Explain circular flow of income in two sector economy.

Question: Explain circular flow of income in two sector economy.

The circular flow of income is a basic model that illustrates the flow of goods and services and income in an economy. It is a simplified representation of the economic activities that take place in a two-sector economy consisting of households and firms. The two sectors are interdependent and work together to create economic activity.

In a two-sector economy, households are the owners of factors of production, such as land, labor, and capital, and firms are the producers of goods and services. The circular flow of income in a two-sector economy can be explained as follows:

Households sell their factors of production, such as labor, to firms in exchange for wages and salaries.

Firms use these factors of production to produce goods and services.

Firms then sell these goods and services to households in exchange for money.

Households use this money to buy goods and services from firms.

The circular flow of income can be represented graphically as a circular flow diagram, which shows the flow of money, goods, and services between households and firms. In this diagram, the outer loop represents the flow of goods and services, and the inner loop represents the flow of money.

The circular flow of income in a two-sector economy illustrates that the income earned by households is spent on goods and services produced by firms. This spending by households, in turn, generates revenue for firms, which enables them to pay wages and salaries to households. Thus, the circular flow of income creates a self-sustaining system where the income earned by households is used to purchase goods and services, which generates income for firms, which is then used to pay wages and salaries to households, and so on. This circular flow of income is the basis for the functioning of a market economy.