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

You are watching: A circular flow model shows the interrelationship between the ____ markets and the ____ markets.

Awards

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

Transcript:

Let’s challenge it, the economy is facility and have the right to be an overwhelming to understand.

Luckily, financial experts have developed models to assist us learn and understand just how the economy functions. Among the most useful is the circular circulation model.

The circular circulation model highlights the “flows” within the economy―the circulation of economic resources, goods and also services, and the circulation of money.

To show the usefulness the the circular circulation model, let’s monitor a couple of dollars through a cycle.

Imagine you room a hungry customer who hears the homemade fries in ~ the diner down the street calling your name. You take her money to the diner because that a tasty meal.

When friend pay her check, you room buying goods and services. But the money doesn’t continue to be in the cash it is registered for long.

Alice, the diner owner, offers the money to purchase resources. She buys homegrown potato from a farmer; pays the server, that took your order, his wages; and makes a payment on the loan she acquired to buy new equipment because that the diner. All of these are prices of production.

After she has actually paid her prices of production, the staying revenue is her profit—the earnings she earns as an businessman owning and also operating she diner.

Let’s say her money goes come the farmer, and that because that him is income. That money won’t continue to be in his wallet forever, though. Before you recognize it the will invest it, and also the bike will start again.

The circular circulation model reflects the interaction between two groups of economic decision-makers―households and businesses―and two species of financial markets―the industry for resources and also the sector for goods and also services. While the real economic climate is much an ext complex, the an easy circular circulation model is advantageous for understanding some an essential economic relationships.

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

On one side of the model are households. Households consist of one or more persons who live in the same housing unit, such as a family. Families own all the economic resources in the economy. The financial resources space land, labor, capital, and entrepreneurial ability.

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

Labor is simply what it sound like―work because that which you space paid.

Capital sources are goods used to develop other goods and services. Because that example, think that a hammer used by a carpenter or a computer system used in ~ a business.

Finally, entrepreneurial capability is the human source that combine the other resources to produce brand-new goods and also services and also bring them to market. So, an entrepreneur might combine land, labor, and also capital in brand-new ways―taking risks along the way―to bring a good or organization to market.

On the various other side we have businesses. A organization is a privately owned company that to produce goods and services and then sell them. Businesses can be large, such as an vehicle manufacturer, or small, such as a diner. And, companies may develop goods, such together computers and bicycles, and services, such as haircuts and car repairs.

But households and also businesses room not isolated, they communicate in markets.

At the top of the design we have the industry for resources. The sector for resources is where family members sell and also businesses buy financial resources―land, labor, capital, and also entrepreneurial ability. An alert that the is family members who very own all the economic resources.

You might think of capital, say a distribution truck, as being own by a business. Yet who owns the businesses? you guessed it―households. Whether a tiny diner own by one individual, a partnership own by several individuals, or a corporation own by stockholders, every one of these businesses space owned by civilization who are also members that a household.

Let’s look at some transactions in the industry for sources by a business. A diner:it provides a mix of financial resources, such as land―potatoes because that fries; labor―cooks and also wait staff, and also capital ―kitchen equipment; and also cash register sources to create goods and also services―in this case cheeseburgers, fries, and also milkshakes. The company buys these economic resources indigenous households.

For example, let’s to speak you work-related at the diner. You space selling and the diner is buying your labor resources. Those homemade fries come indigenous potatoes―a natural resources―bought indigenous a regional farm, i beg your pardon is own by a household. The new milkshake machine and french fry cutter―capital resources―were bought native a business three claims over and also the shareholder of that company are members the households. Finally, the diner itself is owned by Alice, that is a member that a household and an businessman who has actually turned her skill of making the best homemade fries in town into a successful business.

In exchange for your resources, families earn income. Each source has the own income category.

Households obtain wages for their labor, rental for usage of their land, interest for usage of your capital, and profit for your entrepreneurial ability. For functioning at the diner, for example, your revenue would be wages paid in the kind of a paycheck at the finish of the month.

So, in the sector for resources, families sell resources and businesses buy resources. The resources circulation one way (counter-clockwise) and money operation the other (clockwise).

At this allude in the cycle, families sell sources to businesses. So, family members are stop income and businesses space holding resources. But, what do families do v the income? What perform businesses perform with the resources?

To answer this questions, let’s focus on the bottom the the model, the market for goods and services, wherein the goods and services produced by businesses space bought.

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

Businesses sell these goods and services to families in the industry for goods and also services. Because that example, the diner produce cheeseburgers, fries, and also milkshakes.

Households use part of your incomes to buy goods and also services. The payment businesses receive is dubbed revenue. For example, in ~ the diner, revenue comes from customers paying for your food.

In short, the market for goods and services is just where the goods and also services created by businesses are bought.

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

Let’s step ago a bit and notice a few things about the circular circulation model.

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

Households room sellers in the industry for resources. Households sell land, labor, capital, and also entrepreneurial activity in exchange because that money, i beg your pardon in this instance is referred to as income.

Households space buyers in the industry for goods and also services. Households exchange revenue for goods and services.

Businesses are sellers in the industry for goods and also services. Businesses sell goods and also services in exchange because that money, i m sorry in this situation is dubbed revenue.

Businesses are buyers in the industries for resources. Businesses exchange the revenue earned in the industry for goods and services to buy land, labor and also capital in the industry for resources. In this case, the money invested is dubbed the price of production.

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

Money flows clockwise, if goods, services, and resources flow counter-clockwise.

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

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Plus, that shows how money keeps financial resources and goods and services relocating around and also around and around the economy. And that’s something Alice appreciates.