Three Sectors, Three Markets

• Household Sector: This includes everyone, all people, seeking to satisfy unlimited wants and needs. This sector is responsible for consumption expenditures. It also owns all productive resources.
• Business Sector: This includes the institutions (especially proprietorships, partnerships, and corporations) that undertake the task of combining resources to produce goods and services. This sector does the production. It also buys capital goods with investment expenditures.
• Government sector: This includes the ruling bodies of the federal, state, and local governments. Regulation is the prime function of the government sector, especially passing laws, collecting taxes, and forcing the other sectors to do what they would not do voluntary. It buys a portion of gross domestic product as government purchases.

• Product markets: This is the combination of all markets in the economy that exchange final goods and services. It is the mechanism that exchanges gross domestic product. The full name is aggregate product markets, which is also shortened to the aggregate market.
• Resource markets: This is the combination of all markets that exchange the services of the economy's resources, or factors of production--including, labor, capital, land, and entrepreneurship. Another name for this is factor markets.
• Financial Markets: The commodity exchanged through financial markets is legal claims. Legal claims represent ownership of physical assets (capital and other goods). Because the exchange of legal claims involves the counter flow of income, those seeking to save income buy legal claims and those wanting to borrow income sell legal claims.

Spotlight on the Government Sector

The government sector, as such, adds three key flows to the model--taxes, government purchases, and government borrowing. These flows divert, but do not destroy, a portion of the core flow of production, income, and consumption.

Taxing and Spending and Borrowing

Adding Government

• Taxes: With the government sector in place, the next step in the construction of the three-sector, three-market circular flow is taxes. Taxes are household sector income that is diverted to the government sector. The household sector is forced to divert part of income away from consumption and saving because the government sector mandates that they must. Click the [Taxes] button to reveal the flow of taxes from the household sector to the government sector.


• Government Purchases: The primary reason that the government sector collects taxes from the household sector is to pay for government purchases. Government purchases by the government sector then become the third basic expenditure on gross domestic product that flows through the product markets. Click the [Purchases] button to highlight this flow from the business sector to the product markets.


• Government Borrowing: Taxes are not the only source of income used to finance government purchases (which often happens). When taxes fall short of government purchases, the difference is made up with government borrowing. The government sector, like the business sector, often sells legal claims as a means of borrowing the income that can used for government purchases. Click the [Borrowing] button to highlight this flow from the financial markets to the government sector.

Income diverted away from consumption expenditures by the household sector as taxes finds its way back to the product markets as government purchases by the government sector.

The key to the addition of the government sector to the circular flow is that taxes do NOT disappear as they move from sector to sector, they are merely diverted. In other words, taxes do not remain in the government sector, but merely pass through on the way to the product markets.

What It All Means

• First, the government diverts a portion of the circular flow. But this diversion that does not necessarily change the total amount of gross domestic product, factor payments, or national income. It merely diverts income from consumption and saving to taxes. And it diverts gross domestic product from consumption and investment to government purchases.


• Second, the total flow of government purchases is as important, if not more so, than the source of financing. If the government sector spends a trillion on government purchases, this must be paid for with national income, either through taxes or saving. If borrowing declines and purchases remain unchanged, then taxes must rise. If taxes decline and purchases remain unchanged, then borrowing must rise.


• Third, although the total flow is unchanged, shifting income between taxes, consumption, and saving can and does affect the economy. If the tax flow increases, then less remains for consumption and saving. Either the household sector satisfies fewer wants and needs or the business sector borrows less to invest in growth-promoting capital goods. Diverting income to government purchases and away from investment is termed the crowding-out effect, and worries people concerned about big government.


• Fourth, while the size of government is important, so too are specific government purchases. Government spending can be wasteful and unneeded, or it can provide valued goods, including national defense, education, transportation systems, police and fire protection, the judicial system, and environmental quality. In some cases, household consumption and business investment are more valuable than government purchases. In other cases, government purchases are more valuable.

Other Models

• Two Sectors, Two Markets: The simplest circular flow model contains two sectors (household and business) and two markets (product and resource). This model highlights the core circular flow of production, income, and consumption.


• Two Sectors, Three Markets: A second version of the circular flow model adds the financial markets to the basic model. This addition illustrates how saving is diverted from the household sector to the business sector to finance investment expenditures.


• Four Sectors, Three Markets: The most comprehensive circular flow model includes the foreign sector. Adding the foreign sector highlights the role of trade with the rest of the world, especially exports and imports.