Cantillon presented the economy as a unified system, comparable to the cosmos, in which the individual elements were interdependent on one another. Cantillon probably wrote his only surviving work, Essai sur la Nature du Commerce en Général ( An Essay on Commerce in General), in the year 1732 or thereabouts, but it was not published until 1755 in France. An obscure Irish banker named Richard Cantillon (1680–1734) may have been the first to use the concept. The idea that income and goods flow in a circular fashion between businesses and households dates to the earliest economic theorists. Likewise, the products that households need and want come from businesses, and the factors of production that businesses need in order to operate come from households. The money that households use to satisfy their needs and wants comes from businesses, and the money that businesses need in order to operate comes from households. They are bound to one another by supply and demand relationships that, in being played out, dictate the working of the economy. Businesses and households are dependent on one another. This model is a simplification of economic activity, but it allows us to understand some central facts about market economies. The outer circle of the model shows income (money) moving counterclockwise between businesses and households. The inner circle of the model shows products and services moving clockwise between businesses and households. Businesses sell products to households in exchange for money, and households sell products called the factors of production (land, labor, and capital, the resources required to do business) to businesses. Businesses and households act as both buyers and sellers in the economy. The circular flow model illustrates how market forces determine the overall shape of the economy. When buyers decide to purchase or not purchase certain goods in certain quantities, sellers make corresponding decisions about what to supply and in what quantities. Sellers tend to supply more and more of their products as prices rise (because they want to maximize their profits), while buyers tend to buy less and less of a product as prices rise (because they want to maximize their own economic well-being). Most economic decisions in a market economy are based on the forces of supply (the amount of any good or service that a seller is willing to sell at a given price), demand (the amount of any good or service that buyers are willing to buy at a given price), and prices. A market economy is one in which the free interaction of buyers and sellers determines most of the important features of economic life. This situation is often illustrated using a diagram that allows us to visualize the basic workings of the overall economy.Ī market is any place or system allowing buyers and sellers to come together. This means that money and products (including the products businesses need to operate) move in a circular fashion between businesses and households. Circular Flow of Economic Activity What It MeansĪll market economies are characterized by a circular flow of economic activity.
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