(2) In a modem economy, exchange takes place through financial flows which move in the reverse direction to the “real” flows. These are the real flows of goods and services from firms to consumers which are linked with productive resources from consumers to firms through the medium of exchange or barter. In the diagram, the sale of goods and services by firms to consumers in the product market is shown in the lower portion of the inner circle from left to right and the sale of their services to firms by households or consumers in the factor market is shown in the upper portion of the inner circle from right to left. They sell them to firms for producing goods and services. (1) Consumers or households own all the factors of production, that is, land, labour, capital and entrepreneurship, which are also called productive resources. They are also linked through the factor market where the factors of production are sold and bought.Ĭonsumers and firms have a dual role, and exchange with one another in two distinct ways: Consumers and firms are linked through the product market where goods and services are sold. In a simplified economy with only two types of economic agents, households or consumers and business firms, the circular flow of economic activity is shown in Figure 10. The Circular Flow in a Two-Sector Economy: Thus these two flows are interrelated and interdependent through exchange. Both production and consumption, in turn, depend upon exchange. In other words, production is a means (beginning) and consumption is the end of all economic activities. Production leads to consumption and consumption necessitates production. Consumption and production are flows which operate simultaneously and are interrelated and interdependent. Production, consumption and exchange are the three main activities of the economy. These decision-making agents take economic decisions to produce goods and services and to exchange them in order to consume them for satisfying the wants of the whole economy. The government also uses resources to produce goods and services itself which are sold to households and firms. It removes its defects by regulating the activities of the private sector and by providing incentives to it.
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