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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 elasticity
Osei Reply
what is structural inflation please help
Reliance Reply
in the structural inflation, some branches of demand got increased and other got fall. same act is happening in supply.
Usama
Hi am new can u please introduce how u guys answer de questions to me
Agnes Reply
u can post your questions. if I'm able too solve I will help you out.
Saurabh
Ok tanks
Agnes
hi
suraj
what is commodity?
chinemerem Reply
anyone with economics paper 1?
Sereena
a commodity is an economic goods or services
Tessa
what is pure Monopoly?
Amit
consider Apple company or microsoft. I guess that's the company with pure monopoly. because at his level he is not having a single competitor. I don't know the definition of pure monopoly. U can google it.
Saurabh
I'm not sure about microsoft but apple is.
Saurabh
another example of monopoly will be intel and amd like these 2 make processors for computers
MUKUL
what is confidential documents
Ibrahim
such documents which have secret information is known as confidential documents.
Usama
a kind of raw material, semi finish goods or finish goods that can be bought or sold is known as comodity
Usama
Examples of fixed and variable inputs
Esther Reply
Waht is the basic pirnciple of eco
Bertu Reply
scarcity, efficiency, and sovereignty.
Abuba
scarcity
Ayush
due to uncertainties about the future amidst covid19, suppose consumers reduce their consumption expenditure. in Keynesian cross , explain what this change would translate into terms of production employment and income
nayanja Reply
kk
Kwaku
what is the most profitable business in any country
Amin Reply
what is Marginal analysis in Economics can sameone explain to me pliss
Gary Reply
facts and proof
Jibril
what matters in comsumption
Jibril
money speaks sales
Jibril
if marginal utility is coins then it analysis is choice of preference
Jibril
facts
Skills
what is money
Emmanuel Reply
hy
Usama
Money refers to the exchange value of goods and services.
Mbye
can you more explain it?
Usama
money is defined as any legal tender use in the exchange of goods and services.
Emmanuel
we can say commodity. A tool of change..
Baki
Money is a tool which is use to fullfil our needs and desires in the shape of goods and services.
Usama
good definition.
Baki
how does indirect tax increase the total expenditure?
Madishez
Money is any things which generally accepted as a medium of exchange by the general pubblic.
shakeel
indirect tax also the part of indirect expense. when tax occure then expenses increase
Usama
I can't understand this type becousr it's difficult for me that's why could you help me
Sheikh Reply
how will demand question will be like in an examination
ekua Reply
demand supply cycle
Omkar
like questions
Omkar
or different types of demand
Omkar
based on societal class structure
Omkar
or the most common and basic demands
Omkar
Give a simple explantion of the LAW OF DEMAND?
IT Reply
the law of demand says that all things been equal the higher the price the lower the quantity is demanded vise versa
Mensah
As price the increases the demand decrease
Gary
Income elasticity of demand
Shaan Reply
income elasticity of demand
Adjei
what
Omkar
what is labour force
ademu Reply
Labour force is the number of people who are actively and presently working in a country to increase the availability of goods and services.
Mbye
It refers to the active population available for work at a going rate.
Daniel
labour force is the number of people who are active and present working in a country to increase the availability of goods and services
Deborah

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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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