Circular Flow of Income

According to neoclassical economics, the terms circular flow of income is described as the reciprocal circulation of income between producers and consumers. In the circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income. Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households. The circular flow model has been criticized by ecological economists for failing to show that the economy has a physical root in its larger environment, and hence for being at the root of the neoclassical models' inability to conceptualize effectively environmental constraints and costs, such as global climate change and the loss of ecosystem services that leads to uneconomic growth. Economists advancing this idea include Herman Daly; Joshua Farley; Robert Costanza; and political theorist Eric Zencey .

The circle of money flowing through the economy is as follows: total income is spent (with the exception of "leakages" such as consumer saving), while that expenditure allows the sale of goods and services, which in turn allows the payment of income (such as wages and salaries). Expenditure based on borrowings and existing wealth – i.e., "injections" such as fixed investment – can add to total spending.

In equilibrium, leakages equal injections and the circular flow stays the same size. If injections exceed leakages, the circular flow grows (i.e., there is economic prosperity), while if they are less than leakages, the circular flow shrinks (i.e., there is a recession).

More complete and realistic circular flow models are more complex. They would explicitly include the roles of government and financial markets, along with imports and exports. To the extent that they remain circular flow models, however, they do not effectively model the one-way flow of energy through the economy. (That energy flow must be one-way and not a circular flow is a consequence of the second law of thermodynamics, the law of entropy. This failure ultimately allows neoclassical models to treat environmental values as a subcategory of economic values, rather than seeing economic activity em placed as a subcategory of human activity which in turn is a subcategory of activity within ecosystems.

Labor and other "factors of production" supplied by households are sold on resource markets. These resources, purchased by firms, are then used to produce goods and services. The latter are sold on product markets, ending up in the hands of the households, helping them to supply resources. Again, critics say that it is unrealistic and dysfunctional to model the economy as if energy and other resources were extracted from households instead of planetary systems. This criticism is further elaborated within an article in the Encyclopedia of Earth .