Circular Flow of Products

Market is a very common term used by all of us on a daily basis. Any place enabling buyers and sellers of a particular good/service to interact with each other is called market. If there is a place where buyers and sellers of sugar are coming together and trading with each other, it will be called a sugar market. Similarly, if buyers and sellers of furniture are trading with each other on an online portal, then that portal is also a furniture market.

Suppose you want to set up a cloth manufacturing unit. First thing that you would need is a piece of land to setup the factory. Once you have the land, you need capital. By capital, we are referring to related infrastructure like factory building, machines and software systems. Finally, you would be needing people to work in your factory, called labor. These are the three essential things that are always required for production and are called factors of production. Now the next question, where will you obtain them from? You would be buying these factors from other individuals. You can very well argue that you can buy them from other firms as well, but ultimately somebody would have bought it from individuals.

Let’s divide the whole economy into two parts, firms and households. All land, capital and labour ultimately belongs to households, let’s consider these households as individual families. Firms will be buying these 3 factors of production from households. So we have firms who are the buyer’s, households are the seller’s and factors of production as the product. As per our definition of market,  this setup would be called a factor market.

Let’s now revisit our example where you were trying to setup a cloth manufacturing unit. Suppose, now the factory is set up and you begin manufacturing. Who will buy your products? Again it’s the households (individuals) who would be buying your products in the cloth market. Let’s broaden our example and think about who would be buying all the finished goods manufactured in the economy, it will be the households who would be buying these products. Thus, in finished goods market, firms are the sellers and households are the buyer’s.

As we saw, firms buy factors of production from households in factor market. Then they manufacture finished goods using these factors of production and sell it back to households in finished goods market. Full circular process can be seen in the figure below.


Let’s now try and understand how money flows in the whole process.