Circular Flow of Income

The Circular Flow of Income is an economic model which depicts how an economy on a most basic level functions.

Starting point…

We start by observing that two economic agents exist in any economy:

(i) Households- so they own factors of production such as land, labour capital and enterprise and demand goods and services

(ii) Firms – They use factors of production and turn them into goods and services because they seek rewards – which is not only money but recognition etc. 

Before we go on, you may be wondering what about government? Other countries we trade with? They are all valid economic agents but the whole point of economics is formulate simple models which allow us to experiment. So the Circular Flow of Income model is based on 3 assumptions;

(1) The economy operates with closed trade which means no international trade exists 

(2) No government exists 

(3) No economic agent saves, any money received will be spent. 

We will see in a short while what actually happens when these assumptions are removed. But for now let me explain how the two economic agents (firms and households) are engaged in this model.

What happens is household they own factors of production which firms demand in order to produce goods and services. So a trade takes place, households sell land for rent; labour for a wage; capital for interests, profits and dividends and finally; enterprise (by which I mean entrepreneurial skill) for recognition and a salary. This is demonstrated by the two arrows shown on the diagram. 

On the other end firms sell these goods and services to households in return for a payment which if provides sufficient revenue not only encourages a firm to keep on producing but attracts more firms into the industry. 

It is important to note two things. In some place this model is depicted with four stops in the circle firms, households, market for goods and service and market for factors of production. These markets simply denote that a trade is taking place between some form of money and goods and services/factors of production. 

The second thing to note is that these arrows are incredibly important when we look at more serious models of the Circular Flow of Income. For example, the goods and services one can denote national output and rent/wage/profit one can denote national income.

So now to make the model more realistic. In reality we know that the three assumptions (no government, international trade and savings) are incorrect albeit at different levels and powers in different countries. But we do know they exist and they come under what we term in economics as leakages and injections. Leakages and Injections are external sources which either bring money in or out an economy.

So injections are external sources whereby money is gained in an economy and there are three of these which can be remembered by the abbreviation GXI – Government Spending, Exports (foreign money) and Investment. Leakages conversely are SMT (senior management team) Savings, Imports and Taxation. They are merely opposites and we can add an additional arrow to show these and make the model more realistic.

Income Elasticity of Demand (YED)

Income elasticity of demand = YED

What is income elasticity of demand?

It is the responsiveness/sensitivity of demand to income.

How do economists calculate income elasticity of demand?

Income elasticity of demand = Percentage change in quantity demanded
Percentage change in income

How do you interpret income elasticity of demand values?

If YED has a negative value (i.e. less than zero)…

The good is an inferior good. Demand decreases as income increases. It is a negative correlation. For example ASDA’s Smart Price notebooks.

If YED is between 0 and 1…

The good is a necessity – it is income inelastic. Demand will increase if income increases, although demand will increase by a smaller percentage than what income will increase by. For example, If income rises by 10% then demand for lets say apples will increase by less than 10%.It has a positive correlation.

If YED is greater than 1…

This good is a luxury, a normal good. Demand will increase as income increases. The good is income elastic. However this time if income increases by 10% the demand for lets say TVs will increase by more than 10%.

Want to test yourself?

Try out this quiz – beware it contains other elasticities too!


What is demand?

It is desire from consumers for a particular good/service/commodity.
The demand curve…
The demand curve shows the quantity demanded by consumers at each price of a good/service.
Price and demand are inversely related i.e. as price increases the quantity demand decreases. This describes the demand curve is downward sloping.
There are two reasons one must know for why price and demand have an inverse relationship.

1. The real income effect

As the price of a good/service increases it will eat a bigger chunk of the consumers income making them feel poorer so there are only a few people who are rich enough not to feel this impact. Also, the purchasing power has decreased (and all this means is that only a few people can afford expensive goods and services as they have the financial power.)
2. The substitution effect
This is that in our economy there is a lot of competition which keep prices low which is good for consumers. This means that there are many alternatives to the particular product you are looking for. For example if you wanted to buy window cleaning spray and saw it was £5.99 that may be relatively expensive for you so you might go into another shop and buy a different brand or similar cleaning product which will be cheaper therefore as the price of a good increases the demand decreases as consumers’ will switch to alternatives.

Important key term:

Demand schedule: This is a table showing quantity demanded by consumers at each price level. This is table used to draw a demand curve.

Demand Schedule
What about shifts?
Well a shift in the demand curve will only exist if a non-price determinant changes and the quantity demanded by consumers changes at every price.
shift of demand
In the demand curve above we can see that the demand for shares has decreased and this can be for several reasons.

Why does the demand curve shift?

1. Tastes – social trends and fashion changes and this affects the demand for a good, For example at one point cassettes were very popular but as soon as CDs came the fashion changed to listening to CDs. The demand for cassette tapes decreased.

2. Income – If income increases then people have more purchasing power so the demand at every price level will increase. Vice versa if incomes suddenly decreased than the demand would decrease as people do not have a strong purchasing power.

3. Price of substitutes – substitutes as we mentioned before are alternatives. So if these decrease people are likely too buy more of them as their consumer surplus increases. This means that the good itself will incur a reduction in demand. For example if Pantene Pro-V hairspray became cheaper the demand for L’oreal hairspray would decrease because people would switch to the pantene Pro-V hairspray.

4.The price of complements – these are goods which complement each other i.e. go with each other. For example tea and milk. If the price of complement increases then the demand decreases. So for example if the price of milk rises then the demand for tea will decrease as people may switch tcheapero other cheaper alternative like black coffee or herbal tea,

5. Expectation of future price change – this doesn’t tend to be as big as other factors. But in markets such as the housing industry or the share it has a big impact. If for example houses were supposed to increase prices in the future then the demand for houses will increase because people will wan to buy as they know they can sell it at a later date for a profit.

6. Population increase/migration- If there are more people then the demand for a product is likely to be be bigger. The two main ways in which a population can change are (i) population increase/ decrease through baby boom or increased availability of contraception and (ii) migration – this means people moving in and out of a country.

7. Distribution of income – This is by far the most interesting one. this suggest if the government increased taxes or benefits to the poor then demand for necessities will increase as that is what poor people will demand and the demand for luxuries will decrease as rich people loose some of their purchasing power for it,


1. Demand for a normal product may cause the demand curve to shift outwards if…
a) price increases
b) price decreases
c)the price of a substitute falls
d) the price of a substitute rises.

2.A decrease in income should:
a) Shift demand for an inferior product outwards
b) Shift demand for an inferior product inwards
c) Shift supply for an inferior product inwards
d) Shift supply for an inferior product outwards

Answers under photo…


1) D- The demand curve will only shift outwards because of non-price factors such as the price of substitutes. If the price of substitutes increases then people are more likely to switch and buy this product. For example; orange juice and apple juice are close substitutes and if the price of apple juice goes people more people will be attracted to buy orange juice.

2) A – if income decreases then the quantity demand of an inferior will increase as they have an inverse relationship. Supply is not affected by the income elasticity of a product.