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Circular Flow Model and Environment

The document discusses the standard circular flow model of economics and how it fails to account for natural resources and the environment. It presents a broader circular flow model that depicts the economic system as embedded within the larger ecological system, with resources and waste flowing between the two. This implies that the economy depends on renewable and non-renewable resources from the environment, and that measures of well-being and growth are limited by ecological constraints.

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776 views4 pages

Circular Flow Model and Environment

The document discusses the standard circular flow model of economics and how it fails to account for natural resources and the environment. It presents a broader circular flow model that depicts the economic system as embedded within the larger ecological system, with resources and waste flowing between the two. This implies that the economy depends on renewable and non-renewable resources from the environment, and that measures of well-being and growth are limited by ecological constraints.

Uploaded by

damodaran
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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CIRCULAR FLOW MODEL AND ENVIRONMENT

A basic building block of mainstream economic theory is the standard


circular flow model of an economic system.
This simple model depicts the relationships between households and business
firms in two markets:
1) the market for goods and services and
2) the market for factors of production.
Factors of production are generally defined as land, labor, and capital. The
services that these factors provide are “inputs” into the production of goods
and services, which in turn provide for households’ consumption needs.
Goods, services, and factors flow clockwise; their economic values are
reflected in the flows of money used to pay for them, moving counter
clockwise. In both markets, the interaction of supply and demand determines
a market-clearing price and establishes an equilibrium level of output.
Where do natural resources and the environment fit in this diagram?
Natural resources, including minerals, water, fossil fuels, forests, fisheries,
and farmland, generally fall under the inclusive cat egory of “land.” The two
other major factors of production, labor and capital, continually regenerate
through the economic circular flow process, but by what processes do natural
resources regenerate for future economic use? Environmental economists
recognize that it is necessary to address the limitations of the standard circular
flow model in this respect. But ecological economists place a particular
emphasis on a broader circular flow model that takes into account ecosystem
processes as well as economic activity.
Taking this broader view, we notice that the standard circular flow diagram
also omits the effects of wastes and pollution generated in the production
process. These wastes, from both firms and households, must flow back into
the ecosystem somewhere, either being recycled, through disposal, or as air
and water pollution.
In addition to the simple processes of extracting resources from the
ecosystem and returning wastes to it, economic activities also affect broader
natural systems in subtler and more pervasive ways not illustrated in Figure
1.2. For example, modern intensive agriculture changes the composition and
ecology of soil and water systems, as well as affecting nitrogen and carbon
cycles in the environment.
Figure 1.2 provides a broader framework for placing the economic system in
its ecological context. Natural resources include both renewable and non-
renewable resources.
Renewable resources are those that are regenerated over time through eco-
logical processes, such as forests and fisheries. Renewable resources can be
managed sustainably if extraction rates don’t exceed natural regeneration
rates. However, if renewable resources are over-exploited, they can be
depleted, such as species that go extinct through over-harvesting.
Non-renewable resources are those that do not regenerate through
ecological processes, at least on a human time scale. Non-renewable
resources such as oil, coal, and mineral ores are ultimately available in a fixed
supply, although new resources can be discovered to expand the known
available supply. The other input into the economic system is solar energy,
which as we will see later in the text provides a limited but incredibly abundant
source of continual energy.

[The biosphere, (from Greek bios = life, sphaira, sphere) is the layer of the
planet Earth where life exists.]

What does this expanded circular flow model imply for economic theory?
There are at least three major implications:

1. The recognition that natural resources and solar energy provide the
essential input into economic processes implies that human well-being is
ultimately dependent on these resources. Measuring well-being using
standard economic metrics, such as gross domestic product, understates
the importance of natural resources. This suggests a need for alternative
indicators of well-being, which we will discuss in Chapter 10.
2. As shown in Figure 1.2, the ecological system has its own circular flow,
which is determined by physical and biological rather than economic laws.
This broader flow has only one net “input”—solar energy—and only one net
“output”—waste heat. Everything else must somehow be recycled or
contained within the planetary ecosystem.
3. In the standard circular flow model, the economic system is unbounded and
can theoretically grow indefinitely. But in the expanded model, economic
activity is limited by both the availability of natural resources and the ability
of the environment to assimilate wastes and pollution. Thus the overall
scale of the economy relative to the available natural resources must be
considered.
As with some of the other questions we have discussed, there can be
significant overlap between environmental and ecological economics
perspectives on these issues. In terms of the double circular flow shown in
Figure 1.2, a standard environmental economics perspective economic term.
Ecological economists place greater emphasis on the outer circle, with its
starts from the inner, economic, circle and tries to understand broader
ecological issues in biophysical laws and limitations, but are also aware of the
importance of the way resources and the environment are taken into account
in economic analysis.

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