The Circular Flow Model

Overview of the Circular Flow

The circular flow model illustrates the movement of resources, goods, services, and money between households and firms in an economy. It highlights how market-based prices, wages, and interest rates coordinate the behavior of economic agents.

• Households demand commodities (goods and services) and supply labor and savings.

• Firms supply commodities and demand labor and capital.

• Commodity Markets determine prices for goods and services.

• Labour Markets determine wages for labor.

• Capital Markets determine interest rates for savings and borrowing.

Payments flow from households to firms for goods and services, while receipts flow from firms to households for labor and capital. In a closed economy, these flows are balanced.

Market Equilibrium

Equilibrium in Commodity Markets

Market equilibrium occurs when the quantity demanded by buyers equals the quantity supplied by sellers at a particular price. This ensures that there are no shortages or surpluses in the market.

• Demand Curve: Shows the relationship between price and quantity demanded, holding other factors constant.

• Supply Curve: Shows the relationship between price and quantity supplied, holding other factors constant.

• Equilibrium Price: The price at which quantity demanded equals quantity supplied.

• Equilibrium Quantity: The quantity bought and sold at the equilibrium price.

Formula for Demand:

Formula for Supply:

Where p is price, I is income, w is wage, r is interest rate, and p_1, ..., p_n are prices of related goods.

Reservation Price

The reservation price is the maximum price a buyer is willing to pay for a good or the minimum price a seller is willing to accept. It determines the position of the demand and supply curves.

Shifts in Demand and Supply

Changes in exogenous determinants (such as income, prices of related goods, technology, or preferences) can shift the demand or supply curves, leading to new equilibrium prices and quantities.

• Increase in Demand: Shifts the demand curve to the right, raising equilibrium price and quantity.

• Decrease in Demand: Shifts the demand curve to the left, lowering equilibrium price and quantity.

• Increase in Supply: Shifts the supply curve to the right, lowering equilibrium price and raising equilibrium quantity.

• Decrease in Supply: Shifts the supply curve to the left, raising equilibrium price and lowering equilibrium quantity.

Applications and Problem Solving

Solving for Equilibrium

To find the equilibrium price and quantity, set the demand and supply equations equal to each other and solve for p and q.

• Example: If and , set to solve for p and q.

Comparative Statics

Comparative statics examines how changes in exogenous variables (such as income or wages) affect equilibrium outcomes.

• Example: If income increases, the demand curve may shift right, leading to a higher equilibrium price and quantity.

Factor Markets: Labour and Capital

Labour Markets

Labour markets determine the equilibrium wage and quantity of labor employed. Households supply labor, and firms demand labor.

• Labour Supply Curve: Shows the relationship between wage and quantity of labor supplied.

• Labour Demand Curve: Shows the relationship between wage and quantity of labor demanded.

• Equilibrium Wage: The wage at which labor supplied equals labor demanded.

Example Equation:

and

Set to solve for equilibrium wage w.

Capital Markets

Capital markets determine the equilibrium interest rate and quantity of funds saved and borrowed. Households supply savings, and firms demand funds for investment.

• Supply of Funds:

• Demand for Funds:

• Set to solve for equilibrium interest rate r.

Related Goods: Substitutes and Complements

Definitions

• Substitute Goods: Goods that can replace each other in consumption. An increase in the price of one increases the demand for the other.

• Complement Goods: Goods that are consumed together. An increase in the price of one decreases the demand for the other.

Example: If apples and bananas are substitutes, a rise in the price of apples increases the demand for bananas.

Summary Table: Effects of Shifts in Demand and Supply

Practice Problems and Applications

Sample Questions

• Given and , solve for equilibrium price and quantity.

• If the price of a substitute increases, what happens to the demand for the original good?

• Illustrate the effect of a wage increase on the supply of labor and equilibrium wage.

• Given and , solve for equilibrium when income changes.

Additional info:

• Some diagrams and tables referenced in the original material are omitted here but should be drawn for practice.

• Equations and examples are expanded for clarity and academic completeness.