Factor Markets

You may have heard about goods or product markets, but have you heard about factor markets? As an employable individual, you are a supplier in a factor market too! Find out how as we explain factor markets in this article. In doing this, we will introduce the factors of production, including labor, land, capital, and entrepreneurship. Other concepts in economics that are also fundamental to understanding factor markets will also be explained. Can't wait to dive in together!

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Table of contents

    Factor Market Definition

    Factor markets are important in the economy because they allocate scarce productive resources to companies which enables them to use these resources in the most efficient way. These scarce productive resources are referred to as the factors of production.

    So, what is a factor of production? A factor of production is simply any resource a company uses to produce goods and services.

    A factor of production is any resource a firm uses to produce goods and services.

    Factors of production are also sometimes called inputs. This means that factors of production are not consumed by households, but are used as resources by the firms to produce their final outputs - goods and services, which are then consumed by the households. This is the main difference between factors of production and goods and services.

    Based on the explanations so far, we can now define factor markets. 

    Factor markets are the markets in which the factors of production are traded.

    In these factor markets, the factors of production are sold at set prices, and these prices are referred to as the factor prices.

    Factors of production are traded in factor markets at factor prices.

    Factor Market vs Product Market

    The four main factors of production in economics are labor, land, capital, and entrepreneurship. So what do these factors entail? Though these are factors of production, they belong to the factor market and not the product market. Let's briefly introduce each factor of production.

    1. Land - This refers to resources that are found in nature. In other words, these are resources that are not man-made.

    2. Labor - This simply refers to the work human beings do.

    3. Capital - Capital is categorized into two main parts:

      1. Physical Capital - This is often simply referred to as “capital”, and mainly includes man-made or manufactured resources used in production. Examples of physical capital are hand tools, machines, equipment, and even buildings.

      2. Human Capital - This is a more modern concept and entails enhancements in labor as a result of knowledge and education. Human capital is just as important as physical capital since it represents the value of the knowledge and experience a worker possesses. Today, advancements in technology have made human capital more relevant. For instance, workers with advanced degrees are in higher demand compared to those with regular degrees.

    4. Entrepreneurship - This refers to the creative or innovative efforts in combining resources for production. Entrepreneurship is a unique resource because unlike the first three factors explained, it is not found in factor markets that can be easily identified.

    Figure 1 below illustrates the four main factors of production in economics.

    Factor Markets Diagram showing the factors of production StudySmarterFig. 1 - Factors of production

    As you can see, factors of production are all used by the firms, not the households. Therefore, the main difference between the factor market and the product market is that the factor market is where the factors of production are traded, whereas the product market is where the outputs of production are traded. Figure 2 below will help you remember the difference between the two.

    Factor Markets, Diagram showing the inputs and outputs of factor markets and product markets, StudySmarterFig. 2 - Factor market and product market

    The factor market trades inputs whereas the product market trades outputs.

    Characteristics of Factor Markets

    Let’s put a finger on the main characteristics of factor markets.

    The main characteristics of factor markets are that it deals with the trading of factors of production and that factor demand is a derived demand.

    1. Trading of factors of production – The principal focus of factor markets are the factors of production. So, once you hear that what is being traded is used to produce goods or services, just know that you’re discussing a factor market.

    2. Derived demand – Factor demand comes from the demand for other goods or services.

    Derived demand

    Leather boots are suddenly trendy and everybody, young or old, wants to get their hands on a pair. As a result of this, the leather boot manufacturer needs more shoemakers to be able to meet this demand. Therefore, the demand for shoemakers (labor) has been derived from the demand for leather boots.

    Perfect competition in the factor market

    Perfect competition in the factor market refers to a high level of competition that pushes the supply and demand for each factor to an efficient equilibrium.

    If there is imperfect competition in the shoemaker labor market, then one of two things will occur:A shortage of laborers workers will force firms to pay an inefficiently high price, reducing total output.

    If the supply of shoemakers exceeds the demand for shoemakers, then a surplus will occur. Resulting in underpaid labor wages and high unemployment. This will actually make the firms more money in the short run, but in the long run, can hurt demand if unemployment is high.

    If the market has perfect competition, then the supply and demand of shoemakers will be equal at an efficient quantity and wage.

    Perfect competition in the factor market provides the highest total quantity of workers and at a decent wage as the market can handle. If the quantity of workers or wages changes, the market will only decrease in overall utility.

    Similar market forces apply to the other factors of production such as capital. Perfect competition in the capital market means the loanable funds market is in equilibrium, providing the highest overall quantity of loans and price efficiency.

    Factor Market Examples

    Knowing that factor markets are the markets where the factors of production are traded, and knowing what the factors of production are, we can simply identify the examples of factor markets there are.

    The main factor market examples are:

    1. Labor Market – Employees
    2. Land Market – Land for hire or purchase, raw materials, etc.
    3. Capital Market – Equipment, tools, machines
    4. Entrepreneurship Market – Innovation

    Factor Market Graph

    Factor markets are characterized by factor demand and factor supply. As their names suggest, factor demand is the demand side of the factor market whereas factor supply is the supply side of the factor market. So, what exactly are factor demand and factor supply?

    Factor demand is the willingness and ability of a firm to purchase factors of production.

    Factor supply is the willingness and ability of suppliers of the factors of production

    to offer them for purchase (or hire) by firms.

    We know that resources are scarce, and no side of the factor market is unlimited. Therefore, the factor market deals in quantities, and these come at various prices. The quantities are referred to as quantity demanded and quantity supplied, whereas the prices are referred to as factor prices.

    The quantity demanded of a factor is the quantity of that factor firms are willing and able to buy at a given price at a particular time.

    The quantity supplied of a factor is the quantity of that factor made available for firms to purchase or hire at a given price at a particular time.

    Factor prices are the prices at which the factors of production are sold.

    Let’s see how these simple definitions work together to plot the factor market graph. We’ll be using labor (L) or employment (E) in these examples, so the factor price of labor will be indicated as wage rate (W).

    You may see labor (L) or employment (E) on a factor market graph. They are the same thing.

    The demand side of the factor market graph

    First, let’s look at the demand side of the factor market.

    Economists plot the quantity demanded of a factor on the horizontal axis and its price on the vertical axis. Figure 3 below shows you that the factor market graph is using labor. This graph is also known as the labor demand curve (or generally, the factor demand curve). On the demand side, the wage rate is negatively related to the quantity of labor demanded. This is because the quantity of labor demanded reduces when the wage rate increases. The resulting curve slopes downward from the left to the right.

    Factor Markets Labor demand curve StudySmarterFig. 3 - Labor demand curve

    The supply side of the factor market graph

    Now, let’s look at the supply side of the factor market.

    Just like in the case of demand, economists plot the quantity supplied of a factor on the horizontal axis and its price on the vertical axis. The supply side of the factor market is illustrated in Figure 4 below as the labor supply curve (or generally, the factor supply curve). However, on the supply side, the wage rate is positively related to the quantity of labor supplied. And this means that the quantity of labor supplied increases when the wage rate increases. The labor supply curve shows the curve with an upward slope from the left to the right.

    Would you not want to be employed in a new factory if you heard they were paying twice the amount you’re making now? Yes? So would everybody else. Therefore, you will all make yourselves available, making the quantity of labor supplied go up.

    Factor Market Labor supply curve StudySmarterFig. 4 - Labor supply curve

    You have already made it through the introduction of factor markets. To learn more, read our articles -

    Markets for Factors of Production, Factor Demand Curve and Changes in Factor Demand and Factor Supply

    to find out what firms think about when they want to hire!

    Factor Markets - Key takeaways

    • Factor markets are the markets in which the factors of production are traded.
    • Land, labor, and capital are found in traditional factor markets.
    • Factor demand is a derived demand.
    • Land, labour, capital, and entrepreneurship markets are examples of factor markets.
    • Factor markets have a supply side and a demand side.
    • Factor demand is the willingness and ability of a firm to purchase factors of production.
    • Factor supply is the willingness and ability of suppliers of the factors of production to offer them for purchase (or hire) by firms.
    • The factor market graphs include the factor demand curve and the factor supply curve.
    • The factor market graph is plotted with the factor price on the vertical axis and the quantity demanded/supplied of the factor on the horizontal axis.
    • The factor demand curve slopes downward from the left to the right.
    • The factor supply curve slopes upward from the left to the right.
    Frequently Asked Questions about Factor Markets

    What is a factor market?

    It is a market in which factors of production (land, labor, capital, entrepreneurship) are traded.

    What are the characteristics of factor markets?

    They primarily focus on the factors of production. Factor demand is a derived demand derived from the demand of products.

    How does a product market differ from a factor market?

    The factor market is where the factors of production are traded, whereas the product market is where the outputs of production are traded.

    What is an example of a factor market?

    The labor market is a typical example of a factor market.

    What do factor markets provide? 

    Factor markets provide productive resources or factors of production.

    Test your knowledge with multiple choice flashcards

    There are two types of capital

    On which axis do we plot the rental rate?

    Land demand is the same as quantity of land demanded.

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