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Circular Flow

Circular flow of goods and services in a market economy

Money income from wages, rents,
Costs interest, and profits
Resource Markets

Resources Labor, natural resources,
capital, and entrepreneurship

Businesses Households

Goods and Services Goods and Services
Product Markets

Receipts Consumer Spending for Goods and Services

Figure 1

purchase stock in companies, CDs, land, or another type they might seem rather extreme, are when the government
of investment. ordered the breakup of the Bell Telephone System and
later of Microsoft Corporation because it was determined
LIMITATIONS that they violated antitrust legislation and had become
monopolies. This kind of breakup affects business opera-
The circular flow model is an accepted way to show the
flow of goods and services in a market economy. In a tions and households.
mixed economy, the government plays an important role The model that is shown in Figure 1 could also be
as well, but this is not shown in the circular flow model. influenced by pricing factors—that is, the laws of supply
Local, state, and federal governments also produce, or and demand. The model does not take into consideration
cause the production of, goods and services. Schools, changes in prices or how prices are determined, nor does
highways, water-treatment plants, parks, and other facili- it take into consideration how businesses choose the prod-
ties are examples of government spending. Governments ucts or services they produce and market.
take part of household incomes in the form of taxes, but Another limitation of this model is that not all the
they also inject money back into households in the form products and services offered by businesses go to the
of wages. Some of that money goes back to the govern- households that provide the resources. For example, some
ment in the form of taxes and still more goes into other of the electronic equipment produced in the plant
places. described earlier might be exported to another country. In
The government has considerable control over the that case, the goods and services leave the circular flow
economy, which in turn affects production, employment, and the resources to pay for the goods and services come
and economic growth. If interest rates go up, households from outside the circle. It might be easier to simplify the
will purchase fewer goods and services. If interest rates go explanation and include all households and all businesses
down, households will spend more. This spending adds to in the world, but most economists would not agree with
or takes away from businesses’ operations and the amount that simplification.
of goods and services being produced. While readers should be aware of the influence that
Governments can influence the mix of goods and government, exporting and importing, and pricing and
services offered to households. Good examples, although production has on businesses and households, it is not

116 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION