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What is Circular Flow of Income in a Two-Sector Economy? With Diagram

In an economy, there are innumerable goods and services being produced and consumed. The millions of people who live in that economy are involved in producing these goods and services and also consuming them. 

In other words, people produce these goods, people also consume these goods. It may look like a complicated process, but it is a very basic concept happening in every economy. 

To understand the working of an economy, we will simplify by assuming that there is no role of Government (no government interference in economic activities), no international trade (i.e no export and import of goods and services) taking place and no savings done by the household (i.e whatever is earned is spent on consumption).

Let us start with a household which wants to buy goods and services for consumption. The household would need money income to buy these goods and services. Now, from where does this income come? 

This income will come when households or more specifically members in the household will work or get employed. When these household members work, they get income in return. This income is used to demand the goods and services needed by the household. In other words, when households supply their factor services, they get or generate income which is used to finance their consumption needs. 

These factor services are supplied to firms in the economy which are involved in the production of goods and services. These firms hire factors of production to produce goods and service and pay these factors their remuneration or income in return. 

Now, what are these factors of production?  Factors of production are nothing but resources such as land, labour, capital and entrepreneurship which are used to produce goods and services.  Each factor of production generates some income in return of the service it provides.

  • The factor payment paid for the use of labour is called wage; or the remuneration of labour is wages
  • The factor payment paid for the use of capital is called interest; or the remuneration of capital is interest
  • The factor payment paid for the use of natural resources such as land is called rent; or the remuneration of land is rent
  • The factor payment paid for the use of entrepreneurship is called profit; or the remuneration of entrepreneurship is profit.

Thus, the act of production of goods and services generates factor incomes. These factor incomes generate purchasing power in the hands of factors of production which is used to demand goods and services. When these household buy the goods and services from firms or in other words incur expenditure on goods and services, the money received in exchange for goods and services by the firms becomes their revenue. This revenue is then used to produce goods and services in the next period by hiring factors of production.

In short, households supply the factor services to firms and get income in return. This income is used to demand goods and services. On the other hand, firms supply goods and services in return for money that they receive from households. This money they receive is the Revenue of the firm, which is used to produce goods and services by paying factors of production for their services.

During this process, there is also the circulation of money taking place in the economy. The money which is in the hands of the households gets transferred to the firms when they buy goods and services from them. When firms use this money to pay factor services supplied by the households in order to produce goods and services, the money again gets transferred into the hands of the households and the cycle gets complete.

Therefore, if we want to summarize the working of a simple economy, there are two decision making units in the economy: the households and the firms. Their interaction and interdependence with each other form the working of a simple economy.  

Also, there are two markets in the economy, the goods market and the factor market. In the factor market, households are the suppliers of factor of production and which are demanded by firms to produce goods and services. The households get money income in return of their factor services. In the goods market, firms are the suppliers of goods and services which are demanded by households. The goods and services are supplied in exchange for money which becomes the revenue of the firms.

It should be kept in mind that owners of firms are themselves members of the household who are also engaged in the buying of goods and services from other firms for consumption.

The above diagram explains the Circular Flow of Income in an Economy. The inner circle shows the flow of inputs and outputs between firms and households. The households which are the owners of factors of production supply land, labour, capital and entrepreneurship to the firms. By using these factors of production Firms are able to produce goods and services to be ultimately supplied to households.

The outer circle in the diagram depicts the circular flow of money in the economy. The factor services are rewarded by the firms through rent, wage, interest and profit. The factor payments give the purchasing capacity to households to buy goods and services from firms. This expenditure on goods and services incurred by the households becomes the revenue of the firms and the cycle gets complete. Now, in the next period, this revenue is used to pay the factors of production their income and the process continues. 

Key Points

  • Circular flow of income represents the continuous flow of income from households to firms, and form firms to households.
  • For every good and service sold, money is exchanged between firms and households, which becomes a part of revenue of the firm.
  • Households provide factor services to firms to produce goods and services and earn factor incomes in return. The factor incomes are paid out of the revenue generated by firms

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