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. In economics, theories are expressed as diagrams, graphs, or even as mathematical equations. Then they use the theory to derive insights about the issue or problem. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. 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).Įconomists carry a set of theories in their heads like a carpenter carries around a toolkit. 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. This is shown in the inner circle and represents the two sides of the labor market in which households supply and firms demand. Households sell their labor as workers to firms in return for wages, salaries and benefits.
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. In the diagram, firms produce goods and services, which they sell to households in return for revenues. The circular flow diagram simplifies this to make the picture easier to grasp. Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. In the labor market, households provide labor and receive payment from firms through wages, salaries, and benefits. The direction of the arrows shows that in the goods and services market, households receive goods and services and pay firms for them. The circular flow diagram shows how households and firms interact in the goods and services market, and in the labor market. 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. 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.Ī good model to start with in economics is the circular flow diagram, which is shown in Figure 2. Models are used to test theories, but for this course we will use the terms interchangeably.įor 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. Strictly speaking, a theory is a more abstract representation, while a model is more applied or empirical representation.
Sometimes economists use the term model instead of theory. A good theory is simple enough to be understood, while complex enough to capture the key features of the object or situation being studied. If done well, this enables the analyst to understand the issue and any problems around it. The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. A theory is a simplified representation of how two or more variables interact with each other.
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. Watch this video about John Maynard Keynes and his influence on economics.Įconomists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline.
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