Business, Politics, & Society

Understanding the Circular Flow Model in Economics: Definition and Factors of Production

Written by MasterClass

Dec 21, 2018 • 4 min read

The economy can be thought of as two cycles moving in opposite directions. In one direction, we see goods and services flowing from individuals to businesses and back again. This represents the idea that, as laborers, we go to work to make things or provide services that people want.

In the opposite direction, we see money flowing from businesses to households and back again. This represents the income we generate from the work we do, which we use to pay for the things we want.

Both of these cycles are necessary to make the economy work. When we buy things, we pay money for them. When we go to work, we make things in exchange for money.

The circular flow model of the economy distills the idea outlined above and shows the flow of money and goods and services in a capitalist economy.

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What Is the Circular Flow Model in Economics?

The circular flow model is an economic model that shows the flow of money through the economy. The most common form of this model shows the circular flow of income between the household sector and the business sector. Between the two are the product market and the resource market.

Households purchase goods and services, which businesses provide through the product market. Businesses, meanwhile, need resources in order to produce goods and services. Members of households provide labor to businesses through the resource market. In turn, businesses convert those resources into goods and services.

4 Factors of Production

In economics, there are four types of resources, known as factors of production. Each factor of production has a unique type of payment associated with it, called factor payments.

  1. Labor. These are workers. The factor payment for labor is referred to as “wages.”
  2. Land. This includes land that is rented or purchased, as well as other components like natural resources and raw materials. The factor payment for land is referred to as “rent.”
  3. Capital. This is money used to buy the tools that labor implements to convert land (i.e., natural resources) into goods. The factor payment for capital is called “interest.”
  4. Entrepreneurs. These are the people who put the other three resources together to create a successful business. The factor payment for entrepreneurs is called “profit.”
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How Do Costs, Revenue, and Consumer Spending Relate to the Circular Flow Model?

In the simple circular flow model of the free market, money flows in the opposite direction.

Here’s how it works:

  • When households need a good or service, their money flows to the product market in a process called consumer spending.
  • To provide goods and services to households, the product market purchases them from businesses, generating revenue.
  • To make goods and services for the product market, businesses purchase resources from the resource market, generating cost.
  • Finally, to generate resources businesses need to create goods, the resource market pays for other resources—namely, workers and land. This generates income for labor and landholders.

The above process can be summarized as follows:

Consumer spending —> Revenue —> Cost —> Income

This is the basic circular flow diagram.

5 Factors Not in the Circular Flow Model

While the basic circular flow matrix explains supply and demand in a simplistic economic vacuum, this model doesn’t take into account these other key factors of economic systems.

  1. Government sector. Government is an important factor since it both injects money into the flow and also takes money out of it (called “leakage”).
  2. Government spending. The government injects money into the economy by buying things from both the product market (like garbage trucks or aircraft carriers), and the resource market (like teachers or fuel). Payments the government makes to both the resource market and the product market are called “government spending.” The government uses goods, services, and resources to provide “public goods” like education, roads, and police services. Government spending can also be a public good in itself: examples of this kind of public good include subsidies to businesses (to spur economic development and incentivize manufacturing of a specific type of good) and welfare to households (to help alleviate poverty).
  3. Taxes (sales, income, property, and others). In addition to spending and distributing money in this circular flow model, the government is also a cause of “leakage”—that is, the removal of money from the system through taxes. Governments tax households and businesses in the form of income tax, sales tax, property tax, and other types of taxes. This leakage enables the government to inject money into the economy in other ways and places.
  4. Financial institutions (banks). Financial institutions also contribute to leakage through household and business savings. These are monies that would have otherwise flowed into the economy but have been removed semi-permanently. In turn, the financial sector injects money into the economy through investment and loans, which can help both the household sector (e.g., mortgage loans) and the business sector.
  5. Foreign sector (imports and exports). Instead of money, the foreign sector typically injects goods into the circular flow model in the form of imports and leaks goods in the form of exports.

An economy with the household sector and the business sector on each end and product and resource markets in between is the simplest version of the circular flow model. However, it does not provide a complete picture of the economy. Once the government, financial institutions, and the foreign sector are incorporated into this model, we get a more entire and accurate model of the economic system as a whole.

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