Question

Explain Circular Flow of economic activity in a two-sector model.

Answer 1

The Circular Flow in a Two-Sector Economy: In a simplified economy with only two types of economic agents, households or consumers and business firms, the circular flow of economic activity is shown in Figure 10. Consumers and firms are linked through the product market where goods and services are sold.

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Answer 2

In a simplified economy with only two types of economic agents, households or consumers and business firms, the circular flow of economic activity is shown in attachment Consumers and firms are linked through the product market where goods and services are sold. They are also linked through the factor market where the factors of production are sold and bought.

Consumers and firms have a dual role, and exchange with one another in two distinct ways:

1) Consumers or households own all the factors of production, that is, land, labour, capital and entrepreneurship, which are also called productive resources. They sell them to firms for producing goods and services.

In the diagram, the sale of goods and services by firms to consumers in the product market is shown in the lower portion of the inner circle from left to right; and the sale of their services to firms by households or consumers in the factor market is shown in the upper portion of the inner circle from right to left. These are the real flows of goods and services from firms to consumers which are linked with productive resources from consumers to firms through the medium of exchange or barter.

2) In a modem economy, exchange takes place through financial flows which move in the reverse direction to the “real” flows. The purchase of goods and services in the product market by consumers is their consumption expenditure which becomes the revenue of the firms and is shown in the outer circle of the lower portion from right to left in the diagram.

The expenditure of firms in buying productive resources in the factor market from the consumers becomes the incomes of households, which is shown in the outer circle of the upper portion from left to right in the diagram.

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