“Circular Flow of Income principle is based on the assumption – One’s expenditure is other’s income.” Justify the given statement.
“Circular Flow of Income principle is based on the assumption – One’s expenditure is other’s income.” Justify the given statement.
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The given statement is justified in a two-sector economy.
In a two-sector economy, there are only two sectors.
- Households
- Firms
The following are the assumptions of it:
1. Households spend all their income
2. Firms retain nothing as undistributed profit
3. Savings are nil for both households and firms
Households provide factors services in the form of (Land, Labour, Capital, and entrepreneurship) to the firm.
In return, the Firm pays money as factor payments to the households in the form of (Rent, Wages, interest, and profit).
Thus the Expenditure of the firm is the income of the household.
The Households purchase the products of the firm to satisfy their wants with the money received as factor payments from the firm.
Thus the expenditure of the households is the income of the firm.
The same amount of income is used by the firm to pay the factor payments to the households for their factor services in the second round of production.
As the production is a continuous process to satisfy the unlimited wants of society. The process goes on.
We have concluded the following observation:
In a two-sector economy:
1. Total production of goods and services = Total consumption of goods and services
2. Factor payments by firms = Factor income of household
Thus, the flow of income is circular because of the assumption that one’s expenditure is income of the others.
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