Circular Flow Diagram in Economics: Definition & Example

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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