Circular Flow Model Explained

This essay centers on the circular flow model as explained and applied in economics. This model is used to explain the flow of money to and fro the economy of a particular society. This model shows the flow of the economy from the household sector to a firm or business sector and vice versa. Between the household sector and the firm, both the produce market and the resource market engage in a symbiotic relationship.

There are 2 types of markets in the circular flow model. The first type of market is the resource or labor market while the second market type is called the product or the consumer market.

Labor or resource market is the market where firms or businesses seek the factors of production (which will be explained below) to produce the goods and services the household needs and barters for money.

The product or consumer market is the market for goods and services where households can purchase their needs from the firms or businesses using money as a medium of exchange. This will also be explained in detail in this essay.

To achieve a total understanding of the circular flow model as explained in economics, a conscious effort must be paid to the important characters in this model. The important characters are therefore the household resource sector and the firm or the business sector.

Household resource explained

The household resource comprises the economic activities households engage in the system which contributes to production. The household resource is commonly referred to as the factors of production. The factors of production are also regarded as scarce resources in economics.

Scarce resources are resources that are not only rare to find but are resources that are not free. At this, land, labor and capital are the most important scarce resources without which there can't be production.

Hence, the factors of production comprise land, labor, and capital, while entrepreneurship is the total of all other 3 resources. However, land, labor, and capital are the basics. At this, the land is a resource that can be privately owned or government-owned. A resource that a firm must pay for to use.

At this, only the household (a private owner of a piece of land) or the government in charge of a public property can sell or lease the land to any firm. Knowing that the land is important for either planting of crops or mining of minerals or harvesting of fishes. The land is a resource in the resource market in which the household contributes to.

Also, the household contributes labor (which a firm or business needs) in the resource market. Labor is a human resource, an input into the production of goods and services which involves workers. This form of input is in numerous ways, there are both skilled and unskilled laborers, educated and uneducated laborers; laborers who offer aid into any pattern of goods and services production.

The capital is also another important resource material that the household offers. Capital here is the technology through which goods and services can be produced. Capital is the device that could be farm tools, tractors, or workshop appliances. They can also be office devices. However, the equipment needs money for the purchase, which is why capital is most regarded as money.

Hence, the household resource encompasses land which could be held by private or public individuals; labor which comes from workers in a factory or an office depending on the nature of the business their skills are needed for, and capital comes the market economy through the use of money.

The firm or business

The firm or businesses are entities established by entrepreneurs or individuals from the household who are interested in commencing a means of production of goods and services which the community desires. The firms need resources from the household which creates the resources needed in the production of goods and services which are in turn sold to the household.

Firms make use of the household resource market, they buy land, labor and get capital through the resource market for goods and services production. Bearing in mind that the factors of production in the resource market are scarce resources and they are not free, money as a medium of exchange comes into play. Hence, money makes the circular flow function.

Hence, firm exchange resources through the use of money while resources are used by the firms or businesses to make goods and services which the household consumes. In other words, the household provides land, capital, and labor as factors of production necessary to firms and businesses which are being paid for. The money paid for these resources becomes the income of the household.

Circular flow of economy between the household and the firms or businesses

The goal of the business or firm is profit. Hence, businesses find ways to maximize their profits by selling goods and services for more than they spent on resources. At this, a firm's revenue is greater than its total cost.

The goal of the household is to maximize utility. Utility in economics means happiness which is achieved through the consumption of goods and services in a market. The household earns income through the rent of land sold, wages from labor provided, and interests also on the labor provided. The income is used to purchase goods and services provided by the firm. At this, a household which intends to earn an income that would meet the needs of their standard of living has to give more resource to the firm.

The circular flow model of the market is hence a chain. The household provides the factors of production which the firm needs. The household earns income which is money, from the firm in the form of rent, wages and interest.

The firm, on the other hand, provides goods and services which is value to the utility which the household depends on for happiness. Hence, the money that had previously been provided to the household (through the resource market) is spent in purchasing the firm’s goods and services.

Conclusion

The circular flow model deals with the chain in which the economy funnels. There are both the resource market and the produce market. The resource market consists of land, labor, and capital while the produce market consists of the goods and services the household needs to survive.

The symbiosis here is that both the household and the firm cannot exist individually. The firm needs the household to supply the factors of production while the household needs the firm to produce and supply necessary goods and services for their consumption.

Further, the household needs the firm to hire them (from the resource market) and pay them while the firm needs the household to purchase their goods and services (I.e. utility) without which either cannot survive in the society.