Circular Flow Model
What is Circular Flow Model?
The circular flow model represents the flow of goods, services, and payments between households and firms in a simplified economy.
In the circular flow model, households provide factors of production like labor to firms in the factor market. Firms use these inputs to produce goods and services, which they sell to households in the product market. Households use the income they earn from selling factors of production to buy goods and services from firms. This creates a continuous flow of economic activity.
Circular Flow Model: a worked example
Take a two-sector economy with no saving, taxes or trade. Firms pay households $700 billion in wages, $50 billion in rent, $100 billion in interest and $150 billion in profit, so household income is $1,000 billion. Households spend that entire $1,000 billion in the product market, so firm revenue is also $1,000 billion, which firms pay straight back out as those same factor payments. The two figures match by construction, which is why national output can be measured either as total spending or as total income.
The mistake students make with circular flow model
Students put households on the selling side of the product market because households sell things in everyday life. The roles reverse by market: households are sellers in the factor market (supplying labor, land and capital) and buyers in the product market, while firms are buyers in the factor market and sellers in the product market. Getting this backwards flips every arrow on the diagram.
Circular Flow Model questions
What are the four sectors of the circular flow model?
The four sectors of the circular flow model are households, firms, government and the foreign sector, whereas the simplest version has only households and firms. Government adds taxes and government spending to the flow, and the foreign sector adds exports and imports.
What are leakages and injections in the circular flow?
Leakages in the circular flow are income households receive but do not spend on domestic output, namely saving, taxes and imports, while injections are spending that enters the flow from outside household consumption, namely investment, government spending and exports. National income is at equilibrium when total leakages equal total injections.
Why are the two flows in the circular flow model equal?
In the simple circular flow, household income equals firm revenue because every dollar a firm earns from selling output is paid out to somebody as wages, rent, interest or profit. This identity is the reason GDP can be calculated by the expenditure approach or the income approach and give the same answer.
Related terms
Common comparisons
Get AP Econ exam tips in your inbox
Occasional emails with study tips, new interactive graphs, and exam-season reminders. Free, no spam.
No spam. Unsubscribe anytime. Read our privacy policy.
Keep track of what you have studied
A free EconLearn account adds progress tracking, your quiz history, and achievements. Studying here is free either way, and there is nothing to pay for as a student.
Create a free accountAlready have one? Sign in
Last updated