The Circular Flow of Income- Two sector model

The Circular Flow of Income

Two sector model

The model of the circular flow of income can help us to understand how it is possible to measure national income in three different ways to arrive at the same figure.

Producers and consumers of goods and services are separate groups. Producers are represented as firms, and consumers as households. This is a two sector model of the circular flow of income as it just comprises households and firms.  

Households are assumed to hold all of the economy's factors of production (land, labour, capital and enterprise). These factors are sold to firms, which use them to supply goods and services. The firms then sell these goods and services to households and receive payment in return.


The income households spend on goods and services is called expenditure. The firms make use of the factors of production, for these, they pay households the factor payments, such as rents, wages, interest profits. 

This is based on three assumptions:

• There is no government sector- therefore there are no taxes paid or government spending
• Households spend all the income they receive- there is no saving; firms spend all the money they receive from households on factor services
• The economy doesn't trade with the rest of the world- no exports or imports

In this model, income=expenditure=output
                       Y=E=O
It is possible to measure a country's national income using three methods that provide the same answer as they are measuring the same flow. These methods are the income, output and expenditure methods.


I would advise using the tutor2u site, as their explanation and diagrams go into more depth with this topic, looking at all sectors.
http://www.tutor2u.net/economics/reference/circular-flow-of-income-and-spending