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Factor Markets

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Economics

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.

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 and product market: the difference

The four main factors of production in economics are labor, land, capital, and entrepreneurship. So what do these factors entail? 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 Market Factors of production StudySmarterFigure 1. Factors of production - StudySmarter

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, Factor market and product market, StudySmarterFigure 2. Factor market and product market - StudySmarter

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.

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 StudySmarterFigure 3. Labor demand curve - StudySmarter

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 Markets Labor Supply Curve StudySmarterFigure 4. Labor supply curve - StudySmarter

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.

Factor Markets

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

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

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

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

Factor markets provide productive resources or factors of production.

Final Factor Markets Quiz

Question

What does the factor demand curve illustrate?

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it shows the quantity demanded of a factor of production at various factor prices.

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In which direction does the factor demand curve slope?

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It has a negative slope

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What is a determinant of the factor demand curve?

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Any factor that causes the curve to shift. These include the changes in the price of a product, supply of other factors, or technology.

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What are the determinants of the factor demand curve?

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Changes in the price of goods, the supply of other factors, and technology

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What does an increase in the price of a good do to the factor demand curve?

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It shifts upward or outward

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What does an increase in the supply of another factor of production do to the factor demand curve?

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It shifts outward or upward

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What will technological advancements do to the factor demand curve?

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It depends. However, most times it shifts upward or outward.

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Most economic decisions are made by comparing marginal costs with their...

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marginal benefits

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What is factor demand?

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the willingness and ability of a firm to purchase factors of production

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What is the marginal revenue product?

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It is the extra revenue generated from adding an extra factor of production

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What do lower factor prices do to the quantity demanded of that factor?

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they cause an increase in the quantity demanded of the factor

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Why does the factor demand curve have a negative slope?

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higher factor prices come with lower quantities demanded

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On which axis of the labor demand curve are Wage Rate and Employment?

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Wage Rate is on the vertical axis whereas Employment is on the horizontal axis

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What is the formula for the marginal revenue product of labor?

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MRPL = MPL × MR

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Why is the marginal revenue product of labor equal to the wage rate?

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because naturally, firms must at least break even.

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What are factor markets?

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

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Why is factor demand a derived demand?

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Factor demand is derived from the demand for products. For instance, the demand for more shoes will result in the demand for more shoemakers.

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What is a factor of production

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

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What does labor refer to as a factor of production?

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Labor refers to the work human beings do. 

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What does land refer to as a factor of production?

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land refers to resources that are found in nature. For example, land, and raw materials.

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What is human capital?

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It refers to enhancements in labor as a result of knowledge and education.

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What is physical capital?

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Physical capital includes man-made or manufactured resources used in production.

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What is entrepreneurship as a factor of production?

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Answer

It refers to the creative or innovative efforts in combining resources for production.

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What is the difference between the factor market and the product market?

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

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What is the quantity demanded of a factor?

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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.

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What is the quantity supplied of a factor?

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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.

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What are factor prices?

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

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What is the factor market graph?

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The factor market graph is either the factor demand curve or the factor supply curve.

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How is the factor market graph plotted?

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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.

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In which direction does that factor demand curve slope?

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The factor demand curve slopes downward from the left to the right.

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In which direction does that factor supply curve slope?


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The factor supply curve slopes upward from the left to the right.

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What is capital?

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Capital refers to the durable man-made goods that are used by firms in production.

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There are two types of capital

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True

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What are the two types of capital

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Physical capital and human capital

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What is the law of diminishing marginal returns of capital?

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The law of diminishing marginal returns of capital states that the continued addition of extra units of capital results in smaller increases in additional output, and eventually, decreases in additional output.

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Why are capital markets important?

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Capital markets are important because they allocate capital resources to firms so they can use them in their productive processes.

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What is capital demand?

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Capital demand is the willingness and ability of firms to purchase capital at any given time.

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Define the rental rate of capital

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The rental rate of capital is the cost of using a unit of capital for a given period of time.

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What is the quantity of capital demanded?

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The quantity of capital demanded is the quantity of capital firms are willing to purchase or rent at a given price at a given time.

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What is capital supply?

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Capital supply is the availability of capital for purchase or rental by firms at any given time.

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What is the quantity of capital supplied?

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The quantity of capital supplied is the quantity of capital made available for firms to purchase or rent at a given price at a given time.

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What is equilibrium in the market for capital?

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Equilibrium in the market for capital is where the supply of capital meets the demand for capital.

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In which direction does the capital demand curve slope?

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It slopes downward from the left to the right

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In which direction does the capital supply curve slope?

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It slopes upward from the left to the right 

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On which axis do we plot the rental rate?

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Vertical axis

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For marginal analysis, firms compare the marginal cost of adding an extra unit of capital to

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the marginal benefit of adding an extra unit of capital 

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What is the land market?

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The land market is the market where land is traded.

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How is equilibrium reached in the land market? 

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Equilibrium is reached in the land market when the supply of land meets the demand for land.

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What is land?

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Land refers to the resources that are found in nature and used by firms as factors of production. 

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Firms compare the marginal cost of acquiring land to the

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marginal benefit of acquiring the land

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