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3 (18) - CHAPTER 2 Transactions The Circular-Flow Diagram...

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Unformatted text preview: CHAPTER 2 Transactions: The Circular-Flow Diagram The little economy created by Tom and Hank on their island lacks many features of the modern American economy. For one thing, though millions of Americans are self-employed, most workers are employed by someone else. usually a company with hundreds or thousands of employees. Also. Tom and Hank engage only in the sim- plest of economic transactions. barter, in which an individual directly trades a good or service he or she has for a good or service he or she wants. In the modern econo- my. simple barter is rare: usually people trade goods or services for money—pieces of colored paper with no inherent value—and then trade those pieces of colored paper for the goods or services they want. That is. they sell goods or services and buy other goods or services. And they both sell and buy a lot of different things. The U.S. economy is a vastly complex entityI with more than a hundred million workers employed by millions of companies, producing millions of different goods and services. Yet you can learn some very important things about the economy by considering the simple graphic shown in Figure 2-7. the circular-flow diagram. This diagram represents the trans- actions that take place in an economy by two kinds of flows around a circle: flows of physical things such as goods. services, labor. or raw materials in one direction. and flows of money that pay for these phySical things in the opposite direction. In this case the physical flows are shown in yellow, the money flows in green. The simplest circular-flow diagram illustrates an economy that contains only two kinds of “inhabitants": households and firms. A household consists of either an individual or a group of people (usually. but not necessarily. a family) that share their income. A firm is an organization (usually. but not necessarily, a corporation) that produces goods and services for sale—and that employs members of households. As you can see in Figure 2-7. there are two kinds of markets in this simple economy. On one side (here the left side) there are markets for goods and services in which households buy the goods and services they want from firms. This produces a flow of goods and services to households and a return flow of money to firms. On the other side, there are factor markets in which firms buy the resources they need to produce goods and services. Recall from earlier in the chapter that the main factors of production are land, labor, capital. and human capital. rrcuee 2-7 The Circular-Flow Diagram This diagram represents the flows of Money money and goods and services in the economy. In the markets for Goods goods and services, households pur- and chase goods and services from firms, SEMCES generating a flow of money to the firms and a flow of goods and serv- ices to the households. The money flows back to households as finns purchase factors of production from the households in factor markets. Households Markets for goods and services Goods and services Money ECONOMIC MODELS: TRADE-OFFS AND TRADE 35 Trade takes the form of honor when people directly exchange goods or serv- ices thatthey have for goods or services that they wa nt. The circular-flow diagram represents the transactions in an economy by flows around a circle. A household is a person or a group of people that share their income. A firm is an organization that produces goods and services for sale. firms sell goods and services that they produce to households in markets [or goods and services. firms buy the resources they need to produce goods and services in factor markets. Factor markets ...
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