Transactions: The Circular-Flow Diagram

Trade takes the form of barter when people directly exchange goods or services that they have for goods or services that they want.

The model economies that we’ve studied so far—each containing only one firm—are a huge simplification. We’ve also greatly simplified trade between the United States and Brazil, assuming that they engage only in the simplest of economic transactions, barter, in which one party directly trades a good or service for another good or service without using money. In a modern economy, simple barter is rare: usually people trade goods or services for money—pieces of colored paper with no inherent value—and then trade those pieces of colored paper for the goods or services they want. That is, they sell goods or services and buy other goods or services.

And they both sell and buy a lot of different things. The U.S. economy is a vastly complex entity, with more than a hundred million workers employed by millions of companies, producing millions of different goods and services. Yet you can learn some very important things about the economy by considering the simple graphic shown in Figure 2-6, the circular-flow diagram. This diagram represents the transactions that take place in an economy by two kinds of flows around a circle: flows of physical things such as goods, services, labor, or raw materials in one direction, and flows of money that pay for these physical things in the opposite direction. In this case the physical flows are shown in yellow, the money flows in green.

The Circular-Flow Diagram This diagram represents the flows of money and of goods and services in the economy. In the markets for goods and services, households purchase goods and services from firms, generating a flow of money to the firms and a flow of goods and services to the households. The money flows back to households as firms purchase factors of production from the households in factor markets.

The circular-flow diagram represents the transactions in an economy by flows around a circle.

A household is a person or a group of people that share their income.

The simplest circular-flow diagram illustrates an economy that contains only two kinds of inhabitants: households and firms. A household consists of either an individual or a group of people (usually, but not necessarily, a family) that share their income. A firm is an organization that produces goods and services for sale—and that employs members of households.

A firm is an organization that produces goods and services for sale.

Firms sell goods and services that they produce to households in markets for goods and services.

As you can see in Figure 2-6, there are two kinds of markets in this simple economy. On one side (here the left side) there are markets for goods and services in which households buy the goods and services they want from firms. This produces a flow of goods and services to households and a return flow of money to firms.

Firms buy the resources they need to produce goods and services in factor markets.

On the right side, there are factor markets in which firms buy the resources they need to produce goods and services. Recall from earlier that the main factors of production are land, labor, physical capital, and human capital.

An economy’s income distribution is the way in which total income is divided among the owners of the various factors of production.

The factor market most of us know best is the labor market, in which workers sell their services. In addition, we can think of households as owning and selling the other factors of production to firms. For example, when a firm buys physical capital in the form of machines, the payment ultimately goes to the households that own the machine-making firm. In this case, the transactions are occurring in the capital market, the market in which capital is bought and sold. As we’ll examine in detail later, factor markets ultimately determine an economy’s income distribution, how the total income created in an economy is allocated between less skilled workers, highly skilled workers, and the owners of capital and land.

The circular-flow diagram ignores a number of real-world complications in the interests of simplicity. A few examples:

Figure 2-6, in other words, is by no means a complete picture either of all the types of inhabitants of the real economy or of all the flows of money and physical items that take place among these inhabitants.

Despite its simplicity, the circular-flow diagram is a very useful aid to thinking about the economy.

!worldview! ECONOMICS in Action: Rich Nation, Poor Nation

Rich Nation, Poor Nation

Although less productive than American workers, Bangladeshi workers have a comparative advantage in clothing production.
Robert Nickelsberg/Getty Images

Try taking off your clothes—at a suitable time and in a suitable place, of course—and taking a look at the labels inside that say where they were made. It’s a very good bet that much, if not most, of your clothing was manufactured overseas, in a country that is much poorer than the United States—say, in El Salvador, Sri Lanka, or Bangladesh.

Why are these countries so much poorer than we are? The immediate reason is that their economies are much less productive—firms in these countries are just not able to produce as much from a given quantity of resources as comparable firms in the United States or other wealthy countries. Why countries differ so much in productivity is a deep question—indeed, one of the main questions that preoccupy economists. But in any case, the difference in productivity is a fact.

But if the economies of these countries are so much less productive than ours, how is it that they make so much of our clothing? Why don’t we do it for ourselves?

The answer is “comparative advantage.” Just about every industry in Bangladesh is much less productive than the corresponding industry in the United States. But the productivity difference between rich and poor countries varies across goods; it is very large in the production of sophisticated goods like aircraft but not that large in the production of simpler goods like clothing. So Bangladesh’s position with regard to clothing production is like Embraer’s position with respect to producing small jets: it’s not as good at it as Boeing, but it’s the thing Embraer does comparatively well.

Bangladesh, though it is at an absolute disadvantage compared with the United States in almost everything, has a comparative advantage in clothing production. This means that both the United States and Bangladesh are able to consume more because they specialize in producing different things, with Bangladesh supplying our clothing and the United States supplying Bangladesh with more sophisticated goods.

Quick Review

  • Most economic models are “thought experiments” or simplified representations of reality that rely on the other things equal assumption.

  • The production possibility frontier model illustrates the concepts of efficiency, opportunity cost, and economic growth.

  • Every person and every country has a comparative advantage in something, giving rise to gains from trade. Comparative advantage is often confused with absolute advantage.

  • In the simplest economies people barter rather than transact with money. The circular-flow diagram illustrates transactions within the economy as flows of goods and services, factors of production, and money between households and firms. These transactions occur in markets for goods and services and factor markets. Ultimately, factor markets determine the economy’s income distribution.

2-1

  1. Question 2.1

    True or false? Explain your answer.

    1. An increase in the amount of resources available to Boeing for use in producing Dreamliners and small jets does not change its production possibility frontier.

    2. A technological change that allows Boeing to build more small jets for any amount of Dreamliners built results in a change in its production possibility frontier.

    3. The production possibility frontier is useful because it illustrates how much of one good an economy must give up to get more of another good regardless of whether resources are being used efficiently.

  2. Question 2.2

    In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the United States, an automobile can be produced by 6 workers in one day and a washing machine by 2 workers in one day.

    1. Which country has an absolute advantage in the production of automobiles? In washing machines?

    2. Which country has a comparative advantage in the production of washing machines? In automobiles?

    3. What pattern of specialization results in the greatest gains from trade between the two countries?

  3. Question 2.3

    Using the numbers from Table 2-1, explain why the United States and Brazil are willing to engage in a trade of 10 large jets for 15 small jets.

  4. Question 2.4

    Use the circular-flow diagram to explain how an increase in the amount of money spent by households results in an increase in the number of jobs in the economy. Describe in words what the circular-flow diagram predicts.

Solutions appear at back of book.