The Circular Flow of Income

Economics: IB Diploma, topic 2.1.1

Circular Flow of Income

This model provides an illustration of the flow of money around an economy.

This model pictures the economy as consisting of two groups—households and firms—that interact in two markets:
The goods and services market in which firms sell and households buy.
The labor market in which households sell labor to business firms or other employees.

Firms produce and sell goods and services to households in the market for goods and services (or product market). Arrow “A” indicates this.
Households pay for goods and services, which becomes the revenues to firms. Arrow “B” indicates this.
Arrows A and B represent the two sides of the product market.

Where do households obtain the income to buy goods and services?
They provide the labor and other resources (e.g. land, capital, raw materials) firms need to produce goods and services in the market for inputs (or factors of production). Arrow “C” indicates this.
In return, firms pay for the inputs (or resources) they use in the form of wages and other factor payments. Arrow “D” indicates this.
Arrows “C” and “D” represent the two sides of the factor market.

This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy.
We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports).

Which factor of production is paid for by wages?
Which of the following are factors of production?
Who owns the factors of production that firms need to produce goods and services?