Two Sector Economy

Yaser Rahmati | یاسر رحمتی

A two-sector model is one of the simplest frameworks used to understand the basic functioning of an economy. It consists of two main sectors:

• households

• companies (firms)

This model helps to illustrate the fundamental interactions between these sectors, such as production, income distribution, and consumption. Let's break down the structure and key components of this model:

Key Components and Assumptions

1. Households:

• Role: Households provide factors of production (mainly labor and capital) to companies and receive income in return (wages, rents, dividends, etc.).

• Consumption: Households use their income to purchase goods and services produced by companies.

• Savings: Part of the household income can be saved and deposited in financial institutions.

2. Companies (Firms):

• Role: Companies produce goods and services using the factors of production provided by households.

• Revenue: Companies earn revenue from selling these goods and services to households.

• Investment: Companies invest in capital to enhance future production capabilities.

Key Interactions

1. Factor Markets:

• Households supply labor and capital to companies in the factor markets.

• Companies demand these factors of production and pay households in the form of wages, rents, and profits.

2. Product Markets:

• Companies produce goods and services and sell them in the product markets.

• Households purchase these goods and services using the income they receive from factor markets.

Circular Flow of Income and Expenditure

The circular flow diagram is a key feature of the two-sector model. It illustrates the continuous movement of money and resources between households and companies:

1. Income Flow:

• Households provide labor and capital to companies.

• Companies pay wages and returns on capital to households.

2. Expenditure Flow:

• Households use their income to purchase goods and services from companies.

• The revenue generated from these sales goes back to companies.

Key Equations and Concepts

1. Income (Y):

$$Y=C+S$$

• Y: Total income earned by households

• C: Consumption expenditure by households

• S: Savings by households

2. Expenditure (E):

$$E=C+I$$

• E: Total expenditure in the economy

• I: Investment by companies

In equilibrium, the total income (Y) equals total expenditure (E):

$$Y=E \\ C+S=C+I$$

Therefore, savings (S) must equal investment (I):

$$S=I$$

Assumptions

• No Government: This model does not include government spending, taxation, or intervention.

• No Foreign Trade: The model assumes a closed economy with no imports or exports.

• Full Employment: All resources, including labor, are fully employed.

• Simplified Financial Sector: The model often abstracts away detailed financial sector activities.

Limitations

• Simplistic: The two-sector model is highly simplified and does not account for government and foreign trade.

• Static: It typically represents a static view and does not easily accommodate changes over time.

• Assumes Perfect Markets: Assumes no market imperfections, like monopolies or information asymmetries.

Extensions

To better reflect real-world economies, the two-sector model is often extended to include:

• Government Sector: Introducing taxes, government spending, and public goods.

• Foreign Sector: Accounting for imports, exports, and international trade.

• Financial Sector: Including banks and financial institutions that mediate savings and investments.