UNIVERSITY OF PERADENIYA
Circular Flow of Income and Spending
(Case Study: Drug Economy)
Name Thevuni Kotigala
University University of Peradeniya, Sri Lanka
Faculty Faculty of Arts
Programme Masters in Development Practice (MDP)
Course Year 2020/21
Academic Year Pre-MDP
Lecturer Prof. N.D. Samarawickrama
Department Department of Economics & Statistics
Subject Code DPR 403
Subject Name Principles of Economics
Medium English
Circular Flow of Income and Spending
Topic
[Case Study: Drug Economy]
Word Count 1,340 words
, 1. Develop a model of circular flow of income to a hypothetical economy giving values to all
cages starting from the firm sector level assigning some value for the value of production
(GDP).
The Circular Flow also known as Circular Flow of Income and Spending, is a model of the economy
in which the major exchanges are represented as flows of money, goods and services, etc. between
different sectors of an economy. The circular flow analysis is vital as it is the basis of national accounts
which lays the foundation for macroeconomics as well.
The circular flow diagram is a closed circuit, where values are corresponding, but are running in the
opposite directions. It illustrates the interdependence of the flows/ activities, that occur in the economy,
such as the production of goods & services and the income generated from that production. Thus, the
circular flow illustrates the equality between the income earned from production and the value of goods
and services produced.
For further explanations, the following hypothetical economy is used to explain a two-sector circular
flow model (Refer Figure 1). In this simple economy, only a household and a firm exist where the
economy can be thought of as two cycles moving in opposite directions in between those two.
In this basic circular flow of income model, the economy consists of two sectors: (1) households, and
(2) firms. There are other models with three-sectors [(1), (2) & (3) Government sector], Four-sectors
[(1), (2), (3) & (4) Overseas sector], and five-sectors [(1), (2), (3), (4) & (5) Financial sector] as well.
However, this hypothetical model assumes that there is no financial sector, no government sector, and
no foreign sector.
The following model recognizes the objectives;
• Firms aim at profit maximization, and
• Households aim at utility maximization.
Furthermore, the model assumes;
• Through their expenditures, households spend all of their income on goods and services or
consumption, and
• Through their expenditures, households purchase all output produced by firms. This means that
all household expenditures become income for firms.
The model flows between the two sectors as explained below,
1
Circular Flow of Income and Spending
(Case Study: Drug Economy)
Name Thevuni Kotigala
University University of Peradeniya, Sri Lanka
Faculty Faculty of Arts
Programme Masters in Development Practice (MDP)
Course Year 2020/21
Academic Year Pre-MDP
Lecturer Prof. N.D. Samarawickrama
Department Department of Economics & Statistics
Subject Code DPR 403
Subject Name Principles of Economics
Medium English
Circular Flow of Income and Spending
Topic
[Case Study: Drug Economy]
Word Count 1,340 words
, 1. Develop a model of circular flow of income to a hypothetical economy giving values to all
cages starting from the firm sector level assigning some value for the value of production
(GDP).
The Circular Flow also known as Circular Flow of Income and Spending, is a model of the economy
in which the major exchanges are represented as flows of money, goods and services, etc. between
different sectors of an economy. The circular flow analysis is vital as it is the basis of national accounts
which lays the foundation for macroeconomics as well.
The circular flow diagram is a closed circuit, where values are corresponding, but are running in the
opposite directions. It illustrates the interdependence of the flows/ activities, that occur in the economy,
such as the production of goods & services and the income generated from that production. Thus, the
circular flow illustrates the equality between the income earned from production and the value of goods
and services produced.
For further explanations, the following hypothetical economy is used to explain a two-sector circular
flow model (Refer Figure 1). In this simple economy, only a household and a firm exist where the
economy can be thought of as two cycles moving in opposite directions in between those two.
In this basic circular flow of income model, the economy consists of two sectors: (1) households, and
(2) firms. There are other models with three-sectors [(1), (2) & (3) Government sector], Four-sectors
[(1), (2), (3) & (4) Overseas sector], and five-sectors [(1), (2), (3), (4) & (5) Financial sector] as well.
However, this hypothetical model assumes that there is no financial sector, no government sector, and
no foreign sector.
The following model recognizes the objectives;
• Firms aim at profit maximization, and
• Households aim at utility maximization.
Furthermore, the model assumes;
• Through their expenditures, households spend all of their income on goods and services or
consumption, and
• Through their expenditures, households purchase all output produced by firms. This means that
all household expenditures become income for firms.
The model flows between the two sectors as explained below,
1
