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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

what is economic
Okechukwu Reply
Economics is a science of wealth
Taur
hi
scor
what is economic and what is the definition
scor
economic is science and arts both........
SHADAB
to me is a science which study human behavior as a relationship between ends and scare which have alternative use
Ada
economic is a science which study human and environment
Akor
Explain any five limitation to division of labour
Aliyu Reply
production
Abddeeyat
size of the market. for example..let's take a look at a barbing saloon. the number of hands needed there isnt up to the one needed in a company or production line because the number of people the barbing saloon is serving cant be up to the ones of the company
Abisola
Answer: The four basic problems of an economy, which arise from the central problem of scarcity of resources are: What to produce?How to produce?For whom to produce?What provisions (if any) are to be made for economic growth?
Yusuf Reply
what is the basic economic problem
Arnold Reply
what is the basic problem
Arnold
importance of elasticity of demand
Ayuk Reply
what nature is price elasticity
Ayuk
nature of price elasticity
Ayuk
is it de basic economic problem
Arnold
Answer: The four basic problems of an economy, which arise from the central problem of scarcity of resources are: What to produce?How to produce?For whom to produce?What provisions (if any) are to be made for economic growth?
Yusuf
All teachers economic development
HASSAN
what is macro economics
ROGATH Reply
In the short-run, the monopoly makes?
Felix Reply
A demand which gives rise to the reverse of the law of demand is?
Felix
Price  (₦)Quantity Demanded 8  610  12 If we move from 8 to 6, the elasticity of demand is
Felix
inelastic demand
ROGATH
there is change in price but no change in demand. if price increase 10% but demand remain constant
Taur
does inventories accumulation included in GDP?
kelly Reply
Selling goods and services below or above the equilibrium price.
Daniel Reply
I will be there at the same time .....
SHADAB
Yes
HASSAN
Economics it big in the capital in
HASSAN
what is the meaning of black market
David Reply
the law of demand to price of goods if price is $13 and quantity $60, price $20 and y variable how calculate
Jackie Reply
what is diminishing marginal utility
Harish Reply
what is indifference curve
Harish
when the rate of utility goes on diminishing with every success ful unit is know as diminishing marginal utlity
Sana
what's economic growth
Rukundo Reply
what is economic growth
Rukundo
what is growth
Amina
growth is a sort form of development growth means development of only one specil part
RAJESH
one special part
HASSAN
what is wants
Daudu Reply
want is a specil desire whereas have you available resources for satisfying desire of products
RAJESH
what is scarcity
Syanda Reply
scarcity means wants
Daudu
scarcity is the situation whereby there are limited means in a world of unlimited ends.
suleysh
ok
Daudu
what is end?
Daudu

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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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