In this illustration of the economic Lowdown video Series, economic education specialist Scott Wolla describes the circular circulation model. Viewers will certainly learn exactly how households and also businesses interact in the industry for resources and in the industry for goods and also services, and see just how money keeps the whole procedure moving.

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This video clip received the 2015 Curriculum silver Award from the national Association of financial Educators and was a 2014 gold Winner that the AVA Digital Awards.Read more about our award-winning resources »

Transcript:

Let’s challenge it, the economic situation is complicated and can be difficult to understand.

Luckily, financial experts have developed models to help us learn and also understand exactly how the economic climate functions. Among the most advantageous is the circular flow model.

The circular flow model highlights the “flows” in ~ the economy—the circulation of financial resources, goods and services, and the flow of money.

To demonstrate the usefulness the the circular flow model, let’s monitor a couple of dollars with a cycle.

Imagine you room a hungry consumer who hears the homemade fries at the diner down the street calling your name. Girlfriend take your money to the diner because that a tasty meal.

When girlfriend pay her check, you are buying goods and services. However the money doesn’t continue to be in the cash register for long.

Alice, the diner owner, uses the money to acquisition resources. She buys homegrown potato from a farmer; pays the server, that took her order, his wages; and also makes a payment ~ above the loan she obtained to buy brand-new equipment because that the diner. Every one of these are prices of production.

After she has actually paid her costs of production, the remaining revenue is her profit—the earnings she earns together an businessman owning and operating her diner.

Let’s say her money goes come the farmer, and also that for him is income. The money won’t continue to be in his wallet forever, though. Before you know it he will invest it, and the cycle will begin again.

The circular flow model shows the interaction in between two teams of economic decision-makers—households and also businesses—and two species of economic markets—the sector for resources and the industry for goods and services. If the real economic climate is much much more complex, the an easy circular circulation model is helpful for understanding some key economic relationships.

Let’s start with the two groups of financial decision-makers.

On one side of the model are households. Households consist of one or more persons that live in the same real estate unit, such together a family. Family members own every the economic resources in the economy. The economic resources room land, labor, capital, and also entrepreneurial ability.

Land resources are herbal resources. For example, these could be really land own by a farmer or other herbal resources such together oil, water, and trees.

Labor is just what it sound like—work for which you are paid.

Capital sources are products used to create other goods and also services. Because that example, think of a hammer offered by a carpenter or a computer system used at a business.

Finally, entrepreneurial ability is the human source that combine the other resources come produce brand-new goods and also services and bring them come market. So, an businessman might combine land, labor, and also capital in new ways—taking dangers along the way—to lug a good or service to market.

On the other side we have actually businesses. A company is a privately owned company that produce goods and services and also then selling them. Businesses have the right to be large, such as an automobile manufacturer, or small, such as a diner. And, businesses may develop goods, such together computers and also bicycles, and also services, such as haircuts and also car repairs.

But households and businesses space not isolated, they interact in markets.

At the top of the model we have actually the industry for resources. The market for sources is where families sell and also businesses buy economic resources—land, labor, capital, and entrepreneurial ability. Notification that the is families who own all the economic resources.

You could think that capital, to speak a delivery truck, as being own by a business. Yet who own the businesses? girlfriend guessed it—households. Even if it is a tiny diner own by an individual, a partnership own by numerous individuals, or a corporation owned by stockholders, all of these businesses space owned by people who are also members that a household.

Let’s look at at part transactions in the sector for sources by a business. A diner:it supplies a mix of financial resources, such as land—potatoes for fries; labor—cooks and also wait staff, and also capital—kitchen equipment; and also cash register sources to produce goods and services—in this situation cheeseburgers, fries, and also milkshakes. The business buys these economic resources native households.

For example, let’s to speak you work at the diner. You room selling and the diner is buying her labor resources. Those homemade fries come native potatoes—a organic resources—bought indigenous a neighborhood farm, i beg your pardon is own by a household. The brand-new milkshake maker and french fried food cutter—capital resources—were bought indigenous a company three says over and also the stockholders of that organization are members that households. Finally, the diner itself is own by Alice, who is a member that a household and also an business man who has turned her skill of do the finest homemade fries in town right into a successful business.

In exchange for their resources, family members earn income. Each resource has the own revenue category.

Households obtain wages for your labor, rental for use of their land, interest for use of their capital, and also profit for their entrepreneurial ability. For functioning at the diner, because that example, your earnings would be earnings paid in the form of a paycheck in ~ the finish of the month.

So, in the sector for resources, families sell resources and also businesses to buy resources. The resources flow one method (counter-clockwise) and money operation the other (clockwise).

At this allude in the cycle, families sell resources to businesses. So, families are holding income and businesses room holding resources. But, what do families do with the income? What carry out businesses execute with the resources?

To answer these questions, let’s emphasis on the bottom the the model, the market for goods and services, whereby the goods and also services created by businesses space bought.

Let’s start with businesses. Businesses use the financial resources lock buy in the market for resources to develop goods, such as computers and also bicycles, and also services, such together haircuts and also car repairs.

Businesses offer these goods and services to families in the sector for goods and also services. For example, the diner produces cheeseburgers, fries, and also milkshakes.

Households use component of their incomes come buy goods and services. The payment businesses get is called revenue. For example, in ~ the diner, revenue originates from customers paying for their food.

In short, the industry for goods and also services is simply where the goods and services developed by businesses are bought.

So, in the markets for goods and services, businesses offer goods and services and households to buy goods and also services. Products flow one means (counter-clockwise) and money operation the other (clockwise).

Let’s step ago a bit and notification a couple of things about the circular flow model.

First, the shows how businesses and also households interact in the two markets—the sector for resources and also the sector for goods and also services. Notice that households and businesses are both buyers and sellers.

Households are sellers in the sector for resources. Families sell land, labor, capital, and entrepreneurial activity in exchange for money, i m sorry in this case is called income.

Households room buyers in the industry for goods and services. Family members exchange earnings for goods and services.

Businesses are sellers in the market for goods and also services. Businesses market goods and also services in exchange for money, which in this case is called revenue.

Businesses are buyers in the industries for resources. Enterprise exchange the revenue earned in the market for goods and services come buy land, labor and capital in the industry for resources. In this case, the money spent is called the cost of production.

Second, the version shows the circulation of money in exchange because that goods and services and resources.

Money flows clockwise, when goods, services, and also resources circulation counter-clockwise.

The circular circulation model is a simple tool for learning about the economy. It shows the relationship between households and also businesses and how these various decision-makers in the economic situation fit together.

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Plus, the shows exactly how money keeps economic resources and goods and also services moving around and around and also around the economy. And that’s other Alice appreciates.

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