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Lesson overview: economic systems, the role of incentives, and the circular flow model

A summary of the circular flow model which demonstrates the interdependence of households and firms in a market system

Key terms

TermDefinition
MarketA place where buyers and sellers meet to engage in mutually beneficial, voluntary exchanges of goods, services, or productive resources
HouseholdsThe owners of resources—supplied to firms in the resource market—and the buyers of goods and services—demanded from firms in the product market
FirmsBusiness entities that demand land, labor, and capital from households in the resource market and produce goods and services, which they supply to households in the product market
Resource marketWhere households supply land, labor, capital, and entrepreneurship/technology to firms in exchange for money
Product marketWhere firms supply goods and services to households in exchange for money
Economic systemA system of allocating the means of production and the goods and services produced in an economy
WagesThe payment firms make to households in exchange for their labor
RentThe payment firms make to households in exchange for land
InterestThe payment firms make to households in exchange for capital
ProfitThe payment to entrepreneurs who start or own businesses
Market economyIn its purest form, a market economy answers the three economic questions by allocating resources and goods through markets, where prices are generated.
Command economyIn its purest form, a command economy answers the three economic questions by making allocation decisions centrally by the government.

Key model

The circular flow model illustrates how a market economy works. In the model, households and firms engage in mutually beneficial exchanges of resources and products in the market.
Households are the owners of the factors of production and sell labor in exchange for a wage, land in exchange for rent, and capital in exchange for interest. Firms sell goods and services in exchange for money.
AgentSellsIn exchange forTo whomIn market
Households sellLandFor rentTo firmsIn factor markets
Households sellLaborFor wageTo firmsIn factor markets
Households sellCapitalFor interestTo firmsIn factor markets
Firms sellGoods and servicesFor moneyTo householdsIn product markets
The circular flow diagram
In the model, money flows in one direction—counterclockwise—and goods, services, and resources flow in the opposite direction—clockwise. In a market economy, one of the main functions that money serves is to facilitate the exchange of goods in the product market and the exchange resources in the resource market.

Key Takeaways

Property rights

Property rights are the ability to own and use resources (and anything made from those resources). Property rights are like the rules of a game such as soccer or hide-and-seek. When everyone knows the rules, and those rules are consistently enforced, people can focus on playing their best and having fun.

Economic systems

An economic system is any system of allocating scarce resources. Economic systems answer three basic questions: what will be produced, how will it be produced, and how will the output society produces be distributed?
There are two extremes of how these questions get answered. In command economies, decisions about both allocation of resources and allocation of production and consumption are decided by the government. In market economies, there is private ownership of resources—established though property rights—and the factors of production and consumption are all coordinated through markets. In a market system, resources are allocated to their most productive use through prices that are determined in markets. These prices act as a signal for buyers and sellers. Most economies are mixed economies that lie between these two extremes.
In either system, a rational agent would allocate resources and production using marginal analysis. In command economies, this is more difficult to do because without markets, prices fail at being an effective signal.

Want to join the conversation?

  • male robot hal style avatar for user Aryan  Pai
    Why would a firm demand land from households in the resource market?
    (4 votes)
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  • blobby green style avatar for user Sizhe Zhang
    Why is the capital in exchange of interest?
    And what does the interest mean here?
    (8 votes)
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  • blobby green style avatar for user yosef wolf
    Please confirm I have this right:

    In Market Economies, in addition to prices "controlling" the product market, prices also "control" the resource market. This would explain why, in market economies, an employee's field of work impacts the size of their wages: an employee with a scarce-yet-much-demanded-skill-set can charge lots of money for their "resources".
    (10 votes)
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  • blobby green style avatar for user Aisyah A.J
    "Rent is the payment firms make to household in the exchange for land". What if the firm bought that land? Do the firms still need to pay rent or now it has become capital, and firms need to pay interest?

    And what are the example of "household" as the owner of resources? I could only think household as in a member of a house/dwelling. Which in its smallest scale, only provide
    labor to firms.
    (4 votes)
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    • leafers seedling style avatar for user Peter
      the firm that owns the land is itself owned by folks that are the shareholders (or, in a small firm, it can be just the proprietor).
      So ultimately "households" indirectly own the land the firms are using. in this case the "interest" would be the dividends paid to the stockholders.
      Note: not all households equally own stuff, Rich folks are "households" that own lots of stuff, and poor folks are folks that often provide only labour.
      (1 vote)
  • blobby green style avatar for user sakria.z
    are there any online teachers for grade 10 students on this topic cause i feel like i need to be thought to understand
    (3 votes)
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  • leafers seed style avatar for user kalvin page
    Hi,
    I am not confident that this is an error and perhaps I am the only user suffering it.
    It seems as though there is a large jump in unexplained concepts between the 2 videos featured in this unit and the Overview.
    Is some content missing or are there only meant to be the videos: "Property rights in a market system" and "Markets and property rights"? If so, it seems like a large jump in the content.
    Thanks guys, I appreciate what you do!
    (3 votes)
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  • stelly green style avatar for user Maddie Palmer
    im confused on what the economic systems is. Are there specific kinds? or just one simple definition? I read the whole thing but i still dont understnd
    (1 vote)
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    • leaf green style avatar for user aaron.oustrich
      A command economy is one where the government has a large or complete control of the economy (for example communist or socialist states such as North Korea or the former USSR). Market or mixed economies give power to both the government and individual firms and households. An example of this is the USA economy where the private sector (firms) is not controlled extensively by the government.
      (4 votes)
  • blobby green style avatar for user awahnadege02
    thanks is was helpful enough
    (2 votes)
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  • male robot donald style avatar for user Josiah Carlson
    How does a big movie production company like Pixar use capital (and what kind of capital does it use)? I imagine the company would be involved in different resources than, say, a company producing physical products.
    (2 votes)
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  • blobby green style avatar for user 2683352572
    If Household sell labor for wage, does this means each individual is a household for their own labor? Because all individual can work (use their labor) in exchange for wage.
    (2 votes)
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