WHAT DOES A CIRCULAR FLOW DIAGRAM REPRESENT?

CIRCULAR FLOW DIAGRAM

A circular flow diagram is an economic model which is built on some assumptions and they are:

1. There are only two participants in the market i.e. households and firms
2. The market is not regulated
3. There are no exports or imports
4. The output is equal to the inputs

• As mentioned earlier that there are two participants in the market and they are households and firms.
• Households are the consumers and firms are the producers.
• Households consume goods but they supply factors of production namely land, labor and capital.
• Firms produce goods but they require factors of production
• The outer circle in the diagram represents the flow of inputs whereas the outer circle represents the flow of dollars 

OUTER CIRCLE 

• If we start from the top product markets supply goods to the households. 
• The households consume the products and provide factors of production to resource markets
• These resource markets provide the resources to the firms and firms use the resources to produce goods and services
• Now we come to the inner circle

INNER CIRCLE

• Again we start from product markets. The revenue collected by the product markets is given to the firms
• The firms use this revenue to pay for the factors of production
• This payment is a source of income for households 
• The households then spend their income in purchasing goods from the product markets.

The link http://www.econforkids.com/CE-Lesson7.pdf illustrates the circular flow diagram in a very simple way.

The above video explains the circular flow diagram comprehensively