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!

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.

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. 

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

Fig. 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.

Fig. 2 - Factor market and product market

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.

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.

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?

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.

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).

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.

Fig. 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.

Fig. 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!