The circular flow diagram (also called the circular flow model) is perhaps the simplest diagram/model of economics to understand. In essence, the circular flow diagram displays the relationship of resources and money between firms and households. Every adult and even most children can understand its basic structure from personal experience. Firms employ workers, who spend their income on goods produced by the firms. This money (income spent by workers which turns into revenue by firms) is then used to compensate the workers and buy raw materials to make the goods. This is the basic structure behind the circular flow diagram (seen below.)
In the model, firms and households interact with one another in both the product market (or goods market) and the factors of production market (or factors market). The product market, as mentioned in the name, is where all products made by businesses/firms are exchanged. The factors of production market is where inputs such as land, labor, capital, and other resources are exchanged. Households earn money by selling their “resources” (most often labor) to businesses in the factor market. In return, households receive income. The price of the resources the businesses purchase (labor from households) are the “costs.” From the resources provided by households, businesses produce goods, which are then sold in the product market. Households use their incomes to purchase these goods in the product market. In return for the goods, businesses bring in revenue. While this may seem like a lot of information, it is actually quite logical. Even though the graph itself is extremely simple to most people, it is important to have it completely memorized. Know the names of each market and the actions that occur in each. For high school and college students, the circular flow diagram is a common theme on many tests. It should result in easy points for those of you that have it memorized.