Page 229 - DECO405_MANAGERIAL_ECONOMICS

Managerial Economics

Notes (g) Expenditure on purchase of old share is excluded.
(h) Government expenditure on all transfer payment is excluded.
9. Challenges like difficulties in getting information especially those related to underground
economy (illegal activities).
14.5 Circular Flow of Income

Circular flow of income model shows the flow of income between the producers and the
households who buy their goods or services. Income moves from households to producers as
the households purchase goods or services and income moves from producers to households in
the form of wages or profits. Let’s discuss the circular flow of income in a simple 2 sector model
and in a 4 sector model.
14.5.1 Circular Flow of Income in a 2 Sector Model

One of the most important insights about the aggregate economy is that it is a circular flow in
which output and input are interrelated (Figure 11.1). Household’s expenditures (consumption
and saving) and firm’s expenditures (wages, rents, etc.) are household’s income.
Figure 14.1

Source: www.medlibrary.org/medwiki/Circular_flow
The circular flow of income model is a model used to show the flow of income through an
economy. Through showing the leakages in the economy and the injections, the different factors
affecting the economic activities are apparent. Just like a leakage in a bucket leads to decrease in
the level of water, a leakage in the economy leads to a decrease in economic activity. And just
like an injection into the bucket where the water level rises, an injection in an economy leads to
an increase in economic activity.

Basic Assumptions of a Simple Circular Flow of Income Model

1. The economy consists of two sectors: households and firms.
2. Households spend all of their income (Y) on goods and services or consumption (C). There
is no saving (S).

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