Lesson 10 - The Circular Flow of Economic Activity

IN ODUCTION

Econom ics The circular fl ow of econom ic acti vity is a sim­plified macroeconomi c model of the ba sic eco­nomic relationships in a market economy. This mod el gives the students a n overview of how households, businesses a nd government inter­a ct in different ma rkets by excha nging goods and services, pr oductive resources (also known as inputs or the factors of producti on) and money.

Reasoning P eople respond to incentives . Households have incentives to pr ovide resources to businesses to receive income in r etur n . Th ey then have in cent ives to use their income to purchas e goods a nd services to sa tisfy their wants. Businesses have in cent ives to ea rn pr ofits and, therefore, to produce the goods and services that consumer s wa nt. To produce goods and services, businesses need to purchase re sources from ho useholds. The circular -flow mod el and the simulation in this lesson demonstrate these impor tant relationships .

CONCEPTS

Circula r flow of goods, services, productive resources and money payments

Inter dependence Productive resources

(na tural, human and capital) Resource payments

(wages and salaries, rent, interest, profit)

CONTENT STANDARDS

7. Markets exist when buyers and sellers interact . Th is interaction determines mar­ket pri ces and thereby alloca te s scarce goods and serv ices .

16 . There is an economic rol e for government to play in a market economy whenever the benefits of a government policy ou tweigh its costs . Governments often provide for national defense, address environ menta l concerns , define and protect property r igh ts, and attempt to make markets more competitive. Most government policies al so redi stribute income.

18. A nation's overall levels of income, employ ­ment a nd prices are determined by the interaction of spending and production deci sions made by all households, firms , government agencies and others in the economy.

OBJECTIVES

Students will 1. Identify and describe the three types of

productive resources (inputs) and the kind of income each resource earns.

2. Analyze the economic relationships between households and businesses in a market economy.

3. Use a circular-flow diagram to illustrate the economic relationships among house­holds, businesses and government.

ECON<1:I llCS IN ACTION, 'Q NATIONAL COL:-:CIL m~ ~; CO~O M I C EDUCATION, NEWYORK, NY Sf

. LESSON 10 - THE CIRCULAR FLOW OF ECONOMIC ACTIVITY

LESSON DESCRIPTION

In this lesson, the students read about market int eractions and participate in a simula tion . "Econoland" involves transactio ns between bu sinesses and households in tv 0 kinds of ~ ar1( et s: product ma rkets and resource (or in put) marke t s. They discuss how the govern­ment fit s in to this mode l and transla te their conclusions int o a circular -flow diagra m.

TIME REQUIRED

7fj minutes: 45 minu tes to conduc t a nd discuss the simula t ion and 30 minutes t o complete . ct ivit ies 10.5 and 10.6

MATERIALS

Note : Prepare material s for the simula tion before cla ss, mainly cutting ap art activity sh eets and creating sets of ma ter ials for the s tudents. If possible, laminate badges, cards a nd money to use in mul tip le classes .

I . Visuals 10.1 and 10.2

2. A copy of Act ivity 10.1 (two pages) for each student

3. Enou gh copies of Act ivity 10.2 (one Business Badge and 10 $100 bill s) for h alf the stud ents in the class . These students will represe nt bu sinesses .

4. Enough copies of Act ivity 10.3 (five H uman Resources ca rds, five Natural Resources' cards and five Capit al Goods ca rds) for the rest of the students in the clas s, wh o will represen t hou seholds. Mix the se ts up so the cards are not distr ib ­u ted equally: Make one set with 15 Natural Resources ca rds, for example, an d a nother with 10 Hu man Resources cards a nd five Capital Goods ca rds . Just ma ke su re each set includes a total of 15 cards .

5. Enough copies of Activity 10.4 (10 Econo ca rds) for half the students in the class. You will ~ee d to cut these car ds apart, but t~ey don t need to be put into sets. Econos will be distributed during the simulation,

so you ca n put them in an envelope or con ­t ai ner to ma ke it ea sy to give them out .

6. A copy of Act ivity 10.5 and Acti vity 10.6 for each student

7. A large piece of pa per on which you have written ECON O FACTORY

8. Masking tap e or straight pins so the s tu­den ts ca n wear the Business Badges

9. (Optional) Two sma ll prizes

PROCEDURE

1. Expl ain to the students that people pa rtic ­ipa te in the economy in a variety of ways. People make deci ions as cons umers when they purchase goods and services . They make decisions as produ cer s when they provide human and natural resources they own to bu ine sses or when their sa vings allow businesses to borrow to make invest ­ments in capit al goods. They a lso make decisions as cit izen s , especially as voter s, that influence the economic decisions mad e collectively in t he economy.

2. Explain that the class will engage in a sim­ul ation called "Econoland" to learn about the interrela tionships between households an d businesses in a market economy.

3. Give each student a copy of Activi ty 10.1. In struct the students to read "Overview." Review th e role of h ous ehol ds, th e three ca tego r ies of productive resources a nd the roles of business fir ms. Ans wer a ny qu es­tions ab out th e conce pts in volved.

4. Divide the class in half. Student s in one group will represent business firms and students in the othe r group will represent households. Give each business fir m 10 $100 bills and a Business Badge t o wear during the simula t ion . Have bu siness firms tape or pin their badges t o their shirts to make them more recognizable to the households. Give each household a se t of 15 resources cards.

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THE CIRCULAR FLOW OF ECONOMIC ACTIVITY - LESSON 10

5. Have the students read the instructions for the "Econoland" simulation on the sec­ond pa ge of Activity 10.1. Make sure households know they mu st sell their re sources cards for money and then use the money to buy Econo s, wh ich represent products. Make sure businesses know they must pay money for the resources cards and then sell Econos to the households.

6. Tape the ECONO FACTORY sign in the place where firms will exchange three cards - one Natur al Resour ces , one ~Human Resources and one Ca pital Goods - for one Econo. Remind the students that Econos represent goods and services busi­nesses sell to households. You or a student you select will s taff the Econo Factory.

7. R view the instructions for the simulation and a nswer any questions. Re mind the students that th e goal of each business firm is to end the simulation with as much money as possible. Businesses must pay money to obtain the productive-resources cards. The goal of each household is to end wi th as many Econos as possible. Househ olds mu s t sell their re sources cards for mon ey, and they ma y buy only Econos with money.

8. Conduct the simula tion. Allow the stu­den ts up to 20 minutes to engage in their exchange activities (they usually finish in 15 minutes or less). When you observe that about half the households have sold all their resourc s cards, announce that exchanges will end in five minutes. Students must know in advance when the excha nge period will end so they can plan for the orderly sale of their remaining pro­ductive resources and Econos. (Some households might try to circumvent the business process by bringing resources cards directly to the Econo Factory. Explain that they lack a Business Badge and therefore cannot produce Econos. If a student is staffing the Econo Factory, make sure the student is aware of this possibility and knows how to respond.)

9. After the simulation ends and the stu­dents have returned to their seats, ask them how well they did: Which household obtained the most goods and services (Econos) during the simulation? Which business firm now has the most money? (O p tio n a l) Provide a small prize to the household with the most Econos and to the business with the most money.

10. Project Visual 10.1. Explain that the dia­gram shows the circular flow of productive resources (factors of production), goods and services (products) and money pay­ments. Ask the st udents to' describe how households and businesses are in terdepen­dent. Ask them to rela te the circular -flow diagram on Visual 10.1 to the "Econola nd" simula tion. Students who represen ted businesses acquired productive resources (human-resources, natural­resources and capital-goods cards) from households through the Resource Marke t in exchange for money-income p ay m en ts . Busin esses exchanged resou rces cards for Econos, which rep­resent goods and se rvices. Businesses sold Econ os to households through the Product Ma.rhet in exchange for money payments.

11. Distr ibute a copy of Acti vity 10.5 to each studen t. Tell the students to answer Quest ions 1, 2 and 3 using the informa­tion they gained fro m the simulation and from Visual 10.1 (reproduced at the top of Activity 10.5). Discuss their answer to the qu estions.

1. According to the diagram, in which markets do businesses give money-income payments to households in excha nge for their product ive reso urces '? Resource markets

2. I n which markets do households give money payments to bu sinesses in exchange for goods and services? P ro d u ct mar/lets

3. Wh a t did Econos represent in the simulation? Goo ds a n d servi ces busi­nesses sell to households

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LESSON 10 THE CIRCU AR F LOW OF ECONOMIC ACTIVITY

12 . Project Visual 10.2, and as k the students to compare this diagram with the diagram on Activity 10.5. Discuss all the ways the circular-flow mod el was alte red to incorpo­rate the government sector and suggest that even more changes would have to be made to the char t if we were to incorpo­r ate international-trad e rela tionships.

13. Distribute Activity 10.6 a nd note that the circular -flow diagram from Visual 10.2 is re produced at the top. Ins t ruct the stu ­dents to answer Questi ons 1, 2, 3 and 4 using the information on Act ivity 10.6. Discuss the answers .

1. Give an exa mple of a produ tive resource that hou seh olds sell to govern ­

ment. Ansu ers uiil l oary and include teachers toorleing in public sc hools..

2. Give an exa mple of a good or ser vice that businesses se ll to government.

Answers will va ry and include com­pu ters, com m u n ica t io ns s a te ll ite s, accounting seru ic es and ai rplan es . .

3. Give an exa mple of a good or service that government provides to households in exch ange for money payments, mainly

taxes . Answers will va ry and include sch ools. p olice and l i re departments, roads and libraries .

4. Give an exa mple of a good or service that government provides to businesse in exchange for money payme nts .Answers

w ill vary and in cl ud e poli ce, high­ways, air-tra ffic control se rvices and disaster ass is ta n ce.

Not e: Transfer p ayments are government paym ents for which recipi ents do not cur ­rently perform produc tive serv ices. Significant trans fer paymen ts in th e United States today include Social Security ben efits , Me dicar e and Medi caid , government-employee retirement benefit s, unemployment compensation and public assistance su ch as food stamps.

CLOSURE Explain to the class that the U.S . economy is organi zed around a system of private markets in which prices for goods and services are determined by the interacti on of buyers and selle rs . This form of economic activity creates a t ype of interdependen ce between people in househol ds and people in busin esses. Ask:

1. How do individuals and fa milies in house­holds depend on people in bu sinesses?

People in hou seholds buy th e goods and services they d es ire from business­es. Th ey sell th e p roductive resou rces th ey OWIl to businesses to earn in com e.

2. How do businesses depend on in dividuals an d families in households?

Businesses sell goods and se rvices to households to earn re venu e and m ake a profit . They p u rchase product ive resources fr om households to produce th e goods and servi ces consumers d esire.

3. What is the role of governmen t in the cir ­cul ar flow of economic act ivity?

Go ve rnment taxes businesses and h ou seh olds to pay for th e p rod ucti ve resources it uses to provide certain hinds of goods a nd services to house­h olds and businesses.

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THE Cm CULAR FLOW OF ECONOMIC ACTIVITY - LESSON 10

VISUAL 10.1 THE CIRCULAR FLOW OF PRODUCTIVE RESOURCES, GOODS AND SERVICES AND MONEY PAYMENTS

Money Payments

Go ods a n d S ervices

PRODUCT ARKETS

USEHOLDS

RESOURC MARKETS

Prod uc t ive Resou r ces

Mo n ey-In com e Payments ...-........­

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· LESSON 10 - THE CIRCULAR FLOW OF ECO NOMIC ACTIVITY

VISUAL 10.2 GOVERNMENT IN THE CIRCULAR FLOW

Mo n e y P a y m e n t s

Good s and Services

PRODUCT MARKETS

HOUSEHOLDS GOVERNMENT BUSINESSES

Prod u ctive Resources

RESOURCE MARKETS

Mo n ey-I n c om e Payments

-,

..........~....._ ......

Mo n ey Pa y m ent s

(Tax es)

Go ve r nme n t Goo d s a nd Se r vi ce s

l\I o n ey Payments

(Tax es)

Go ve r n m e n t Goods a n d -_-. Se r v ic es

P r od u c t ive Re so u rce s

Money­I n com e

Paym e n ts

Mo n e y Pa yme n t s

Good s a n d Ser v ic es

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THE CIRCULAR FLOW OF ECONOMIC ACTIVITY - LESSON 10

ACTIVITY 10.1 EARNING A LIVING IN ECONOLAND

OVERVIEW

Th e Rol e s of Ho u seh o lds (I nd ividuals and Families)

I ndividuals function as both consu mers and producers. In the U.S. economy, households act as consumers when th ey buy goods and services that businesses produce. Th ese exchanges take place in product m arkets. Buying food at a local grocery store is an exchange in a pr oduct market.

As resource owners, individuals function as producers by sup plying productive r esources to busi­nesses, which use these re sources to produce goods and services. These exchanges t ake place in resource m arkets (also calle d factor, productiue-resource or input markets). Examples of transac­tions th at occur in resource markets are businesses paying wages to worker s, rent to landowners or interest on loans for pla nt and equipment.

Bus ine sses use three cat egories of productive resources to produce goods and services: human l' source . natural re sources and capital.

Human r esources are the number of people av ailablefor work and the skills and motiva­ti on of these in dividual s. Businesses pay wag es ':J.i16 salar ies to households for their labor se rvices. Entrep reneursh ip refers to a specia l type of human re source that as sumes th e risk of organi zing other r esources to produce goods and se rvices . The payment to entrepreneu rs is ca lled profit.

Natural resources a re gifts of nature. Th ese in clude undeveloped land, oceans and rivers, for ests. oil and min eral deposits, and climactic conditions.

Capital refer s to the manufactured or constructed it em s that businesses us e in the produc­tion proc ess. These items include buildings, machinery and equipment. (In everyday speech , people commonly refer to mon ey as capital; but in economics, the term capital refer s to the real productive resources used to produce other goods and services .)

The Roles of Business F irms

Like households, bu sinesses fun ction as both consume rs and producers . Businesses supply goods and services in the product market. They are the buyers, or cons umers, of the productive resources (human re sources , natural resources and capital resources) used to produce goods a nd services. Bu sinesses try to sell their products for more than their costs of production, thereby earning a profit. If a business is not successful, it will incur losses. In order to earn a profit , busi­ne sses mu st supply products that households want to buy and supply these products at competi ­tiv e prices. If a business doesn't produce what households want to buy, or if it doesn't keep it s costs of production low enough to compete with other producers, it will incur loss es . A firm will eventually go out of business if it continues to incur losses.

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LESSON 10 - THE CIRCULAR FLOW OF ECONOMI C ACTIVITY

ACTIVITY 10. 1, continued

EARNING A LIVING IN ECONOLAND

INSTRU CTIONS FOR THE ECONOLAND SIMULATION

I n this simulation, you will play the role of either a household or a business. Read carefully ab ou t both roles. Then your teacher ill assign your role.

Households: Your first goal is to sell to businesses the hu man resources, natur al resources and capital goods the y use to produce a product. Then , with the income you earn from selling those productive resources, you will purchase from businesses the goods and services your household wants to con­sume. In th is simulation, these goods and services are called Econos. Your success as a household will be me asured by the number of Econos you accumulate. You will be given 15 Productive Resource card s. You may not wa nt to sell all your resources immediately because their prices may change as the ga me goes on. In general, however, the more resources you sell, the more money you will earn to acquire Econos . Be sure to sell all you r resource cards before the ac tivity ends, beca use at the end of the simul a tion, only the Econos you have will count.

Bu sines Firms: Your goal is to ea rn a profit by supplying the goods and se rvices households want. In th is activity, the only products hou seholds want to buy are Econos . To produce one Econo, you mu st acquire one un it of huma n resou rces. one unit of natural resources a nd one unit of capita l goods . You must b y th ese resources from households at the best price you can negotia te. Once you have accumulated one unit of eac h re source, you may turn the set of three cards in at the Econo Factory, which will produce one Econo for you . You are then fr e to ell the Econo to any house­hold for the best price you can negotiate. To earn a profit, you must sell the Econo for more than your costs of production , which in th is ga me include the wages and salaries paid for the use of human re sou rces, the rent paid for the use of natural resources and the interest paid for the use of capital. You can then use the money you rec eive to buy more productive res ources in order to produce and sell more Econos. You have $1,000 to start the game . Your business success will be measured by the dolla rs you have at the end of the activity. Try to se ll all your Econos by the end of th e activity. If you run out of money and have no Econos to sell, announce publicly tha t you are bankrupt and re turn to your seat.

A Word ab out Pricing: You will use only $100 bills in this activity. It is possible to arrive at prices other than $100, $200, $300, etc ., by combining sever al items in a single transaction . For example, two Productive Resources cards could be sold for $30 0, which is the equivalent of $150 each. Five cards could be sold for $300, which is the equivalent of $60 each. However, you must agree on a price for which an exchange can take place using the denominations of money provided in the simulation. The suggested price range for Productive Resources cards is $50 to $300, but any price that buyers and sellers agree to a nd can complete using $100 bills is acceptable.

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THE CIRCULAR FLOW OF ECONOMIC ACTIVITY - LESSON 10

ACTIVITY 10.2 BUSINESS BADGE AND MONEY

100 100

BUSINESS

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·LESSON 10 - THE CIRCULAR FL OW OF ECONOMIC ACTIVITY

ACTIVITY 10.3 HOUSEHOLD CARDS

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THE CIRCULAR FLOW OF ECO OMIC ACTMTY - LESSON 10

ACTIVITY 10.4 ECONO CARDS

1 1

1 1

1 1

1 1

1 1

1 1

1 1

1 1

1 1

1 1

o

o PRODUCT

PRODUCT

PRODUCT

PRODUCT

PRODUCT

FINISHED

1

1

1

1 .

1

1

1

1

1

E 1

1

1

1

1

1

1

1

1

1 o

o

o PRODUCT

PRODUCT

PRODUCT

PRODUCT

PRODUCT

Eco:-;mllCS II' ,\ CTIO:\. NATIONAL COUNCIL ON EC ONO ~Il C EDUCATION. NEW YOltK. N Y. 95

LE SSON 10 - THE CIRCULAR FLOW OF ECONOMIC ACTIVITY

ACTIVITY 10.5 THE CIRCULAR FLOW OF PRODUCTIVE RE SOURCES, GOODS AND SERVIC ES AND MONEY PAYMENTS

Mo n ey Payments

Goods and Services

PRODUCT MARKETS

HOUSEHOLDS

RESOURCE MAR K TS

Prod uctive Resources

Mon ey-I n com e Payments .._~.........

1. According to the diagram, in which markets do businesses give money-income payments to households in exchange for their productive resources?

2. In which markets do households give money payments to businesses in exchange for goods and services?

3. What did Econos represent in the simulation?

ECONOMICS IN ACTION, 0 NATIONAL COUNCIL ON ECONOMIC EDUCATION, NEW YORK, NY 96

•

THE CIRCULAR FLOW OF ECONOMIC ACTIVITY - LESSON 10

ACTIVITY 10.6 GOVERNMENT IN THE CIRCULAR FLOW

Mon ey Payments

Goods and Services

PRODUCT MARKETS

HOUSEHOLDS GOVERNMENT BUSINES SE

'.

GOOdS a nd

~ Services

Mo ney P a ym e n ts

RESOURCE MARKETS

P rod u c t ive Resources

Money-Income Paym e n ts .......-­

1. Give an exam ple of a productive r esource that households sell to government,

2. Give an exa mple of a good or service that businesses sell to government,

3. Give an example of a good or service t hat government provides to households in exch ange for money paym ents, mainly taxes.

4. Give an example of a good or service t hat government provides to bu sinesses in exchange for money payments .

ECOt\ OMI C8 IN ACTfO :" " NATIONAL c ouxc n . ON ECm;O ~l!" LD UCATI01\', i\'EW YORK, :\ Y. 97