TWO-SECTOR, TWO-MARKET CIRCULAR FLOW:

A simple circular flow model of the macro economy containing two sectors (business and household) and two markets (product and factor) that illustrate the continuous movement of the payments for goods and services between producers and consumers. The payment flow between the two sectors and two markets is conveniently divided into four segments representing consumption expenditures, gross domestic product, factor payments, and national income.

The two-sector, two-market circular flow model is the simplest way to show the inherent interrelationship between producers and consumers in the macro economy.

Two Sectors, Two MarketsThe two macroeconomic sectors included in this model are: Household Sector: This includes everyone, all people,

seeking to satisfy unlimited wants and needs. This sector is responsible for consumption expenditures. It also owns all productive resources.

Business Sector: This includes the institutions (especially proprietorships, partnerships, and corporations) that undertake the task of combining resources to produce goods and services. This sector does the production. It also buys capital goods with investment expenditures.

The two macroeconomic markets in this basic version of the circular flow are: Product markets: This is the combination of all markets

in the economy that exchange final goods and services. It is the mechanism that exchanges gross domestic product. The full name is aggregate product markets, which is also shortened to the aggregate market.

Resource markets: This is the combination of all markets that exchange the services of the economy's resources, or factors of production--including, labor, capital, land, and entrepreneurship. Another name for this is factor markets.

Consumption GDP

National IncomeFactor Payments

The Basic Circular Flow

Circulating AroundThis diagram presents the simple two-sector, two-

market circular flow. At the far left is the household sector containing people seeking consumption. At the far right is the business sector that does the production. At the top is the product markets that exchange final goods and services. At the bottom is the resource markets that exchanges the services of the scarce resources.

•Gross Domestic Product: Consider first the upper right-hand segment of the circular flow between the product markets and the business sector. This is the revenue received by the business sector for the production of goods and services, what is officially termed gross domestic product (GDP).

Factor Payments: Moving clockwise with the flow, the lower right hand segment between the business sector and the factor markets is factor payments. These are payments to the owners of labor, capital, land, and entrepreneurship for the productive services they provide. Factor payments can be divided into specific items depending on the resources involved, including wages, interest, rent, and profit.  

National Income: Continuing clockwise to the lower left hand segment between the factor markets and the household sector is national income. Definitional speaking this is the income earned by the factors of production, which are owned by the household sector.  

Consumption Expenditures: The last segment of this flow, between the household sector and the product markets in the upper left hand corner, is consumption expenditures.

Illustration 1

The fundamental equations in a two sector economy are given as: Consumption C = 300 + 0.8Y and the investment function I = 400.

1. Derive the saving function

 2. Find the equilibrium level of productivity the equating

the saving leakages to the investment injections

Solution

(1)

The saving function is given by

S         =          Y – C

                                                   S         =          Y – (300 + 0.8Y)

                                                   S          =          – 300 + 1Y – 0.8Y

                                                   S         =          – 300 + 0.2Y

Hence, the saving function is given by S   =       - 300 + 0.2Y

(2)

The equilibrium level of productivity can be determined by equating the saving leakages to the investment injections.

Thus,                                                     - 300 + 0.2Y   =          400

                                                - 300 – 400     =          - 0.2Y

                                                 - 700               =          - 0.2Y

Or                                            0.2Y                =          700

Thus, the equilibrium level of productivity is 3,500

Illustration 2

For a two sector economy we have the following equation for consumption function

C = 120 + 0.75Y, determine the following

1. If investment in a year is $70 million what will be the equilibrium level of income or productivity

2. If full employment level of income is $920 million what investment is required to be undertaken to ensure equilibrium at full employment

Solution

(1)

        We know   Y         =          C + I

                           Y         =          120 + 0.75Y + 70

              Y – 0.75Y       =          120 + 70

              0.25Y              =          190

           Y         =          190 / 0.25

Thus, if the investment in a year is $70 million, then the equilibrium level of income or Productivity (Y) will be $760 million.

(2)

To ensure full employment equilibrium investment should be equal to the saving gap at full employment income. With the given full employment income equal to $920 million,

                                                    S = Y – C

S = 920 – 120 – 0.75 (920)

                                                    S = 800 – 0.75 (920)

                                                    S = 800 – 690

Thus, investment required for full employment equilibrium is $110 millions

Illustration 3

If in a two sector economy Consumption C = 900 + 0.8Y and Investment I = 1,080 then

1. Determine the equilibrium level of income and consumption

2. Derive the saving function and determine the saving at the equilibrium level

3. Determine the equilibrium level of income by equating planned investment

Solution

(1)       

The equilibrium condition is given as Y = C + I

Thus,                                           Y         =          900 + 0.8Y + 1,080

                                      Y         =          1,980 + 0.8Y

                                      Y – 0.8Y         =          1,980

                                      0.2Y               =          1,980

                                        Y         =          1,980 / 0.2

 

Thus, the equilibrium level of income (Y) is 9,900

   

The consumption function C = 900 + 0.8Y

When Y = 9,900

C         =          900 + 0.8(9,900)

C         =          900 + 7,920

Thus, the equilibrium level of consumption C is 8,820

(2) The saving function is given by S = Y – C

                                      S          =          Y – (900 + 0.8Y)

                                       S          =          Y – 0.8Y – 900

                                       S          =          0.2Y – 900

Thus the saving function is given by S = 0.2Y – 900

At equilibrium level, S          =          0.2 (9,900) – 900

S          =          1980 – 900

The saving function at Equilibrium will be S = 1080

The planned saving is given by S        =   - 900 + 0.2Y

(3)In equilibrium, planned saving equals planned investment

Thus, S = 0.2Y – 900

1080=0.2Y – 900

0.2Y - 900 =          1080

                                           0.2Y    =          1080 + 900

                                           0.2Y    =          1980

                                           Y         =          1980 / 0.2

Thus, the equilibrium level of income (Y) is 9,900