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Circular Flow of Income in a Three-sector Economy

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Published: 3rd Jul 2017 in Economics

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Circular flow of income in a three-sector economy

There are three main sectors of economy consists of household sectors, business sectors and government sectors. Household sectors combine their income and product, business sectors with the income and product of the government sector will reach at the national income in the economy.

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Household sector provides the factors of the production such as land, labour and capital and enterprise that the producers require to produce goods and services. They also receive payments as in rent, wages, interest and profits from the business sector. It is also stated that in general, household sector consists of the greatest number of consumers among all sectors and satisfying the wants will cause consume of their climate aim.

Business sector act as a part as in receiving economy resources from household sector and in exchange for consumer expenditure, they also provide household sectors goods and services. Business sector is also given money to buy scarce economic resources from the resource market. While they’re in the product market, business sector sells their products and services, which is also the way they receives their income.

To complete the circular income of income and expenditure in a three-sector closed model, the government sector is added. Taxation is a leakage from the circular flow and government purchases are injections into the circular flow. To do so, government sector implements taxes on businesses and consumers. They also act as a part to spend the money back on business and consumers for the other sectors’ benefits. Government incurs expenditure on goods and services.

The circular flow between the household sector and the government sector:

Household sector pay direct taxes and commodity taxes in terms of building up the leakage from the circular flow. On the other hand, government sector also purchase the services from household sector and make transfer payments to the household sector which has low income. All the expenditure is said to be injected into the circular flow.

The circular flow between the business sector and the government sector:

The action of business sector pay taxes to the government also constituting leakage from the circular flow. Government sector will purchase the final goods from the business sector as well as make transfer payments to firms to induce production from the other sectors.

The circular flow among the household sector, business sector and government sector:

Taxation is a leakage from the circular firm. Taxation reduces savings and consumption of the households. The reduction in consumption will reduce the sale and the income of firms. The government offsets these leakages by making purchases from the business sector and the household sector. It equal to the amount of taxes and total sales again equal production of firms. The equilibrium will show in the circular flows of income and the expenditure too.

The diagram above shows that taxes flow out of the household and business sectors and go to the government. The government makes investment and the purchases goods from firms and also factors of production from households. On the other hand, government purchases of goods and services are an injection in the circular flow of income and taxes are leakages.

If government purchases exceed net taxes, the government will incur a deficit equal to the differences between the public expenditure and taxes. Besides, government purchases will also cause a budget surplus when the net taxes are being exceeded. When such situation occurs, the government will initiate reduce in the public debt. The government also supplies funds to the capital market which are received by firms.

In a business, accounting is essential to measure the profit and loss of a company. It keeps it as a business record for references to guide a company right on track. Similar event apply to a nation GDP. The measurement incomes of a country are measured by three different methods which consist of expenditure approach, income approach and value added approach. These three methods must have the same results due to the interrelation in the circular flow of production, income and expenditure.

Expenditure approach

The expenditures approach concedes the consumption of output in a country within a period of time. The consumption of output comprises of four components, which consists of household consumption, investment, government purchases and net exports. (Anon., 2006)

In order to calculate the national income, a summation of formula is necessary to determine the outcome.

GDP= C+I+G+ (X+M)

“C” means consumption and it represents the total spending of household on durable goods, nondurable goods and services for own use. Durable goods are goods that expected to last long and do not have to repurchase frequently, such as machinery goods, vehicle and furniture. Non-durable goods which known as perishable goods which have less expectation of shelf life, it good that suppose consume or use immediately, such as milk, eggs, bread and shampoo. Services are intangible goods with no ownership claim for the item after purchase, such as car maintenance, foot reflexology and tuition.

“I” means Investment which represents the expenses by the private firm to uphold their business to ensure their business will keep growing. Such investment will fall on fixed capital, business inventories and property assets.

“G” means government purchases. It reflects the government on consumption and gross investment in local infrastructure. Example of expenditure comprises of salaries and wages of the civil servant as well as the material and equipment used, including the maintenance for the entire infrastructures. Under the expenditure approach, transfer payments are excluded in GDP.

“(X-M)” refers to net export of the country. X represents the export of goods and services of the country produced by the country itself. M represent import of goods and services produced by others country.

Income approach

Income approach is another way to compute the national income. It seeks to measure the total amount of income generate by the production of goods and services in the form of wages, rent, net interest and profit. Individuals are paid for their physically and mentally contribution in the production process. Wages are paid to household for providing labor force to the firm or government in a production and services. It is consider one of the largest components in the national income. However, rent is paid to the household who’s owned the property by renting their premises which involve in a production process. Net interest is paid to the household for the capital invested in a business. Last, which is profit, it refers to entrepreneur gains from the production of goods and services from the binding of factors production after sales, exclude the total cost. (Anon., 2011)

National income = wages + rents + interest + profits

While measuring the national income transfer payment, black money, lotteries prize and merit from share must be excluded from the summation in national income. The main reason of the restriction is because the above gains did not contribute in any production of goods as well as services and parts of it are illegally.

Value added approach

Every items which available on the rack with price tag involve the intervention of manufacturer, distributor, supplier and retail. Each time the intermediate good reallocate, the price off the goods will stack up. Therefore, value added approach take account of the value added in to the final product at each stage. (Daniel, 2013)

The above diagram shows the stage of production of chocolate and the value added. Firm A harvest the cocoa bean from the cocoa tree and it will go through fermentation and drying by manual labour. After they pack the bean, it will be sell and transport to Firm B for $20. In order to get the cocoa solid from the cocoa bean, firm B will roast the cocoa bean, winnow the shell and germ off and grind it. Last they press the cocoa mass and separate the cocoa butter. The huge cocoa mass and cocoa butter will be purchased by Firm C for $60 to make variation of chocolate, differ in percentage and flavor. After refining the chocolate, Firm C will distribute their chocolate products to the supplier which is firm D for $80. The confectionary shop which is Firm E will purchases chocolate from Firm D at $130. The chocolatier from the Firm E will use the chocolate to infuse with other ingredients, decorate it to make chocolate bon bon and sell it to customer at the prices of $220. In this case, if we add up all the added value by each stage of production, it will be $220 which is similar to the final goods sold at firm E.

Example of GDP: According to The World Bank


Gross Domestic Product – GDP

USD$ 1260.91 (2013 estimate)

GDP (purchasing power parity)

USD$ 1.845 trillion (2013 estimate)

Real GDP growth (annual)















GDP per capita (PPP)

USD 16,290.81 (2013 estimate)

GDP –composition by sector

  • Agriculture : 3.6% (corn, wheat, soybean, rice, beans, cotton, coffee, fruit, tomatoes, beef, poultry, dairy products and wood products)
  • Industry : 36.6% (food and beverages, iron and steel, motor vehicles, tobacco, chemicals, mining, consumer durables, tourism)
  • Services : 59.8% (transportation, restaurant and hotels, health care, banking and financial services, education, commerce)

(2013 estimate)


USD 1.971 trillion (2013 estimate)


Gross domestic product (GDP) of Mexico

GDP is a mechanism act to measure the aggregate amount of output by factor production within the country border of Mexico. The services sectors in Mexico contribute the greatest amount of national income toward the GDP of the nation.

What is National Income Statistics?

According to most dictionaries, national income is literally the total amount of money earned by a certain country. But in order to calculate the total funds and asset of the country, National Income Statistics are used, which are basically a set of rules, techniques and calculation to measure the total value of final goods and services produced. However, The National Income Statistics are only valid to calculate the national income of a country in a year.

  • The Uses of National Income Statistics

Like every other calculations, The National Income Statistics also have their own uses. The National Income Statistics are very important to the development of a certain country as it is the result of hard works done in a year to contribute in the enhancement of a certain country.

Firstly, as we all know money and riches usually determines the standard of living of a certain someone. For a country, there is also no difference because the total National Income earned by a country will show its quality and standards. Generally, countries with higher National Income has higher standard of living. For instance, United Kingdom has a higher national income than The Republic of Ireland; therefore, it shows that United Kingdom has the higher standard of living.

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The next benefit of the National Income Statistics is that it can be used for comparison over time. Every country will keep all their records of national income statistics in order compare year by year to determine whether the country is progressing, stagnating or deteriorating. In case of stagnating or deteriorating, governments and citizens will take notice and actions will be demanded immediately to improve the country’s national income. For example, Iran whose economics are deteriorating, as a result, government of their country is finding ways to solve their economic problems.

Moreover, as stated before, the total amount national income of a country is generally a status and could prove the country’s profile and development. Thus, national income statistics will cause comparison between countries. Judging and comparing may be against morality as competitions will normally cause conflicts. Yet, by comparing their national incomes, countries will be able to identify and differentiate their countries’ with developed countries and as a result the developing countries could emulate economic policies and strategies of developed countries to improve their economic growth and productivity. For instance, China whose national income was not that desirable in the twentieth century has emulated the economic strategies used by developed countries like Japan and gradually boosted their economics over the years, becoming one of the world’s powerhouse today.

As we all know, inflation is one of the most feared issue by countries across the globe. Inflations are sometimes unpredictable and could lead to depreciations in currencies, or worse, a financial crisis. Fortunately, people around the world are now able to use the national income statistics to solve this issue, which lead us to the fourth uses of the national income statistics, the potential to predict inflations or deflations. Economists nowadays are capable to predict the economic standard of countries by comparing their national income statistics with previous ones. With this, economists can identify the inflation and deflation gap and try to predict the forthcoming economic activities, though the prediction may not be perfectly accurate, but, the data could help governments to implement anti-inflationary or anti-deflationary measure to stabilise the value of money.

Besides that, the national income statistics also largely contributed in the three main sectors of economics, which is the primary sector, secondary sector and tertiary sector. The primary sector is the sector which involves in making direct use of natural resources, such as fishing and mining; the secondary sector involves in taking the output of the primary sector to produce finished goods, like, manufacturing and constructing; the tertiary sector though, is also known as the service sector, for instance, government services and electricity providers are tertiary sectors. What the national income statistics do is that it can identify the sectors that have contributed more to the economic growth. As a result, governments could focus on the sectors that have contributed little and improve it in the following year.

The fact that the national income statistics contains the figures of consumption, savings, investments, imports and exports has enabled people to identify the relative performances of both the public and private sectors in an economy. For example, figures shown by the national income statistics could let us identify whether public and private sectors of our country are developing. In addition, the expenditure pattern shown can also tell us the type of economic system the country is practising. For instance, if most of the activities are performed by state, we could conclude that the public sector is playing a dominant role in a centrally planned economy.

National income statistics too play a major role in the process of national planning as it shows information from consumptions to incomes and also performance of every sector in our country. With this, governments could formulate our country’s economic planning as in short term or long term. For example, with national income statistics, governments could estimate our country’s income for the following year, thus, making them capable of formulating future economic policies for future developments. Just like in the case of us, where financial planning is essential for our future, as in national income statistics is a tool for financial planning, it could be used to forecast future developments based on economic performances. In Malaysia, the government uses the national income statistics to draft the country’s Malaysian Plan for up to five years.

In conclusion, national income statistics is essential to every country as it largely contributed in the development of economics. The national income statistics till today still play a major role for future development and has consistently delivered the benefits mentioned above. Therefore, it is compulsory for future generations like us to practise and study the concepts of national income statistics to contribute in the development of economics of our country.


2011. BYU IDAHO. National Income Accounting. Viewed in 13 February 2015

Available from: https://courses.byui.edu/econ_151/presentations/Lesson_03.htm#Section_03_Link_01

John, S and Alison, W. 2009. ECONOMIC: SEVENTH EDITION. Harlow: Prentice Hall


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