AN ECONOMY can be classified in various ways. One such way is purely theoretical. In this context, there are four sectors of an economy. These are: households, firms, government and the rest-of- the-world. If we consider only the first three sectors, it becomes a closed economy. Inclusion of the last sector (also called the foreign sector) makes it an open economy.
Considering only the first two sectors, it becomes a two-sector model; considering the first three sectors, it becomes a three-sector model and considering all the four sectors, it becomes a four-sector model. Each one explains the functioning of an economy. The first model is the simplest, but the other two models (the three-sector and the four-sector) are slightly complicated. They can be described schematically and also mathematically.
We shall look at the two-sector model schematically to explain the basic idea that the circular flow of income flows in a circular way and that too continuously.
An economy consists of millions of people engaged in many activities (buying, selling, working, hiring, manufacturing and so on). In order to understand in a very simple way as to how the economy functions, or how exactly the economy gets organised, we shall have a visual model, called a circular-flow diagram. In this model, the economy, as we have said, has two types of decision-makers- households and firms.
Firms produce goods and services using various inputs, such as labour, land and capital. These inputs are called the factors of production (both human and non-human). Households own the factors of production and consume all the goods and services that the firms produce. In fact, the households perform two functions: they provide various services for production and they buy to consume. Similarly, the firms also perform two functions: they produce goods and services and they buy the various kinds of factors of production.
Household and firms, thus, interact in two types of markets. In the market for goods and services, households are buyers and firms are sellers. In the market for the factors of production, households are sellers and firms are buyers. The circular-flow diagram offers a simple way of organising all the economic transactions that occur between households and firms in the economy.
The circular flow has four aspects. These aspects are briefly mentioned below:
The inner loop of the interaction between the two sectors shows the flows of goods and services between households and firms. The households sell the use of their labour, land and capital to the firms in the markets for the factors of production. The firms then use these inputs to produce goods and services, which in turn are sold to households in the markets for goods and services, Hence, the factors of production flow from households to firms and goods and services flow from firms to households.
The outer loop shows the corresponding flow of rupees (or any other currency). The firms use some of the revenue from these sales to pay for the factors of production. What is left is the profit of the firm-owners, who themselves are members of the households. Hence, spending on goods and services flows from households to firms and income in the form of wages, rent and profit flows from firms to households.
The upper part shows that the firms sell goods and services to the households in return for money payments.
The lower part shows that households sell their factors of production in exchange for wages, rent and capital etc.
