THE CIRCULAR FLOW OF ECONOMIC ACTIVITIES

There are two basic activities undertaken in any economy: PRODUCTION AND CONSUMPTION.

FIRMS – they perform the production function or the basic producing units.

HOUSEHOLDS – undertake consumption or the basic consuming units.

To be able to produce, firms need the economic resources consisting of land, Labor, and capital.

The individuals comprising the households own these resources and they provide the firms with the services of these resources

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This has now been modified to include environmental resources

Clearly, the natural environment is an important component of the economic system, and without the natural environment the economic system would not be able to function. Hence, we need to treat the natural environment in the same way as we treat labour and capital; that is, as an asset and a resource.

ECONOMIC MODEL OF INCOME & CONSUMPTION

In economics, the terms circular flow of income or circular flow refer to a simple economic model which describes the reciprocal circulation of income between producers and consumers

A continuous flow of production, income and expenditure is known as circular flow of income. It is circular because it has neither any beginning nor an end

The circular flow of income involves two basic assumptions:-

1 .In any exchange process, the seller or producer receives the same amount what buyer or consumer spends

2. Goods and services flow in one direction and money payment to get these flow in return direction, causes a circular flow

Circular Flow Diagram

Circular flow model explains that production during the year is converted into factor income (implying income of the owners of factors of production in terms of rent, interest, profit and wages) during the year, and factor income during the year is converted into expenditure (on goods and services during the year).

Symbolically,

Production ≡ Generation of income ≡ Expenditure on goods and services

Circular flow of income in a two sector economy

Main assumptions:

1. There are only two sectors in the economy, households and firms.

2. Households supply factor services to firms and firms hire factor services from households.

3. Households spend their entire income on consumption.

4. Firms sell all that is produced to the households.

5. There is no Government or foreign trade.

This model offers following observations:

1. Total production of goods and services by firms = Total consumption of goods and serves by the household sector.

2. Factor payments by firms = Factor incomes of the household sector

3. Consumption expenditure of household sector = Income of household sector

4. Real flows of production and consumption of firms and households = Money flows of income and expenditure of firms and households