Circular Flow Model of a Market Economy 2012

Circular Flow Model of a Market Economy © 2012, TESCCC 0

Terminology circular flow model households business firms Factor/Resource Market Product Market © 2012, TESCCC Source: Amos. WEB Encyclonomic © 2012, TESCCC 1

Circular Flow Model • Model used to show the interdependent relationship of buyers and sellers within a market. 2

2 Sector (Part) Circular Flow Model Our two sectors are : 1. Households 2. Business Firms Our two markets are: 1. Factor/Resource Market 2. Product Market © 2012, TESCCC 3

Two Sectors Households Businesses © 2012, TESCCC 4

Households • The household sector includes the entire population of society. • It includes all of the consumptionseeking members of society--the entire population. • It IS society. In effect, the economy exists to satisfy the wants and needs of the household sector. 5

Households • No House Needed • While this sector goes by the name "household, " members are not required to own a house, to live in a house, or to have ever seen a house. The term household sector is merely a short-cut used to indicate the consuming, wants-and-needs-satisfying population of society, most of who actually do live in houses. 6

Households • For example: • Pollyanna Pumpernickel, who lives in a rented two-room apartment, is a member of the household sector. • Winston Smythe Kennsington III, who owns several residences, including an extremely large mansion, a penthouse apartment, and a yacht docked in the harbor, is a member of the household sector. 7

Households • Alton Hogkins, who spends his nights sleeping in a cardboard box under a bridge, is a member of the household sector. • Even Duncan Thurly, who owns an actual house in the suburbs, is part of the household sector. 8

Households • The household sector owns the factors of production—land, labor, and capital. • It sells the services of these resources to the business sector in exchange for income. 9

Households • For example, a pleasant mother of two, Pollyanna Pumpernickel, is a member of the Shady Valley household sector who own labor resources. Pollyanna sells her labor services as a part-time pet store clerk at Perry Paxton's Pet Palace. Labor is the extent of the Pollyanna's productive resources. 10

Households • Winston Smythe Kennsington III, the President, Chief Executive Officer, and Chairman of the Board of Directors of Omni. Conglomerate, Inc. , is also a member of the Shady Valley household sector. Winston also receives income from providing productive labor resources as President of Omni. Conglomerate. In addition, Winston provides his entrepreneurship as the BIG guy who takes the BIG risks and makes the BIG decisions for Omni. Conglomerate. Moreover, Winston owns Omni. Conglomerate stock, which means that he owns part of Omni. Conglomerate's capital and land 11

Households • While the household sector is designated based on WHO is included--households, people--this sector can also be defined based on WHAT it does--which is consumption. 12

Households • Pollyanna Pumpernickel uses her income for consumption expenditures on food, clothing, shelter, entertainment, and other wants-and-needs satisfying goods and services. Pollyanna pays the rent, puts food on the table, and treats her girls to an occasional Hot Momma Fudge Bananarama Ice Cream Sundae. The Pumpernickels also consume goods that require no expenditure, such as "quality" family time. 13

Households • While Winston Smythe's bank account is substantially bigger than Pollyanna's, he also uses his income for consumption expenditures food, clothing, shelter, entertainment, and other wants-and-needs satisfying goods and services. While the quality, expense, and volume of Winston's consumption expenditures might differ from those of the Pollyanna's, the underlying process is the same. Rather than tacos, T-shirts, and 2 room apartments, Winston tends to purchase Filet Mignon, designer suits, and 100 -room mansions. And of course, Winston is also inclined to consume expenditure -free goods, such as strolling through a nearby park. 14

Households Businesses Resources = Land, Labor, Capital, Entrepreneurship Resource Market © 2012, TESCCC 15

Business Firms • Business Firms – an organization that uses resources to produce a product, which it then sells. • Firms transform “inputs” or factors of production, into “outputs” or products. 16

Business Firms • This sector contains the private, profit-seeking firms in the economy that combine scarce resources into the production of wants-and-needs satisfying goods and services. It includes proprietorships, partnerships, and corporations. 17

Business Firms • Firms purchase or rent land. • They hire workers, paying them wages or salaries for their labor. • They also borrow money from households to purchase capital, paying households interest or profits in return. • This makes up what we call national income. 18 © 2012, TESCCC

Households Businesses $$ Nat’l Income = Rent, Wages, Interest, Profit $$ Resources = Land, Labor, Capital, Entrepreneurship Resource Market © 2012, TESCCC 19

Factor/Resource Market • A factor or resource market, where the factors of production are bought/sold 20

Factor/Resource Market • Factor markets, also termed resource markets, exchange the services of factors, NOT the factors themselves. • For example, the labor services of workers are exchanged through factor markets NOT the actual workers. 21

Factor/Resource Market • Buying and selling the actual workers is not only slavery (which is illegal) it's also the type of exchange that would take place through product markets, not factor markets. 22

Factor/Resource Market The services of these resources, however, are exchanged through factor markets. The value of the services exchanged through factor markets each year is measured as national income. 23

Factor/Resource Market • This exchange of resources for income payments takes place in what we call the factor or resource market. Households are the sellers and business firms are the buyers. 24 © 2012, TESCCC

Product Market • Market in which households purchase the goods and services that firms produce • Business firms are sellers…households are buyers 25

Business firms role in the Product Market • Business firms take the resources and turn them into products. • A product can be a good or a service. • They then sell the products to the households. © 2012, TESCCC 26

Product Market Products =Goods & Services Households Businesses © 2012, TESCCC 27

Households • Households use the income they earned from selling resources to purchase these products. This is called consumer expenditures. © 2012, TESCCC 28

Product Market Products =Goods & Services $$$ Consumer Expenditures $$ Households Businesses © 2012, TESCCC 29

Product Market Products=Goods & Services $$ Consumer Expenditures $$ Households Businesses Nat’l Income = Rent, Wages, Interest, Profit Resources = Land, Labor, Capital, Entrepreneurship Resource Market © 2012, TESCCC 30

How do government actions affect the CFM and how is the CFM affected by the rest of the world? (consumption) © 2012, TESCCC http: //tutor 2 u. net/economics/content/topics/macroeconomy/circular_flow. htm 31