Explain circular Flow of Income in a two sector economy (Class 12)

A simple economy assumes the existence of only two sectors.

1. Household Sector
2. Firm Sector

• Households are the owners of factors of production and consumers of goods and services.
• Firms produce goods and services and sell them to the households.

In order to make our analysis simple, we take some assumptions:

1. There are only 2 sectors in the economy: Households and Firms. It means, there is no government and foreign sector.
2. Households sector supplies factor services only to firms and the firms hire factor services only from households.
3. Firms produce goods and services and sell their entire output to the households.
4. Households received factor income for their services and spend the entire amount on consumption of goods and services.
5. There are no savings in the economy, i.e., neither the households save from their incomes, nor the firms save from their profits.

The Circular flow in two sector economy can be better understood with the help of following figure.

The outer loop of diagram shows the real flow, i.e. flow of factor services from households to firms and the corresponding flow of goods and services from firms to households.

The inner loop shows the money flow, i.e., flow of factor payments from firms to households and the corresponding flow of consumption expenditure from households to firms.

In the 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.

Conclusions of Circular Flow in two-Sector Economy

1. Total Production of goods and services by Firms = Total Consumption of goods and services by Households.
2. Factor Payments by firms = Factor Incomes of Households.
3. Consumption Expenditure by households = Factor Income of households
4. Real Flow in the form of factor services and final goods and services = Money Flow between firms and households.