kidneys, and so on. The models allow teachers to show their students very simply how tine important parts of the body fit together. Because these plastic models arc-stylized and omit many details, no one would mistake one of them for a real person. Despite this lack of realism—indeed,bccauscof this lackof realism—studying these models is useful for learning how the human body works.
Economists al9o use models to learn about the world, but instead of being made of plastic, they are most often composed of diagrams and equations. Like a biology tcachcr's plastic model, economic models omit many details to allow us to sec what is truly important. Just as the biology teacher's model does not include all the body's muscles and capillaries, an economist's model does not include every feature of the economy.
As we use models to examine various economic issues throughout this book, you will see that all the models are built with assumptions. lust as a physicist begins the analysis of a falling marble by assuming away the existence of friction, economists assume away many of the detail* of the economy that are irrelevant tor studying the question at hand. All models—in physics, biology, and economics— simplify reality to improve our understanding of it.
Our First Model: The Circular-Fi ow diaciram
The economy consists of millions of people engaged in many activities—buying. Selling, working, hiring, manufacturing, and so on. To understand how the economy works, wc must find some way to simplify our thinking about all these activities. In other words, we need a model that explains, in general terms, how the economy is organized and how participants in the economy interact with one another.
Figure 1 presents a visual model of the economy called a circular-flow diagram, circular-flow diagram In this model, the economy is simplified to include only two types of decision a visual model ol the makers—firms and households. Firms produce goods and services using inputs, economy that shows how such as labor, land, and capital (buildings and machines). The*' inputs are called dollars flow through mar- the/«rt(»rs of production. HousrMds own the factors of production and consume kets among households lhe g<yosk >mtl ^rvkra that the firms produce.
',ri "ms Households and firms interact in two types of markets. In the motets for goods ituJ srivica, households are buyers, and firms are sellers. In particular, households buy the output of goods and services that firms produce. In the ma'tft<(or the factors if production, households are sellers, and firms are buyers. In these markets, households provide the inputs that firms use to produce goods and services. The circular-flow diagram offers a simple way of organizing tlte economic transactions that occur between households and firms in the economy.
The two loops of the circular-flow diagram arc distinct but rclated. The inner loop represents the flows of inputs and outputs. The households sell the use of their labor, land, and capital to the firms in the markets for the factors of production. The firms then use these factors to produce goods and services, which in tum arc sold to households in the markets for goods and services. The outer loop of the diagram represents the corresponding flow of dollars. The households spend money to buy goods and services from the firms- The firm* use some of the revenue from these sales to pay for the factors of production, such as the wages of their workers. What's left is the profit of the firm owners, who themselves are members of households.
Let'* take a tour of the circular flow by following a dollar bill as it makes its way from person to person through the economy. Imagine that the dollar begins at a household, say, in your wallet. If you want to buy a cup of coffee, you take the dolLir to one of the economy's markets for goods ami services, such as your local
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