What is Foolsaurus?

It's a glossary of investing terms edited and maintained by our analysts, writers and YOU, our Foolish community. Get Started Now!


Explanation of the Relevance of Knowing the Circular Flow of Income & Spending As an Economic Model

Original post by Walter Johnson of Demand Media

The circular pattern of income and spending is called the “two-tier” model of economic life. It is different from the more common “three-tier” model in that governments at all levels make up the third tier. The question as to the relevance of the “two tier” model is important, since it does not involve the state, or public authority, its significance seems to be limited.

The Model

The two-tier model contains two variables: consumers and suppliers. Alternatively, the two variables are called households and firms. Either way, the two variables are the two simplest explanations of supply and demand. The significance of this model is precisely that: it deals only with supply and demand without any other variables being used. Producers measure demand, supply what is needed, and households buy what they want. There is no “leakage” in that the cycle is completely closed. All money derives from household labor and this is used to continue to purchase from suppliers.

Assumptions

Using only supply and demand in a vacuum contains several assumptions. Historically, it assumes that the very development of the modern economy has not involved the state or any other public authority such as unions, universities or scientific societies. If you assume that the state and other public authorities were instrumental in developing the modern economy, then the two-tier model is not particularly useful, since there was never a time when the state was not at the forefront of the capitalist and later industrial revolutions.

Significance

The purpose of the two-tier model is to grasp the intrinsic and complex relation between labor and production. The household, in reality, is not different from the firm in that the firm hires labor to produce the product. The household represents “private” life, while the firm is the more “public” and centralized form of economic activity. In essence, households are purchasing the products of their own labor with the money they earn making those very products. It is a cycle of identity: Labor is both producer and consumer. However, the role of labor is different as purchaser or producer.

Distortion

While the model theorizes that there is no leakage in the loop, the radical critique of political economy rejects this. In general, this critique holds that leakage is intrinsically a part of the loop itself. When labor produces a product, they earn wages that they can be used to purchase certain necessities. But if the loop were entirely closed, there would be no reason for the privately owned firm to exist. They exist to make a profit. This is the nature of the “leakage,” or alternatively, the “distortion” in the system. As firms become powerful, they are capable of taking more “surplus” from the workers and keeping it for themselves as profit. The critique therefore does not concern the state, but rather that profit is a built-in distortion of the system. More and more is taken from labor as firms begin to centralize power and put smaller firms out of business.

                   

References

  • "Supply and Demand"; Janeen R. Adil; 2006
  • "The Relentless Revolution: A History of Capitalism"; Joyce Appleby; 2010

About the Author

Walter Johnson has more than 20 years experience as a professional writer. After serving in the United Stated Marine Corps for several years, he received his doctorate in history from the University of Nebraska. Focused on economic topics, Johnson reads Russian and has published in journals such as “The Salisbury Review,” "The Constantian" and “The Social Justice Review."

Advertisement