You buy something at a shop. The money goes to the shopkeeper, who pays a worker a wage, and the worker spends it at the market again. Where did the money stop? Nowhere. Across a whole economy, money and goods keep going round in a circle, and that turning is what keeps the economy running.
1. The two who run the circle
People who take part in production, exchange, consumption and distribution are called economic agents. They deal with one another through the market.
A simple economy has just two kinds of agent: the consumer or household and the producer or firm. A firm buys the factors of production, organises them to make goods and services, and then supplies or sells these in the market.
2. What households sell, and what they earn
The factors of production, which are labour, land, capital and organisation, belong to households. Households earn their income by selling them.
Each factor has its own reward. Labour earns wages, the landowner earns rent, the owner of capital earns interest. And what remains with the entrepreneur after every factor has been paid is profit. Tap the four earnings and see whose each one is.
who earns what?think by factor
Four earnings, four owners
Wage. Labour earns wages. The factor is labour.
Rent. The landowner earns rent. The factor is land.
Interest. The owner of capital earns interest. The factor is capital.
Profit. What the entrepreneur has left after paying all factor costs is profit.
All four seen. Wages, rent and interest go to factor owners; profit is what is left after everyone else is paid.
3. Two markets, two roles
With income in hand, households spend it. They use it to buy goods and services from firms.
Trade happens in two markets: the goods and services market and the factors of production market. In the goods market firms sell and households buy. In the factor market it is the reverse: firms buy, and households sell labour, land and capital. Same two agents, but change the market and buyer and seller swap places.
sort themwho buys, who sells?
Firm or household?
Pick up a chip, then drop it in a box. Ask yourself: who does this?
Right. Next one.
Not yet. Who sells the factors, and who sells the goods?
All in place. Firms buy factors, sell goods and pay wages. Households sell labour, buy goods and receive wages.
4. Following the money round
Set the circle running. Then tell the households to stop spending, and watch what happens to the wheel.
run the wheelrun it, then stop spending
The circular flow, running
In the book's diagram the flow goes like this. In the goods and services market households spend and firms receive income. In the factor market firms pay out wages, rent and interest, and households receive income.
It is through this circular flow of goods, services and income that the wheel of the whole economy keeps moving. This is the circular flow of income. Now tap the boxes in order and turn the circle yourself.
trace the circlewhere does the money go?
From households back to households
Start with the households. The factors of production belong to them.
Households sell labour, land and capital. In which market?
In the factor market firms buy the factors and pay wages, rent and interest. Who is the buyer?
Firms organise the factors, make goods and services and sell them. In which market?
In the goods market firms receive income and households spend theirs on goods and services. Who is the last stop?
The circle is closed. Goods, services and income went round and came back to the households. This is the circular flow of income.
Not yet. Think of the next step in the circle: who is selling, who is buying?
Drawn by hand after the book's diagram, not to scale.
5. Check yourself
Three questions in the exam's style.
check yourselfpick one answer
Question 1
How many kinds of agents are there in a simple economy?
Right. A simple economy has two kinds of agents: households and firms.
This option does not match the book. A simple economy has two kinds of agents: households and firms.
This option does not match the book. A simple economy has two kinds of agents: households and firms.
This option does not match the book. A simple economy has two kinds of agents: households and firms.
In the second, get the roles right.
check yourselfpick one answer
Question 2
The factors of production a firm needs are-
i. Labour ii. Land iii. Capital
Statement iii is left out: Capital is a factor of production.
Statement ii is left out: Land is a factor of production.
Statement i is left out: Labour is a factor of production.
Right. A firm's factors of production are labour, land and capital, all three.
In the last, match the market to the flow of income.
check yourselfpick one answer
Question 3
[Diagram] A circular-flow diagram: 'Goods market' at the top, 'Factors of production market' at the bottom, '?' on the left and 'Households' on the right; the four parts are joined by lines. What will go in the place marked '?'?
This option does not match the book. With the goods market on top, the factor market below and households on the right, firms go on the left.
Wage is the income of labour. The right answer is Firm.
Right. With the goods market on top, the factor market below and households on the right, firms go on the left.
This option does not match the book. With the goods market on top, the factor market below and households on the right, firms go on the left.
The whole note on eight cards.
cut from the notetap to turn over
Eight cards
QuestionWho are called economic agents?
AnswerThose involved in production, exchange, consumption and distribution
QuestionHow many kinds of agents does a simple economy have, and which?
AnswerTwo: the consumer or household and the producer or firm
QuestionIn the circular flow, what do firms buy and what do they sell?
AnswerThey buy factors of production and sell goods and services
QuestionWhat do labour, the landowner and the owner of capital respectively earn?
AnswerWages, rent, interest
QuestionWhat is profit?
AnswerThe entrepreneur's remaining income after paying all factor costs
QuestionWhich two markets appear in the circular flow?
AnswerThe goods and services market and the factors of production market
QuestionIn the factor market, what do firms pay and what do households receive?
AnswerFirms pay wages, rent and interest; households receive income
QuestionWhat is the circular flow of income?
AnswerThe circular flow of goods, services and income that keeps the economy moving