Explain how the circular flow diagram relates to the current economic situation. Using the circular flow diagram, explain a way that your family interacts in the factor market and a way that it interacts in the products market. 200 word minimum

Figure 2: The Circular Flow of Economic Activity

  

Note. From Principles of Microeconomics, by Case, Fair, and Oster, 2009, P. 47, Upper Saddle River, New Jersey: Pearson Prentice Hall.

Figure 2 shows the circular flow of economic activity through a simplified market economy: goods and services flow from firms to households through output markets and resources (labor, capital, land) flow from households to firms through factor markets.  Payments flow in the opposite direction.

Price is the basic coordinating mechanism in a free market system. A price is the amount that a product sells for per unit, and it reflects what society is willing to pay. Prices of inputs—labor, land, and capital—determine how much it costs to produce a product. Prices of various kinds of labor, or wage rates, determine the rewards for working in different jobs and professions. Many of the independent decisions made in a market economy involve the weighing of prices and costs, so it is not surprising that much of economic theory focuses on the factors that influence and determine prices. This is why microeconomic theory is often simply called price theory (Case, Fair, and Oster, 2009).

The most important relationship in any market is that between market price and quantity demanded.   In analyzing the relationship between the quantity demanded of a good per time period and it’s price, it is necessary to hold income, wealth, other prices, tastes, and expectations constant, i.e., using the convention of ceteris paribus or “all else equal.”

It is also necessary to distinguish between price changes which affect the quantity demanded and changes in other factors such as income which change the entire relationship between price and quantity.  Thus, a change in price will affect the quantity demanded per period whereas a change in other factors, say for example income, will affect demand.

Thus, if the price a product increases, it is likely to cause a decrease in the quantity demanded.  However, an increase in income is likely to cause an increase in demand for most products.

A demand schedule shows how much of a given product a household would be willing to buy at various prices.  A demand curve is a graphic illustration of this relationship.