CIRCULAR FLOW IN A SIMPLE ECONOMY (TWO-SECTOR ECONOMY)
In a simple two-sector economy, there exist only two sectors i.e. household and firms, where households are the owners of factors of production (Land, Labour, Capital, and Enterprise) and consumers of goods & services. Firms produce goods and services and sell them to households.
In order to make our analysis simple, we can make some assumptions:-
- Only two sectors in an economy are there i.e. Households and firms. It means there is no government and foreign sector.
- Households provide factor services to firms only and firms hire factor services from household only.
- The amount received by the household from the firm for providing factor services is used entirely on consumption.
This brings us to the following conclusion.
- There are no savings in the economy, i.e. neither the household saves from their incomes, not the firm saves from their profits.
- In the given diagram, it can be seen that households are providing factor services in exchange for factor payment and firms are providing goods & services to households in exchange for consumption expenditure.
- Total Production = Total Consumption
- Factor Payment = Factor Income
- Consumption Expenditure = Factor Income
- Real Flow = Money Flow
Note: In a circular flow of income, production generates factor income, which is converted into expenditure. This flow of income continues, as production is a continuous activity due to never-ending human wants. It makes the flow of income circular.
Synonyms/Similar terms of this chapter
- Generation Phase - Production Phase
- Distribution Phase - Income Phase
- Disposition Phase - Expenditure Phase
- Real Flow – Physical Flow
- Money Flow – Nominal Flow