Exploring the Dynamics of Economic Interdependence: A Circular Flow Approach

Suppose that every businessman sells all their products and consumes their own products based on the market price, which is determined indirectly by the quantity of other goods obtainable by curtailing their private consumption.

Conversely, the quantity of private consumption operates on market price just as if the quantity actually appeared on the market. Therefore, all businessmen are buyers for the purposes of their production and consumption, as well as sellers.

Similarly, workers can be included in this analysis, and their services can be viewed as other marketable goods.

Each businessman produces their product and finds their buyers based on their experience, like the farmer. This is also true when all businessmen are considered together, apart from any disturbances that may occur for various reasons.

All products must be disposed of because they will only be produced with reference to empirically known market possibilities.

Let’s emphasize this.

The amount of meat the butcher discards depends on how much and at what price their customer, the tailor, will buy.

However, this depends on the money from their business, which in turn depends on the needs and purchasing power of their client, the shoemaker, whose purchasing power in turn depends on the needs and purchasing power of the consumers they serve.

Also read: Why Do We Study Economics? Explained in 3 Minutes

In any of the possible directions, the concatenation and mutual dependence of the quantities that make up the economic universe are always apparent.

Wherever one enters and wherever one turns from this point, one must always come back to the beginning after perhaps a large but finite number of steps.

The analysis does not reach a natural conclusion nor encounter an element that exerts more influence on other elements than it is influenced by them.

To further complete our understanding, we should depict the act of consuming differently than is typical. While most people see themselves as consumers of bread, they don’t necessarily view themselves as consumers of land, services, iron, and other goods.

However, by imagining people as consumers of these other goods, we can gain a clearer view of how individual products move in the circular flow.

While each unit of a commodity may not always travel the same path to the same consumer as its predecessor did in the previous economic period, we can assume that it does without altering anything essential.

We can suppose that every recurring use of permanent sources of productive power aims to reach the same consumer year after year. The result of this process is the same as if it did occur.

Therefore, there is always a demand awaiting every supply somewhere in the economic system, and no commodities exist without complements in the possession of people who will exchange them for other goods under empirically determined conditions.

As a consequence, the circular flow of economic life is closed, and all commodity sellers appear again as buyers in sufficient numbers to purchase the goods that will sustain their consumption and productive equipment in the next economic period, and vice versa.

Individual households or firms behave according to empirically given data and in a similarly empirically determined manner. This does not preclude changes in their economic activities, as the data may change, and individuals will respond accordingly.

However, people tend to cling to their customary economic practices and only adjust to changing circumstances when it becomes necessary.

Thus, the economic system is not subject to capricious change on its own initiative, but rather, it is always connected with the preceding state of affairs, which is known as Wieser’s principle of continuity.

Also read: Marginal Benefit: Definition, Examples, Formula, Types, Uses

Assuming that the economic system remains unchanged is not a significant oversight, as it expresses a fact with ideal precision.

Depicting a completely static system is an abstraction that aims to exhibit the essence of what actually happens. This approach is provisional, and it does not contradict orthodox theory but only challenges the customary exposition that does not clearly express the point.

Another way to arrive at the same result is by considering the total of all commodities produced and marketed in a community within an economic period, which is called the social product.

Although the social product does not exist as such, it is a useful abstraction that allows us to imagine that the products of all individuals form a heap at the end of the economic period, which is then distributed according to certain principles.

Each individual contributes to this social reservoir and later receives something from it, and there is a corresponding claim of another individual for each contribution.

Since all individuals know from experience how much they must contribute to receive a particular share, the social product abstraction is a permissible assumption that does not alter the facts.

To achieve their desired outcome, people pay tribute while each share involves a certain contribution. The circular system is closed, and all contributions and shares must cancel out, regardless of the distribution principle used.

The assumption is that all quantities involved are empirically given.

This picture can be refined and provide more insights into the functioning of the economic system using a well-known device.

We assume that all past experiences do not exist and reconstruct the process from scratch.

If the same people with the same culture, tastes, technical knowledge, and initial stocks of goods had to achieve the greatest possible economic welfare through conscious and rational effort, this is how it would work.

We do not imply that people are capable of such an effort in real life, but we want to highlight the rationale behind economic behavior, regardless of the psychology of households and firms under observation.

We do not aim to provide a sketch of economic history. Instead, we want to analyze the working mechanism or organism of the economic process at any given stage of development.

Also read: Price Elasticity of Demand: Definition, Formula, Types, Example, and Solution

This analysis suggests, elaborates, and uses the conceptual tools that we are familiar with. Economic activity may have any motive, even a spiritual one, but its meaning is always the satisfaction of wants.

Therefore, the fundamental importance of the concepts and propositions derived from the fact of wants, among which the concept of wants is foremost.

Utility and its derivative, marginal utility, or the “coefficient of choice,” as it is commonly referred to nowadays, are crucial concepts in economics.

We then proceed to establish several theorems regarding the allocation of resources across a spectrum of potential uses, the interdependency and rivalry between goods, and deduce exchange ratios, prices, and the traditional empirical “law of supply and demand” based on rational thinking.

Lastly, we form a preliminary understanding of a value system and the circumstances under which it can attain equilibrium.

On one side, production is dependent on the physical characteristics of materials and natural processes.

As John Rae has noted, this means that economic activity is primarily about observing natural processes’ outcomes and making the most of them.

The extent to which physical realities are relevant to economics cannot be determined categorically. Depending on the sort of theory one is pursuing, things like the law of diminishing returns may have a significant or little impact on economic outcomes.

A fact’s importance to human welfare has no correlation with its significance in economic theory’s explanatory efforts.

Nevertheless, as the case of Bohm-Bawerk illustrates, we may need to incorporate new technical information into our models at any time.

Social organization facts, on the other hand, are not the same. They are on the same level as technical data in that they are external to economic theory and just serve as “data” for it.


Tofunmi is a BA, MBA, and experienced Researcher in Business Administration and Management. He possesses outstanding communication, leadership, conflict resolution, organization, and teamwork skills. He enjoys teaching and reading books on startups, business, personal finance, investment, and more.

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