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Circular Flow of Economic Activity : Three Sector Model (Household, Firm and Government)

Updated on October 26, 2014
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IRSHAD CV has been a student in Economics. Now he is doing Masters in Economics. He completed B.A. Economics from the University of Calicut.


In the three sector model of economic activity, government sector incorporate with the household sector and business sector. A two sector model of economic activity, shows a very simple model of economic activities (only household and firm sectors). But in reality we can see the presence of government sector in all economies. Since, government sector plays a vital role in an economy, this sector is also important in the circulation of economic output or income.

How Three Sector Model Economy Works.

Government sector plays many important role in an economy including maintenance of army, safety of country, functioning of the government organizations like police services and other official services and so on.

Here in a three sector model of economic activities we analyze the most important role of government with the household sector and business sector. Here following figure will help you to get the idea. See the diagram – I below.

In the diagram the interaction between three sectors are ahowed and it described below. For simplicity each transaction represented with English small letters. In the diagram, shows 10 ( a to h) transactions between the sectors. Now, analyze each transactions.

Transaction ‘a’ = Here the household sector supply the factor services like land, labor etc. to the business sector to produce goods and services.

Transaction ‘b’ = Here the business sector pays rewards to the factor services provided by the household sector in terms of wage, interest etc.

Note that factor services are supplying through the factor market or labor market. In factor market business sector is the demanders and household sector is the suppliers.

Transaction ‘c’ = Here after producing the goods and services the business sector supply it for selling.

Transaction ‘d’ = Here, the household sector buy goods and services and pay their earnings on different goods and services.

Note: goods and services are dealing through goods market. In the goods market household sector is the demanders and the business sector is the suppliers.

Transaction ‘e’ = The transaction ‘e’ says that, in an economy the household sector pays both direct taxes and indirect taxes. This is the income of the government sector.

Transaction ‘f’ = Similarly the business sector also pays both direct taxes and indirect taxes. It is also the income of the government sector.

Transaction ‘g’ = This transaction says about the expenditure of the government sector. Government sector pays transfer payments like scholarships to students, pensions and other allowances to government employees etc. That is payment to the household sector.

Transaction ‘h’ = This transaction is also says the expenditure of the government sector. Government pays subsidies to the industries, and other productive svhemes to minimize their costs. This is the flow from government sector to the business sector.


The circular flow of economic activities in an three sector model economy contain household sector, business sector and the government sector. Compared to the two sector model of circulation of economic activities it highlights the role of government sector in an economy.


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