The Circular-Flow Diagram's Greatest Problems Are Its Circularity and Its Lack of Acting Entrepreneurs

Traditional economic analysis frequently begins with a circular-flow diagram showing an on-going relationship between firms and households, connected through markets for goods and services on the one hand and markets for factors of production on the other hand. The origins of the circular-flow diagram have been attributed to Frank Knight, who first published the modern interpretation, although different versions of the circular flow have appeared in many economic works (Patinkin 1973).

The circular-flow approach is decidedly Neoclassical, and suffers from many problems which traditional Austrians would notice. The circular-flow diagram’s greatest problem is, in fact, its circularity. While real-world economic analysis has a beginning, an ending, and ever-changing processes, the circular-flow diagram has no beginning or ending. It is drawn as though entire macroeconomies sprang into existence from whole cloth. While the circular flow appears to be dynamic, it allows no room for change on any margin: consumer preference, production technique, or availability of factors of production.

The most important actor in the economic process for Austrians, and an element crucial to every single real-world market—the entrepreneur—is missing from the circular flow didactic. It is the entrepreneur who

• judges future expected consumer good prices,
• anticipates future market conditions,
• seeks new production techniques, and
• delivers the product to the consumer.

Without a role for the entrepreneur, the circular-flow diagram loses all touch with reality.

—Barry Dean Simpson and Scott A. Kjar, “Circular Flow, Austrian Price Theory, and Social Appraisement,” Quarterly Journal of Austrian Economics 8, no. 4 (Winter 2005): 3-4.