1.5 CIRCULAR FLOW OF INCOME AND EXPENDITURE

In market economy, the society is divided into two main groups – the consumers and producers.
If you recall the definition of “economy” in subtopic 1.1, we can describe users as a group of people having unlimited wants and needs while producers are the group that utilises limited resources in the production process in order to fulfil those unlimited needs. However, both groups are not separate entities since a consumer may be a producer at the same time and vice-versa (Figure 1.11).

Figure 1.11: Groups within the society in the market economy

The concept of consumers and producers are related to the circular flow of utilisation that is, the utilisation of end products and the utilisation of resources. On the other hand, in the circular flow of income, household is classified as a resource supplier and firms as the supplier of consumer goods. Households will earn income from the sales of resources such as labour, land and capital to firms and use their earnings to buy goods and services produced by the firms, whereas firms will use the earnings from the sale of goods and services to pay for the resources utilised. Figure 1.12 depicts both circular flows.
In a nutshell, households make two main decisions. Firstly in determining the total amount of production factor owned that will be sold in the factors market to earn income, and secondly, determining the quantity of goods and services that will be bought using the earnings. Firms instead, will make decision on the goods and services to be produced and determine the amount of inputs that will be bought from households.

Figure 1.12: Circular flow of production and goods factors