Circular Flow Diagram in Economics: Definition & Example

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  • 0:03 What Are Circular Flow…
  • 0:52 The Role of Households
  • 1:29 The Role of Firms
  • 1:50 Examples
  • 2:34 Lesson Summary
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Instructor
Brianna Whiting

Brianna has a masters of education in educational leadership, a DBA business management, and a BS in animal science.

Expert Contributor
Joseph Shinn

Joe has a PhD in Economics from Temple University and has been teaching college-level courses for 10 years.

In this lesson, we will look at the basic circular flow diagram. We'll learn who the main actors are and what roles they play. We will also look at some examples.

What Are Circular Flow Diagrams?

We all need to buy goods. Sometimes those goods are groceries, while other times those goods are clothing for an important event. Whatever the goods might be, purchasing them forms a crucial piece in a functioning economy.

Simply put, each time we buy a good we are contributing to the economy. In this lesson, we'll look at how those purchases are just part of a bigger piece of the economic puzzle. You see, the economy works in a circular motion known as the circular flow diagram in economics.

The circular flow diagram is a basic model used in economics to show how an economy functions. Primarily, it looks at the way money, goods, and services move throughout the economy. In the diagram, there are two main characters, known as firms and households, where households represent consumers and firms represent producers.

The Role of Households

Let's take a look at the role of the consumer, or the households. In a circular flow diagram, households consume the goods offered by the firms. However, households also offer firms factors so that the firms can produce products for the household to later consume.

For example, households may supply land to produce goods or they may offer themselves in the form of labor. Households also offer capital, which is a monetary form of investing that helps firms create products for consumption. All three forms (land, labor, and capital) are offered to firms so that they can make products that households need and consume.

The Role of Firms

Now let's look at the role of firms. The main function of the firms is to offer goods. In order to do this, firms take the factors (land, labor, and capital) from households and convert products into goods and services that consumers need and want. The role of firms makes up the second part of the circular flow diagram.

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Additional Activities

Additional Questions

Answer the following questions that relate to the circular flow diagram:

  1. What is the circular flow diagram?
  2. Explain the role of money in the circular flow diagram. Be specific about what group pays the other in different stages and what they are paying for.
  3. True/False. The two groups that interact in the diagram are the businesses and the workers.
  4. True/False. Households both receive money and spend money in the circular flow diagram.
  5. True/False. In the simple circular flow diagram, firms will pay all the money that they collect from the goods and services they sell to households for their factors of production.
  6. What are the four factors of production that households provide for businesses?
  7. In the simple circular flow model, who purchases goods and services from whom?
  8. In the simple circular flow model, who provides factors of production for whom?
  9. Explain the role of households in the circular flow diagram. Be specific about the flow of money that they receive and pay in addition to what they give and receive from firms.
  10. Explain the role of businesses in the circular flow diagram. Be specific about the flow of money that the firms receive and pay in addition to what they give and receive from households.

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