ANALYSIS OF THE SIMPLIFIED CIRCULAR FLOW MODEL

Objective:
I.

Analyze the circular flow model of a pure market economy to identify and explain the flows of economic
activity within and between the product and resource markets.

Analysis: A simple circular flow model is used to explain the flows of economic activity in a pure market
(capitalist) economic system. The diagram below is a simple circular flow model.

Goods and Services

Payments for Goods and Services

(Product Market)
Consumer
Households

Business Firms

(Factor or Resource Market)

Payments (Rent, Wages, Interest, and Profits) for Factors of Production

Factors of Production (Land, Labor, Capital, and Entrepreneurship)

1.

The assumptions of the Circular Flow Model (CFM) are the characteristics of capitalism. List the characteristics
(assumptions) below. (Refer to your handout on capitalism or your notes for this information.)
_______________________________________

_____________________________________

_______________________________________

_____________________________________

_______________________________________

_____________________________________

Use the CFM above to answer the questions that follow.

2.

Identify the:
A.

B.

Two major sectors of a market economy included in the CFM:

1.

_______________________________________

2.

_______________________________________

Two markets of the CFM in which exchanges take place between the sectors:
1.

_______________________________________

2.

_______________________________________

3.

Exchanges that occur between sectors in the CFM are called "flows of economic activity." In each market there is
a money flow (payment) and a real flow (good, service or resource for which a payment is made.).
A.

B.

4.

B.

6.

1.

product market: ___________________________________________________________

2.

factor/resource market: _____________________________________________________

Identify the real flow in the:

1.

product market: ___________________________________________________________

2.

factor/resource market: ______________________________________________________

Markets are places where exchanges take place between buyers (demanders) and sellers (suppliers).
A.

5.

Identify the money flow in the:

Identify the sector in the product market that represents the:

1.

demand-side of the market: ___________________________________________________

2.

supply-side of the market:

Identify the sector in the factor/resource market that represents the:

1.

demand-side of the market: ___________________________________________________

2.

supply-side of the market:

___________________________________________________

Identify the source (sector and market) and the components of the income received by consumer households:
A.

sector: ____________________________________

B.

components: _________________

market: _______________________

_______________

_______________

_______________

Considering the above information, the sum of what four payments constitutes the national income earned by
consumer households?
____________________

7.

___________________________________________________

_____________________

____________________

__________________

GDP (Gross Domestic Product), one of the main measures of economic activity, is defined as the total value of
all final goods and services produced within the boundaries of a nation in a year. Identify the flow in the CFM
which represents the GDP:
____________________________________________________________________________________

8.

Identify the flow that:

A.

represents the costs of production for business firms:

flow: ___________________________________ market: ______________________________

B.

represents the expenditures of income by consumer households:

flow: ___________________________________ market: ______________________________

9.

Complete the following:

A.

Business firms pay their costs of production through the receipt of payments for __________________
___________________________sold in the ________________________ market.

B.

The real flow of ___________________________________ in the ______________ market are used to

produce the ______________________________________sold in the _____________________ market.

C.

Consumer households sell their ____________________________________ in the __________________

market to receive ______________ used to purchase ________________________ in the _____________
market.

10.

11.

Carefully analyze the model and determine in which market the answer to each of the following economic
questions is determined:
a.

What will be produced?

__________________________ market

b.

How will goods be produced?

__________________________ market

c.

For whom will goods be produced?

__________________________ market

In your own words and in complete sentences, explain why the model of a market economy is called a circular
flow model. In your answer, explain the relationship of the parts of the model to the whole.
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________

II.

Reading Comprehension: As you read the paragraph below, highlight the six characteristics of
capitalism mentioned. Read and answer the questions that follow each paragraph.

Pure, or laissez-faire, capitalism is characterized by the private ownership of resources and the use of a system of
markets and prices to coordinate and direct economic activity. In such a system each participant is motivated by his or
her own self-interests; each economic unit seeks to maximize its income through individual decision making. The market
system functions as a mechanism through which individual decisions and preferences are communicated and
coordinated. The fact that goods and services are produced and resources are supplied under competitive conditions
means there are many independently acting buyers and sellers of each product and resource. As a result economic
power is widely dispersed. Advocates of pure capitalism argue that such an economy is conducive to efficiency in the use
of resources, output and employment stability, and rapid economic growth. Hence, there is little or no need for
government planning, control, or intervention. Indeed, the term "laissez faire" roughly translates as "let it be," that is, keep
government from interfering with the economy, because such interference will disturb the efficiency with which the market
system functions. Government's role is therefore limited to protecting private property and establishing an appropriate
legal framework in which free markets function. (Source: Economics, McConnell and Brue, p. 30, 1993).
1.

What key characteristic of capitalism accounts for the diffusion of economic power and efficiency in the use of
scarce resources?______________________________________________________________________

2.

Identify 3 advantages of a capitalist system that proponents of the system would use to support their view of a
laissez-faire role for government:
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________

3.

According to advocates of capitalism, what should be the functions (2)of government in a market economy?
____________________________________________________________________________________

____________________________________________________________________________________
Critics of pure capitalism argue that the existence of monopolies and other barriers to entry or exit from the marketplace
reduce the ability of competition to regulate the self interest of market players, thus reducing the allocative efficiency of
the marketplace. Critics also claim that macroeconomic instability and unequal income distribution are inherent features
of free market economies, using business cycle fluctuations as evidence of such instability.
4.

Identify 3 flaws of capitalism according to its critics:

____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________

The U.S. economy leans toward pure capitalism, but with important differences. Government plays an active role in
promoting economic stability and growth, in providing certain goods and services which would be under produced or not
produced at all by the market system, and in modifying the distribution of income. In contrast to the wide dispersion of
economic power among many small units which characterizes pure capitalism, American capitalism has spawned
powerful economic organizations in the form of large corporations and strong labor unions. The ability of these power
blocs to manipulate and distort the functioning of the market system to their advantage is a further reason for
governmental involvement in the economy. (Economics, McConnell and Brue, p. 30, 1993.) Critics of government
involvement within the U.S. claim that government contributes to instability and inefficiency rather than these being
inherent flaws in the market system.
5.

Identify 4 roles of the government in the U.S. economy:

____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________

With these important differences in mind, the simplicity of the CFM limits in many ways its use as a model of the U.S.
economy. Intrahousehold and intrabusiness transactions are concealed. Government, financial, and foreign sectors are
ignored as decision makers even though they play significant roles in our economy. The model subtlety implies constant
flows of output and income, while in fact these flows are unstable over time. Nor is the circular flow a perpetual motion
machine; production exhausts human energies and absorbs physical resources, the latter giving rise to problems of
environmental pollution. Finally, our model does not explain how product and resource prices are actually determined.
For this reason, the model must be modified to account for other sectors and other models must be used with it to explain
features of the U.S. economy that the model does not reflect. (Economics, McConnell and Brue, p. 45, 1993).
6.

If the CFM is used to explain the U.S. economy, what modifications would be needed to depict how the U.S.
economy differs from a pure market economy (what sectors would need to be added to the model)?
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________

7.

Identify the limitations of a simple CFM as a model of the U.S. economy:

____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________
____________________________________________________________________________________

Checking for Understanding:

Please note that the adjacent CFM has been altered slightly. Although the arrangement of
sectors, flows and markets has changed, all of the relevant relationships remain the same.
Given only the flow of goods and services, label the sectors, markets, and flows in the
remainder of the model. Answer on a separate sheet of paper:
Circular Flow Model
I.

Indicate sector, market or flow in the diagram above.

If a flow, be specific as to what it consists of.
A.
E.
B.
F.
C.
G.
D.

C
D
E

II.

Match the following with the appropriate letters on the

diagram:
1.
Land, Labor, Capital, & Entrepreneurship.
2.
Rent, Wages, Interest, and Profit
3.
GDP
4.
National Income
5.
Supplier in the product market
6.
Supplier in the resource market
7.
Demander in the product market
8.
Demander in the resource market

B
F
G
Goods & Services

Checking for Understanding:

Please note that the adjacent CFM has been altered slightly. Although the arrangement of
sectors, flows and markets has changed, all of the relevant relationships remain the same.
Given only the flow of goods and services, label the sectors, markets, and flows in the
remainder of the model. Answer on a separate sheet of paper:
Circular Flow Model
I.

II.

Indicate sector, market or flow in the diagram above.

If a flow, be specific as to what it consists of.
A.
E.
B.
F.
C.
G.
D.
Match the following with the appropriate letters on the
diagram:
1.
Land, Labor, Capital, & Entrepreneurship.
2.
Rent, Wages, Interest, and Profit
3.
GDP
4.
National Income
5.
Supplier in the product market
6.
Supplier in the resource market
7.
Demander in the product market
8.
Demander in the resource market

C
D
E
A

B
F
G
Goods & Services