Simple Economy

An economy is a set of production and consumption activities which help in determining the scarcity of the necessary resources. 

These activities, which include production and consumption of goods and services, are required to meet the demands of those who are operating within such an economy, which can also be referred to as an economic system.

One of the various iterations of economic systems is the simple economics model. 

What do you Mean by a Simple Economy?

Simple economy can be defined as an economic system in which each and every individual is operating is required to partake in the manufacture of goods and services. These manufactured items are then allocated among the individuals of the economy.

In other words, a simple economy is a simplified version of realistic trade which enables us to grasp the fundamentals and thereby make logical predictions about our current economic behaviour. A well-designed simple economic model helps an analyst to take a confusing, real-life situation and pare its features down into a group of essentials. 

Before we carry on with our discussion on the simple economy meaning, take note of the following section to brush up your knowledge on fundamentals on economic systems. 

Test your Knowledge –

1. What are the Types of Economy, and how can they be Classified Further?

Ans. Economy of a region, country or State can be broadly categorised into various types. These can be Industrial Economy, Developed & Undeveloped Economies, Free-enterprise Economy, Planned & Unplanned Economy, etc. The Industrial Economy can be further classified as a socialist economy or a capitalist economy. 

In case of a socialist economy, all productions are socialised that are owned by the State, which means, there is no private sector. In contrast, economic decisions, related to production and the expected rate of profit on such productions, are taken by private entrepreneurs.

2. What Does it Mean by Market System and Command System?

Ans. Economic systems can be broadly categorised into two parts, market systems and command systems.

In case of a market system, the economy of the concerned community is governed by the laws of supply and demand. If a certain product has high demand or its production requires substantial resources and skill levels, individuals have to pay a high price to purchase it. Alternatively, the price of a product will be low if there are comparatively lower demand and minimum requirement of resources or skill associated with its production.

Meanwhile, a command system is a type of economic system where decisions (regarding production in every sector) are centralised, i.e. the State handles both manufacture and allocation of goods and services. A socialist economy is a prime example of this kind of economic system.

Major Sectors in a Simple Economy

For a simple economic model, existence of two sectors is assumed, these are –

a) Household Sector

Household sectors refer to the social unit comprising those individuals living together under the same economic system. In simpler terms, households are not only the owners of various factors of production but also the consumers of goods and services.

b) Firm Sector

A firm sector can be referred to as the industrial sector, in which companies, firms and enterprises put an effort in manufacturing products for a profit. In other words, this sector produces all types of goods and services and sell them to the household sector.

Presence of only these two sectors occurs only in case of a closed economy where there are no government actions or foreign trade involved. 

Before we head to the next and final section of your topic, go through this exercise below to revise the above discussions.

Test your Knowledge –

1. A Closed Economy is one which      

  1. Has no economic relation with rest of the world

  2. Has economic connection with rest of the world

  3. Both

  4. None of the above

2. In Case of a Simple Economy, the Source of Income is From.

  1. Industries and services

  2. Government of the State

  3. Households and firms

  4. None of the above

Circular Flow of Income in a Simple Economy

In order to construct a circular flow of income for a two-sector or simple economy model, several essential assumptions are taken. These are –

  • Households and firms are the only two existing sectors in this economic model. This indicates that there is no government sector or foreign trade involved in such a system.

  • Household sectors are the suppliers of factor services to firms only and firms hire services from none other than the household sectors.

  • The items produced by the firms, i.e. goods and services, are sold to the household sector in its entirety. 

  • From the services provided by the household sectors, an income is earned, which is spent totally on consumption of goods and services. 

One of the primary features of such an economic system is that both sectors are not allowed any form of savings. The total income earned by household sectors is used for consumption of goods and services. In contrast, the profit generated by firms is spent to hire the services of household sectors.

Such a Circular Flow of Income can be Explained with the help of this Illustration –

From the above illustration, it is assumed that the diagonally opposite elements are in one single loop. 

So, the 1st loop indicates the flow of factor services from households to firms along with the corresponding flow of goods and services to households from firms. The 2nd loop indicates the flow of factor payments earned by households for their factor services to firms along with the corresponding flow of expenses of consumption from households to firms.

At Vedantu, we hope that our study material on this topic of Simple Economy will be useful for your preparations in the upcoming exams. Make sure to visit our website and download our mobile app to know more about other topics in the Economics curriculum!

FAQ (Frequently Asked Questions)

1. What is a Simple Economy?

Ans. A simple economy is an economic system in which each and every individual is required to partake in the manufacture and consumption of goods and services.

2. How Many Sectors are there in a Simple Economy?

Ans. There are only two sectors in a simple economy which are household sectors and firm sectors. 

3. Can a Simple Economy also be Called an Open Economy?

Ans. No, a simple economy cannot be called an open economy as it has no economic relations with the outside world.