Download two sector economy

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.
 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 Markets
 The two macro economic 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.




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,
land,
 labor,
 capital, and
 entrepreneurship.
 Another name for this is factor markets.
 The Basic Circular Flow
Consumption
National Income
GDP
Factor Payments
 Circulating Around
 This 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 land, labor,
capital, and entrepreneurship for the productive
services they provide.
Factor payments can be divided into specific items
depending on the resources involved, including rent,
wages, interest, 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 function 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
=
190 / 0.25


Y
Y
=
760
 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

S =110
 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

Y
=
1,980 / 0.2
=9900
 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 at equilibrium will be S = 1080
 (3)In equilibrium, planned saving equals planned
investment
S = 0.2Y – 900
 Thus,
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