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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 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.
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.
Figure 1 below illustrates the four main factors of production in economics.
Figure 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.
Figure 2. Factor market and product market - StudySmarter
The factor market trades inputs whereas the product market trades outputs.
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.
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.
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:
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.
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.
Figure 3. Labor demand curve - StudySmarter
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.
Figure 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!
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.
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