The circular flow of economic activities


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The circular flow of economic activities

  1. 1. THE CIRCULAR FLOW OF ECONOMIC ACTIVITIESThere are two basic activities undertaken in any economy: PRODUCTION AND CONSUMPTION.FIRMS – they perform the production function or the basic producing units.HOUSEHOLDS – undertake consumptionor 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 resources2.4
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  5. 5. This has now been modified to include environmental resourcesClearly, the natural environment is an important component of the economic system, and without the natural environment theeconomic system would not be able to function. Hence, we need to treat the natural environment in the same way as we treatlabour and capital; that is, as an asset and a resource.
  6. 6. ECONOMIC MODEL OF INCOME & CONSUMPTIONIn economics, the terms circular flow of income or circular flow refer to a simple economic model which describes the reciprocalcirculation of income between producers and consumersA continuous flow of production, income and expenditure is known as circular flow of income. It is circular because it has neither anybeginning nor an endThe 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 spends2.Goods and services flow in one direction and money payment to get these flow in return direction, causes a circular flowCircular Flow DiagramCircular flow model explains that production during the year is converted into factor income (implying income of the owners offactors of production in terms of rent, interest, profit and wages) during the year, and factor income during the year is convertedinto expenditure (on goods and services during the year).Symbolically,Production ≡ Generation of income ≡ Expenditure on goods and servicesCircular flow of income in a two sector economyMain 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.
  7. 7. 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 sector3. Consumption expenditure of household sector = Income of household sector4. Real flows of production and consumption of firms and households = Money flows of income and expenditure of firms andhouseholds