign firms in the conduct of business.

Product Market

The product market represents the purchases of finished goods and services in an economy. Households are the main buyers of goods and services in the product market, and businesses are the sellers of goods and services, as shown in the top half of Figure 2.3. From the circular flow model, it appears that the product market is a single physical location where products are bought and sold. But this is clearly not the case. Instead, the product market represents the millions of buy-sell transactions that are made every day in supermarkets, gas stations, convenience stores, department stores, bakeries, laundries, dentist and doctor offices, delis, and coffee shops.

The transactions that take place in the product market are based on the principle of voluntary exchange. That is, both the buyer (household) and the seller (business firm) believe

Figure 2.3 The Circular Flow Model

they will benefit from an exchange; otherwise, it will not take place. The spending by a household becomes revenue earned by a business. In an expanded version of the circular flow model, the government also appears as an important buyer of goods and services in the product market. For example, the government purchases military goods such as submarines and aircraft from private firms. Household and government spending become important sources of revenue for businesses.

In 2012 households purchased $11.1 trillion worth of goods and services in the U.S. product market. This staggering figure accounts for more than two-thirds of the country's gross domestic product—the total output of newly produced goods and services in the U.S. economy. Of this total, $3.8 trillion was spent on goods. Goods are tangible items. The two main categories of goods are durable goods and nondurable goods. Durable goods are items designed for long-term use, such as motor vehicles, household furnishings, and household appliances. Nondurable goods, on the other hand, are items produced for immediate consumption. Commonly consumed nondurable goods include clothing and footwear, food and beverages, and gasoline. The larger part of household spending was on services. Services are activities performed for a fee. In 2012 U.S. households spent $7.3 trillion on services in areas such as health care, transportation, recreation, and personal finance.^[1] The dollar value of transactions between households and businesses in the U.S. product market is, by far, the largest in the world.

Factor Market

The factor market, sometimes called the resource market, represents the purchase of resources in an economy. In the factor market, households are the sellers of resources, and business firms are the buyers of resources, as shown in the bottom half of Figure 2.3.

A river market in Thailand illustrates many features of a free market economy.

Again, the circular flow model makes it appear as though the factor market consists of a single location where resources are bought and sold. This model is a simplification of reality, however. In fact, every day millions of transactions take place throughout the United States in the factor market. How do factor market transactions taken place?

First, resources are owned by households and sold to businesses. These resources are called the factors of production—things that are used to make goods and services. The three main factors of production are natural resources, the gifts of nature; human resources, the human element in production; and capital goods, human-made items that are used to produce other items. Some economists also include entrepreneurship as a fourth factor of production. Entrepreneurship represents the innovative commercial ideas of entrepreneurs working on their own or within existing businesses. Resources have value because they are the main ingredients of production. That is, resources are transformed by businesses into items that households, government, and other businesses are willing to buy.

Second, the costs of production are the payments businesses make in exchange for the factors of production. Note from Figure 2.3 that the costs of production eventually make their way into the pockets of households, who own the factors of production. Some resources are owned directly by people in households. For instance, workers directly own their labor, and entrepreneurs own their special talents or skills. At other times, households own resources indirectly, mainly through their ownership of business enterprises—including the natural resources and capital goods that comprise the holdings of these business firms.

The main costs of production incurred by businesses are wages or salaries, which is the payment for human resources; rents, the payment for natural resources; interest, the payment for capital goods; and profits, the payment for entrepreneurship. The largest category of payments—and thus the largest source of household income—is wages and salaries. In 2012 private businesses paid American workers $5.7 trillion in exchange for their labor. Wages paid by government to public sector employees added another $1.2 trillion to household income. Individual proprietors earned $1.1 trillion from their own businesses.^[2] While workers' pay consists of wages and salaries, entrepreneurs often expect entrepreneurial profits in exchange for their labor. The term “profits” in this context refers to financial “above normal” compensation—a type of financial incentive to reward entrepreneurs for business innovation and risk taking.

Flows of Products, Resources, and Money Payments

The circular flow model also shows the two other flows: the flow of products (goods and services) and resources on the outer circle, and the flow of money payments on the inner circle. The outer circle shows that households willingly supply resources—human resources, natural resources, capital goods, and entrepreneurship—to businesses in the factor market. Businesses, in turn, transform these resources into finished goods and services for sale in the product market. Thus, the outer circle shows the things that are purchased in the factor market and the product market.

The inner circle shows the flow of the money payments as these payments travel through the American economy. In the factor market, businesses make money payments to households in the form of wages and salaries, interest, rents, and entrepreneurial profits. These money payments, which are the costs of production for businesses, become sources of income for households. Households, in turn, use their income to buy finished goods and services in the product market. This household spending on goods and services becomes revenues for businesses. Business revenues enable firms to buy resources from households— and so the money flow continues. In the American market economy, the flows in both the product market and the factor market are free from most types of government regulation.

• [1] U.S. Department of Commerce (DOC), Bureau of Economic Analysis (BEA), “Table 3: Gross Domestic Product and Related Measures: Level and Change from Preceding Period,” BEA News Release, February 28, 2013
• [2] DOC/BEA, “Table 2.6: Personal Income and Its Disposition (Years and Quarters),” March 1, 2013