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.

https://image.slidesharecdn.com/ch-140115071533-phpapp01/95/national-income-and-circular-flow-of-income-18-638.jpg?cb=1389770422

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