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Circular Flow

An exchange is a voluntary agreement between two people in which each gives something to the other and gets in return something that he considers of greater value. When John and Jim exchange baseball cards, John gets cards that he considers more valuable than those he gives to Jim, and Jim gets cards that he considers more valuable than those he gives to John. Unless both sides of the exchange feel that the exchange benefits them, the exchange will not take place. Because both sides benefit, exchange is, in the terms of game theory, a positive-sum game.

An alternative to interaction by exchange is interaction that involves coercion. With coercion, the actions of one side are not voluntary but forced. If Jim takes baseball cards away from John and threatens to beat him up if he complains, we have interaction based on coercion. Economics focuses almost exclusively on interactions based on exchange and ignores those based on coercion. As a result, it has much more to say about markets than about government, which is the primary agent of coercion in society.

People engage in exchange to attain goals. Exchange is not just take; in order to get, one must give. People must do things that they do not want to do in order to get things that they desire. The unpleasant part of this process is work and production, and the pleasant part is consumption. Work and production are not pursued for their own sakes, but only because without them we cannot consume. This division of economic life is illustrated below in what Frank Knight called the Wheel of Wealth, but which is now more commonly known as circular flow.

Circular Flow


The circular flow diagram divides the economy into two sectors: one concerned with producing goods and services, and the other with consuming them. Resources are converted into goods and services by business, and in this transformed state travel back to consumers. Money flows in the opposite direction. These flows involve two markets in which exchange takes place: the resource or factor market in which business buys resources, and the goods and services market in which business sells goods. (Some economists define a "factor of production" as the service of some resource. If resources are land, labor, and capital, the factors of production are the services of land, labor, and capital. We will ignore the distinction between resources and factors of production in the discussion that follows.)

Both the model of supply and demand and consumer choice with utility analysis are key elements of an understanding of an exchange economy. However, this group of readings emphasizes the right side of the circular flow diagram, examining the business firm and the constraints or limitations that it must face in its fight for survival.

The economic theory of the firm is founded on the three fundamental tasks of a firm.

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