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By the end of this section, you will be able to:

  • Interpret a circular flow diagram
  • Explain the importance of economic theories and models
  • Describe goods and services markets and labor markets

John maynard keynes

The image is a photograph of John Maynard Keynes.
One of the most influential economists in modern times was John Maynard Keynes. (Credit: Wikimedia Commons)

John Maynard Keynes (1883–1946), one of the greatest economists of the twentieth century, pointed out that economics is not just a subject area but also a way of thinking. Keynes, shown in [link] , famously wrote in the introduction to a fellow economist’s book: “[Economics] is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions.” In other words, economics teaches you how to think, not what to think.

Watch this video about John Maynard Keynes and his influence on economics.

Economists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline. They analyze issues and problems with economic theories that are based on particular assumptions about human behavior, that are different than the assumptions an anthropologist or psychologist might use. A theory    is a simplified representation of how two or more variables interact with each other. The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done well, this enables the analyst to understand the issue and any problems around it. A good theory is simple enough to be understood, while complex enough to capture the key features of the object or situation being studied.

Sometimes economists use the term model    instead of theory. Strictly speaking, a theory is a more abstract representation, while a model is more applied or empirical representation. Models are used to test theories, but for this course we will use the terms interchangeably.

For example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Companies often build models of their new products, which are more rough and unfinished than the final product will be, but can still demonstrate how the new product will work.

A good model to start with in economics is the circular flow diagram    , which is shown in [link] . It pictures the economy as consisting of two groups—households and firms—that interact in two markets: the goods and services market    in which firms sell and households buy and the labor market    in which households sell labor to business firms or other employees.

The circular flow diagram

The circular flow diagram’s outer arrows represent a goods and services market, and the inner arrows represent a labor market. As illustrated by the outer arrows, in a goods and services market, firms give goods and services to households and, in exchange, households give payment to firms. As illustrated by the inner arrows, in a labor market, households provide labor to firms and, in exchange, firms give wages, salaries, and benefits to households.
The circular flow diagram shows how households and firms interact in the goods and services market, and in the labor market. The direction of the arrows shows that in the goods and services market, households receive goods and services and pay firms for them. In the labor market, households provide labor and receive payment from firms through wages, salaries, and benefits.

Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for revenues. This is shown in the outer circle, and represents the two sides of the product market (for example, the market for goods and services) in which households demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries and benefits. This is shown in the inner circle and represents the two sides of the labor market in which households supply and firms demand.

This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports).

Economists carry a set of theories in their heads like a carpenter carries around a toolkit. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the theory to derive insights about the issue or problem. In economics, theories are expressed as diagrams, graphs, or even as mathematical equations. (Do not worry. In this course, we will mostly use graphs.) Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve. Both micro and macroeconomics are explained in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn a number of others.

Key concepts and summary

Economists analyze problems differently than do other disciplinary experts. The main tools economists use are economic theories or models. A theory is not an illustration of the answer to a problem. Rather, a theory is a tool for determining the answer.

Questions & Answers

how may I solve arithmetic mean ,,,all example
Cee Reply
what is agriculture
Itoe Reply
simple method of understanding cost concept
Oludare Reply
what is inflation
Christiana Reply
Inflation is a general increase in price levels
is the action of inflating something
inflation is the persistent increase in general price level of goods and services in an economy over a considerable period of time .
inflation is the general increase of a commodity in a particular period of time.
inflation is a general increase in price levels of commodities
what are the types of inflation?
inflation is the period of persistent rise in the general level of the price of goods services over time
we have creeping inflation, demand pull inflation ,cost push inflation, and galloping inflation .
how can a location of a firm create difference between producers
joy Reply
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is a monetary from policy that's authorized of country encharces
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Essay about Microsoft
Kwena Reply
what is economics
Julie Reply
what do you mean by means in economics
economic is the wealth of a country.
monetary policy is refer to as being expansionary or contractionary.
pls who can help me to explain money market and capital market
money market is base on short term loan which is within one year period while capital market is long term loan more than one year...
money market is a market were short term loans are dealt with while capital market is a market were long term loans are traded
What is mean by monetory policy
monetary polices are rules that control the rate of monetary exchange in an economic as a whole.
wealth of the nation
important of unemployment
Otwe Reply
Important of unemployed
what is meaning scarcity
Scarcity can be define as human wants to goods,services,resources for exceed of what is available
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Can be defined as the inability to get everything we want
less ability for the available goods and services that's on sale
what is the definition of money market
what is consumer
Brenda Reply
how do consumer help people
by export trading
How do you mean Jayah
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what is MRS
definition of economics according to Adam Smith
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economic is a wealth of nation
in the view of Adam Smith economics is the study of activities of people in production of wealth
Economics is any human activity that lead to the provision of substance and or amassing wealth.

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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