We've talked at length on the function of prices and the importance of when they change. So where do these prices come from? The whole next section is devoted to creating a model which answers that very question. A good starting point is the creation of a basic visual representation of what an economy looks like. We use the Circular Flow Model to visualize the movement of products, resources, and money. These elements move throughout different parts of the economy. Some versions of this model also illustrate the roles of banking and governmental institutions. For the purposes of this class though, we're going to keep the model simple. Consider it a framework upon which we can hang the rest of the course. Later on, you may want to refer to this model again to see how certain topics relate and interact with others.
To begin, we divide our simplified economy in to two distinct sectors. Households consume goods and services. In a free market economy, they own and supply the economic inputs of land, labor, capital, and entrepreneurial ability. Businesses make use of these factors of production to create and sell products. These two economic sectors interact with each other through two distinct markets. The Resource Market deals with the factors of production moving from households to businesses. The Product Market deals with goods and services moving from businesses to households.
Households supply economic inputs to the resource market. In exchange, they receive income. Household income consists of wages, rent, interest, and profits. This income is used to purchase goods and services through the product market. Meanwhile businesses are providing goods and services to the product market. In exchange, they receive revenue. Business revenue is used to cover the cost of purchasing factors of production through the resource market. This cycle creates a bi-directional circular flow as illustrated in the following diagram. Money is flowing clockwise while products and resources are flowing counter-clockwise.