The Simple Mechanics
We being with a simple model of the economy, the Circular Flow. We will progressively be adding new elements to it in subsequent pages. We copy this method from Joseph Schumpeter, who used it in his seminal work, The Theory of Economic Development. In this way we will gain closer approximations to reality. We can also add and subtract pieces from other time periods in order to get a better idea of how things were functioning in those times.
The Circular Flow is the basic model of a functioning economy with a division of labor. By division of labor, we mean that production and consumption are separated, and they take place in different entities. Production takes place among enterprises, businesses; consumption takes place in households.
In the simple model, these two sides are in balance. Looked at from the perspective of the total economy, the goods and services that are produced, are produced by the same work force that, in turn, consumes them. Production and consumption are in balance because remuneration (salaries, fees, etc.) are enough to pay for the entirety of production. So then, “effective demand” (demand that consumers actually can exercise, as opposed to mere wishful thinking) is in balance with what is being produced. According to what has come to be known as Say’s Law (after its originator, Jean-Baptiste Say), total production necessarily generates an equal quantity of total consumption; or, in the usual formulation, “supply creates its own demand.”
This relation is represented in figure 1.
