The simplified circular-flow diagram does not take into account how the government affects economic interactions.
Work Step by Step
The simplified circular-flow diagram provides a visual representation of how households and firms interaction to buy and sell economic goods. For example, the diagram measures how money is transmitted through the market when a person buys a cup of coffee. The person provides a coffee shop with money for a cup of coffee. That money then becomes revenue for the coffee shop. That coffee shop then uses the money to buy more inputs, such as coffee beans, to produce more coffee in the future. However, this is a very simplified interaction. In reality, a complete diagram would include other parts of the interaction, such as the role of the government. More than likely, the coffee shop will need to use some of that revenue to pay taxes to the government, which will affect how much money they have left for future inputs.