Explain what happens in the simple circular flow diagram?

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pohnpei397 eNotes educator| Certified Educator

In a simple circular flow diagram, we see the basic idea of how an economy works.  We see that households and business firms are connected to one another and that the economy cannot function unless both of these are playing their part. 

In a circular flow model, there are two markets and two sets of actors.  There is the product market and the factor market.  The two sets of actors are businesses and households.  The two actors interact in each market.  In the product market, products are bought and sold.  Businesses are doing the supplying in this market and households are doing the demanding.  For example, businesses supply gasoline through gasoline stations.  Households demand that gasoline.  They pay money for it and they get the gasoline.

In the factor market, something is also being bought and sold.  Usually, though, what is bought and sold here is labor.  Here, the households are doing the supplying and the businesses are doing the demanding.  For example, the gas station mentioned above needs workers to sell the gas and whatever else that gas station sells.  Those workers come from the households.  They sell their labor in return for money.

The circular flow model shows that this process happens over and over, with the interactions between firms and households allowing the economy to run.