Limitations of the simple circular flow model

After you have worked through this section of the learning unit, you should be able to:

  • identify the limitations of the simple circular flow

At this stage, the circular flow model only includes firms that produce consumer goods. The diagram could be expanded to allow for firms producing capital goods.

The state, representing the government's action through the markets in the economy, could also be introduced as an independent participant buying goods and services and factors of production in the various markets. The state also influences economic life directly by providing certain services such as defence, policing and education. In order to finance these services, the state taxes both firms and individual households.

The foreign sector is another participant not included in the simplified model. It comprises mainly the imports and exports of goods and services. This participant also operates in the markets for goods and factors of production in the domestic economy. Imports of goods and services may be regarded as an offer of these goods in the various markets, in return for which a reverse flow of money would go to the foreign sector. Exports of goods and services would mean a flow of goods from the relevant participants to the markets to foreign economies, with a corresponding return flow of money.

The model also assumes that prices of goods, services and production factors do exist, but it does not explain how these prices are arrived at (determined) and the impact of a change in prices on the flows.