This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe imports and exports. Economists carry a set of theories in their heads like a carpenter carries around a toolkit.
When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the theory to derive insights about the issue or problem.
In economics, theories are expressed as diagrams, graphs, or even as mathematical equations. Do not worry. In this course, we will mostly use graphs. Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve.
Both micro and macroeconomics are explained in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn a number of others.
Economists analyze problems differently than do other disciplinary experts. The main tools economists use are economic theories or models. A theory is not an illustration of the answer to a problem. Rather, a theory is a tool for determining the answer.
Skip to content Increase Font Size. Chapter 1. Welcome to Economics!
Learning Objectives By the end of this section, you will be able to: Interpret a circular flow diagram Explain the importance of economic theories and models Describe goods and services markets and labor markets. Self-Check Questions Suppose we extend the circular flow model to add imports and exports. Copy the circular flow diagram onto a sheet of paper and then add a foreign country as a third agent. Draw a rough sketch of the flows of imports, exports, and the payments for each on your diagram. What is an example of a problem in the world today, not mentioned in the chapter, that has an economic dimension?
Are households primarily buyers or sellers in the goods and services market? In the labor market? Are firms primarily buyers or sellers in the goods and services market?
Also, suppose you do not have a specific model for analyzing that issue. What should you do? Hint: What would a carpenter do in a similar situation? Glossary circular flow diagram a diagram that views the economy as consisting of households and firms interacting in a goods and services market and a labor market goods and services market a market in which firms are sellers of what they produce and households are buyers labor market the market in which households sell their labor as workers to business firms or other employers model see theory theory a representation of an object or situation that is simplified while including enough of the key features to help us understand the object or situation.
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