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Module 4
The Circular-Flow Diagram
What’s New in the Fourth Edition?
• Worksheets for use in the classroom.
Module Objectives
• How do you interpret the circular-flow diagram of the economy?
• How do individual decisions affect the larger economy?
• How do you interpret positive and normative statements?
Teaching Tips
Transactions: The Circular-Flow Diagram
Creating Student Interest
• Use the example of a dollar in your pocket. Explain where the dollar came from. (It came from
your bank account, and was put there initially by a direct deposit from your university.) Consider
Presenting the Material
• Build the circular-flow diagram by identifying the two major components of the circular-flow
diagram first: households and firms.
Use your ample artistic skills to draw a house at the top of the board and a factory on the bottom.
Tell the class these represent households and firms. Create the circular-flow diagram by asking
What do households get from the firms? (Goods and services.) Where do they go to get the
What do the households provide to the firms? (Worker/labor—add that they provide the other
resources also.) Where do firms go to get these workers? (Labor market) Draw the market for
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What do the households get from the firm in return for their labor/resources? (Payments—
Positive versus Normative Economics
Creating Student Interest
• Find an estimate of the average annual tuition at your institution. Write the estimate on the board
Presenting the Material
• After explaining the difference between positive and normative, quiz the class by asking them to
determine if each of the following statements is positive or normative. If a student identifies the
statement as positive, ask how the statement could be tested. Remind them that a positive
statement need not be correct, it only needs to be testable. Also remind them that even if
everyone agrees with a normative statement, it is still normative.
Module Outline
I. Transactions: The Circular-Flow Diagram
A. The circular-flow diagram is a simplified picture of an economy, as demonstrated in text Figure
4-1, shown here.
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Figure 4-1
B. The circular-flow diagram can help us understand how the economy manages to provide jobs for
a growing population.
1. The number of jobs isn’t fixed, because it depends on how much households spend; the
amount households spend depends on how many people are working.
II. Positive versus Normative Economics
A. Models are especially helpful in answering “what if” questions such as, “How will revenues
change with a tax cut?” The answer is a predictive one, not prescriptive; it does not tell you if the
policy is good or bad.
B. Economists do engage in normative economics. Economic analysis can be used to show that
some policies are clearly better than others, especially if one solution is more efficient than
another. For example, most economists would favor subsidies to renters over rent-control laws as
a more efficient solution to help low-income families obtain housing.
Web Resources
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Handout 4-1
Date_________ Name____________________________ Class________ Professor________________
Circular-Flow Diagram
Activity 1:
Draw the circular flow below. Add banks, government, and exports and imports to the circular flow.
Activity 2:
Consider what will happen in the circular flow from Activity 1 above if consumers decide to spend
more money and save less. Beside each entity in the diagram, describe briefly how this change will
affect the group.
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Handout 4-2
Date_________ Name____________________________ Class________ Professor________________
Positive or Normative?
Read the following sentences. Write whether the statement is positive or normative. Then, rewrite
the statement to make it normative if the original is positive or positive if the original was normative.
1. “More than 60% of women are in the labor market.”
2. “Rent control laws should be implemented because they help to achieve equity or fairness in
housing.” (Normative)
3. “Society should take measures to end gun violence.” (Normative)
4. “People who smoke pass on increased medical costs to the whole society.” (Positive)
5. “Single mothers are more than twice as likely as married mothers to be in poverty.” (Positive)