Question

EC141 Unit 1: Discussion Use examples to distinguish between the resource market and the product market in the circula flow model. As we read this unit, how does the circular flow model illustrate how our economy works? How does the circular flow model work? What are the two flows in the circular flow model? What does your household do with its resources and with its income? How does your household interact in the resource and product markets? In what way is your household both a buyer and a seller in this model?

Answer 1

The circular flow of income or economic activity is the flow of goods and services among the different sectors of the economy, balanced by flow of money payments made in exchange for those goods and services.

In every year large number of goods and services are produced. These goods are produced by the firms with the help of factors of production. These factor services are rendered or supplied by the household sector. Thus there is a constant flow of factor services from the household sector to the firms or business sector. In return of the services of factors, the firms or business sector pay reward to the factors in the form of money. Therefore there is a constant flow of factor services from the household sector to the business sector. This flow is balanced by a counter flow of factor income from the business sector to the household sector. The household sector uses this money income to buy goods from the business sector. Therefore the goods and services flow from business to the household sector. In short there is a constant flow of goods and services from the business sector to the household sector and this flow is matched by the counter flow of money income to pay for the goods sold from the household sector to the business sector. This flow of factor services from household sector to the business sector and the counter flow of factor remuneration from business to the household sector and the second stream of flow in the form of goods and services from business to household and its counter flow in the form of the prices of these goods and services from households to business sector is uninterrupted and never ending. This flow is basically known as the circular flow of income or economic activity.

The circular flow of income can be analyzed in the context of two sector model which include only household and business sector, three sector model which includes household, business and government and four sector model which consist of households, business, government and foreign sector.

1. In a two sector model the expenditure of the household sector becomes the income of the business sector and the expenditure of business sector becomes the income of the household sector. Thus there is a constant flow of income and expenditure between the business sector and the household sector. This flow is called circular flow since it has neither any beginning nor any end. It is continuous and uninterrupted. The circular flow can be viewed in two angles. They are the flow of goods and services which is called Real Flow and the other flow is the flow of money which is called monetary flow.

The product market in a circular flow model is the business sector where the goods and services produced and sold. In the product market the business firms are the sellers and households are the buyers. The household sector buys the goods and services produced by the business firms.

Household sector is the factor market. The resources are owned by the household sector. In other words the factors like land, labour, capital and organization are owned by the household sector. In the factor market the households are the sellers and business firms are the buyers of the factors. The household sector sells their factor services to the business firms in return of factor remuneration.

In a simple two sector model of economic activity the business sector hires the factor services from the households. Thus there is a real flow of factor services flow from households to business sector. In return for the services of the factors the business sector pays factor remuneration. Thus there is a money flow in the form of rent, wage, interest and profit from the business to household sector.

The household sector uses this income to buy goods and services. Therefore there is a real flow of goods and services from the business to the household sector. The household sector pays price for the goods and services. Then there will be a counter flow of money from households to business.

In short the flow of factor income and the counter flow of factor remuneration, the flow of goods and services and the counter flow for the payment of goods and services go on as uninterrupted and the economy works itself through this flow and counter flows.

2. The two flows in a circular flow of income are the Real Flow and the Monetary Flow. One is in the form of goods and services which is called the Real Flow and the other is in the form of money called Monetary Flow.

3. The household sector supplies its resources to the business sector to produce goods. In return the household sector receives income which is used to purchase the finished goods and services.

4. The resource market is the household sector. In the resource market the households are the sellers of factors and the business firms are the buyer of factors. The product market is the business sector which produces numerous goods and services. In the product market the firms are the suppliers or sellers and household are the buyers. Thus in the factor market the households are the sellers but in the product market they are acting as buyers.