Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed.
PART I Introduction
Chapter 2 of 36 Thinking Like An Economist
Section 4 of 14
…
Figure 1 here
…
Figure 1 is a representation of the organization of the economy.
Households and firms interact both in
· the markets for goods and services, where households are buyers and firms are sellers
· the markets for the factors of production, where firms are buyers and households are sellers
The outer loop shows the flow of dollars.
The inner loop shows the flow of inputs and outputs.
The economy consists of millions of people engaged in many activities including buying, selling, working, hiring, and producing.
…
In Figure 1 the economy is simplified to include only two types of decision makers, firms and households.
Firms
· produce and sell goods (and services)
· hire and use factors of production
Households
· buy and consume goods
· own and sell factors of production
…
In markets for goods
· firms sell goods
· households buy goods
In markets for the factors of production
· households sell factors of production including their labor
· firms buy factors of production
…
The inner loop shows the flow of inputs and outputs.
Households sell their labor, land, and capital to the firms in the markets for factors of production.
Firms use these factors of production to produce goods.
Firms sell their goods to households in the markets for goods.
…
The outer loop shows the flow of dollars.
Households buy from firms in the markets for goods.
Firms use most of this revenue pay for the factors of production in the markets for factors of production.
The remainder is the profit of the firm owners, who themselves are household members.
…
Imagine a dollar begins at your household and you want to buy a cup of coffee.
You take the dollar to one of the economy's markets for goods, your local Starbucks.
There you spend your dollar.
The dollar becomes revenue for the shop.
The shop then uses the dollar to buy inputs including labor in the markets for the factors of production.
The dollar becomes income of households
…
A more complex entire view circular flow model includes the roles of government and international trade.
Starbucks might use some of the dollar to pay taxes and buy coffee beans from a farmer in Brazil.
… …

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