Firms sell the goods and services they produce in product or output markets. The resources they purchase in order to make their outputs are bought in input or factor markets. Where do firms get these inputs? From households! Think about when you or some other member of your household goes off to work. Where are you (or they) going? You (or they) are probably going to a firm!
Household members supply the labor that enables firms to produce their outputs. In addition, households supply the funds that firms use to purchase land, factories, office buildings, and equipment. How do they do this? When members of a household save for the future by putting money in a bank, or buy stocks or corporate bonds, they are supplying firms with funds to finance such expenditures.
An input market is where the resources used to produce goods and services are exchanged.
REALITY CHECK: It may be obvious that when household members work, they are supplying the labor input to firms. But what about the other things firms use as inputs? For example, what if a firm uses electricity? Doesnt it buy that from another firm? The answer of course is yes, but remember that the electric supplier also demands inputs from households to produce the power that it in turn sells to others. ULTIMATELY, all inputs come from households, even if they come indirectly through other firms!
Households are not just the consuming units of the economy. As seen by the descriptions of the different types of input markets, we can see that households are the ultimate suppliers of inputs to firms. Firms are producing units, but they also are consumers of the labor, land, and other inputs produced by households. Each fundamental unit of the economy acts both as producer and consumer.
This relationship is shown by the circular flow diagram. This diagram illustrates the interaction of firms and households in markets for outputs and inputs.
To understand how markets work, we will first build a theory of demand that describes a relationship between the demand of the quantity of a product and different market prices. We will then build a theory of supply that describes a relationship between the quantity of a product supplied and the different market prices. Then we will put them together in order to show how the production and consuming sides of the economy interact and how prices are determined.