What is the circular flow of economic activity?
Meaning of the circular flow of economc activity: – The circular flow of economic activity is an economic model that shows the flow of money through the economy. This model shows the most common circular flow of income between the household sector and the business sector. There are product markets and resource markets between the two.
Households purchase goods and services that businesses provide through the product market. Trade, meanwhile, requires resources to produce goods and services. Members of families provide labor to businesses through the resource market. In return, businesses convert those resources into goods and services.
What are the 4 factors of production?
In economics, there are four types of resources, known as factors of production. Each factor of production has a specific type of payment associated with it, which is called factor payment.
- Labor: – They are workers. The factor payment for labor is called “wages”.
- Land: – It includes land that is rented or purchased, as well as other components such as natural resources and raw materials. The factor payment for land is called “rent”.
- Capital: – This money is used to purchase equipment that applies labor to convert land (i.e. natural resources) into goods. The factor payment for capital is called “interest”.
- Entrepreneurs: – These are the people who put together the other three resources to build a successful business. For entrepreneurs the factor payment is called “profit”.
How do costs, revenue, and consumer spending relate to the circular flow model?
It is the simple circular flow model of the free market, money flows in the opposite direction.
Here’s how it works: –
- When families need a good or service, their money goes to the product market in the process of consumer spending.
- To provide goods and services to households, the product market buys from businesses, generating revenue.
- To create goods and services for the product market, businesses purchase resources from the resource market, thereby generating costs.
- Finally, to generate resources businesses need to make goods, the resource market pays for other resources namely workers and land. It generates income for labor and landholders.
The above process can be summarized as follows: –
Consumer spending —> Revenue —> Cost —> Income
The circular flow of economic activity in a two sector economy
In the above figure, one can identify that there are majorly four stakeholders involved in the circular flow: –
- Factor market
- Product market
Overview: – The flow depicts how money flows in an economy. Homeowners buy products and services from companies, which are sold on the product market. Business owners, on the other hand, need capital to manufacture services and products. In the resource sector, participants of households supply manpower to businesses. Businesses then turn those capital into products and services.
The role of two major stakeholder parties is explained in detail below: –
- Households: – Their primary goal is to meet the needs of their members while staying within their budget constraints. Land, labor, money, and entrepreneurship are all factors of production owned by households. They market these factors’ services for a fee, which they earn in the form of rent, salaries, interest, and gain.
- Firm: – Their primary goal is to meet the needs of their members while staying within their budget constraints. Land, labor, money, and entrepreneurship are all factors of production owned by households. They market these factors’ services for a fee, which they earn in the form of rent, salaries, interest, and gain.
Explaining the flows in the diagram
The selling of products and services by firms to customers in the commodity market is depicted in the bottom part of the innermost circle from left to right, whereas the sale of services by houses or consumers to firms in the factor market is depicted in the upper part of the innermost circle from right to left. These are the actual flows of goods and services from businesses to consumers, which are connected to productive resources from consumers to businesses through trade or exchange.
Whereas in an economy which is modern, exchange takes place through financial flows which happen in the opposite direction compared to the ‘real’ flows. When the households consumes products manufactured in the commodities market that becomes revenue for the firms which is depicted by the outer circle of the lower portion from right to left. Similarly, the firms also spend on acquiring resources from households and generate income for these households which is depicted by the outer circle of upper part in the diagram.
This is how financial and real resources flow in an economy and hence constitute circular flow of economic activity.
The circular flow of economic activity in a three sector economy
- To all of this, we introduce the state market, making it a three-sector closed template of economic activity circular flow. Government purchases are inflows into circular flow, while taxes are withdrawals from it. The diagram above depicts the flow in a three-sector economy.
- Take, for example, the circular flow between both the household and government sectors. Taxes paid by consumer sector in the form of income tax and product taxes are leakages from the circular flow. However, the state purchases domestic utilities, provides transfer payments in the form of retirement benefits, unemployment benefits, sickness benefits, and so on, etc. and spends money on them just to deliver welfare programs such as schooling, health, shelter, sanitation, gardens, and other amenities.
- Both of the government’s expenses are injections into the circular flow. Take a look at the circular movement between the private and public sectors. Seepage from the circular flow include all forms of taxes charged by the private sector to the government.
- But at the other side, the government buys all of its products from private sector, provides incentives, and makes fiscal transfers to businesses in order to enable them to produce. These public expenditure decisions are injections into the cycle.
- Now we’ll display the sources and uses of the household, industry, and government sectors in a circular flow. Taxes, as previously said, are a leak from the circular flow. They have a tendency to minimize consumer spending and savings. Lower consumption, in essence, decreases the firm’s revenue and earnings.
- Taxes on businesses, but at the other end, aim to decrease investment and efficiency. The government compensates for these leakages by purchasing goods and services from the private sector in a sum equal to the amount of taxes paid. In the circular flow, injections match leakages.
The circular flow of economic activity in a four sector economy
- Exports are capital inflows or injections into the monetary cycle. Imports, on the other side, are leaks in the circular flow. They are costs borne by the consumer sector in order to import products from abroad.
- In reference to the foreign market, consider the inflows and outflows of the household, industry, and governmental organizations. The household sector purchases and pays for products purchased from abroad, resulting in a money leak from the circular flow of money. For services provided in overseas nations, the householders’ may collects transfer payments from the foreign sector.
- The corporate sector, on the other side, exports goods from other countries, and its transactions contribute to the circular flow of revenue. Likewise, many businesses provide facilities to overseas nations, such as transportation, banking, insurance, and so on, for which they are paid from overseas.
- For capital invested in other nations, they earn fees, interest, dividends, taxes, and so on. The corporate sector, on the other hand, pays the international sector for imported capital products, equipment, raw materials, consumer products, and facilities. These are the money leaks that occur as a result of the circular flow of money.
- Modern states, like the private sector, export and import commodities / services, as well as loan to and borrow from other nations. The government collects payments through globally for all products exported.
- Foreigners often pay the government when they enter the country as visitors and attend college, as well as when the state gives shipping, banking, and investment funds to foreigners via state-owned entities. Govt. also earns royalties, interests, dividends etc. for investments made abroad, these act as inflows into the circular flow whereas outflows happen when payments are made to foreigners for the purchase of services/goods.
Savings, taxation, and imports are shown as seepage from the circular flow on the right hand side of the image, while investment, government expenditure, and exports are shown as injections into the circular flow on the left hand side of the figure.
Import tariffs, imports, and transfer payments have also been linked to the three domestic markets of the household, industry, and government. The international market, also known as the “Balance of Payments Sectors,” channels these capital inflows and outflows.