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Markets for Factors of Production

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Markets for Factors of Production

The leather jacket or pair of shoes you love so much were produced using a combination of resources. You may have bought it from a designer store, but the designer needed to first acquire the necessary resources to make the product you love so much. These resources are referred to by economists as factors of production, and this article tells you all about the markets for these factors of production.

Markets for Factors of Production in the Circular Flow Diagram

Firms are in the business of making products. These products require resources to make, and these resources must be acquired from suppliers. This describes the factor market. However, let's break things down.

What is a factor of production? The answer is simple - it is any resource used by the firm in its productive process. They are also known as inputs!

A factor of production is any resource used by the firm in its productive process.

Factors of production are important because firms simply cannot operate without them. Why is this so? We will explain all the factors of production to understand why. Figure 1 illustrates the factors of production.

Markets for factors of production Factors of production StudySmarterFigure 1. Factors of production, StudySmarter Original

Economists typically group the factors of production into these categories: land, capital, labor, and entrepreneurship. A business needs at least one of these four--and often more--to be able to operate. So, what is included in these categories?

  • Land - refers to not just land but also all resources that are found in nature, like water and timber.
  • Capital - refers physical capital and human capital.
    • Physical capital - refers to all the man-made resources used in production. This includes tools, equipment, and machinery. This is often what economists mean when they mention capital.
    • Human capital - refers to improvements in labor resulting from knowledge and experience.
  • Labor - refers to the work done by humans.
  • Entrepreneurship - refers to the innovative effort in combining resources productively. This is who creates firms and introduces innovative products.

Notice how everything we could possibly use to make a product has been covered in the list. Firms need the factors of production!

So, now that we know what exactly the factors of production are, what are the markets for factors of production? They are the markets where these factors of production are bought and sold.

The markets for the factors of production are the markets where each factor of production can be traded.

Now, we are aware that the firm must buy these factors of production. However, who sells them? The answer is households! Yes, if you have ever had a job, then you are a supplier in the labor market!

Households are the suppliers in the markets for factors of production.

In the products market, or the goods market, firms are the suppliers while households are the buyers. However, in the markets for factors of production, this relationship reverses, and households become the suppliers while the firm becomes the buyer. This relationship is illustrated in the circular flow diagram shown in Figure 2.

Markets for factors of production Circular flow diagram StudySmarterFigure 2. Circular flow diagram, StudySmarter Original

The Importance of Markets for Factors of Production

So, why is the factor market important? Firms simply cannot produce without the factor markets. To produce goods, the firm needs to acquire the resources somehow, and it can only do this by buying from the factor market. Consider the example below.

A new coffee processing plant is established in a small town. The company already owns equipment and has a acquired the land needed to build its facility. However, the company now needs to employ workers to build the facility and operate the coffee processing equipment. This means the company needs labor from the labor market, otherwise, all the other things it has are useless to its coffee processing goal.

From the above example, we can tell that firms will be out of business in the absence of a factor market. Therefore, factor markets are necessary for firms to operate.

Types of Markets for Factors of Production

The types of factor markets are simply the markets for each factor of production. Therefore, the types of factor markets include each of the following:

Determination of Wages in Factor Markets

Economists tend to take a special interest in labor and the labor market since it deals directly with humans. Humans provide labor at wage rates, and firms employ labor at wage rates. But how is this wage rate determined in the labor market?

The labor market is characterized by demand and supply, with the firm on the demand side and households on the supply side.

Labor demand is the willingness and ability of firms to employ labor at any given time.

Labor supply is the availability of workers for employment by firms at any given time. Workers weigh labor time against leisure time and decide how much to work at a given wage rate.

The wage rate is the cost of employing a unit of labor--typically one hour of work by one laborer.

Economists represent a factor market in the usual way--a graph showing both the demand and the supply. The "price" appears on the vertical axis, and quantity on the horizontal axis. In the labor market, the price of labor is the hourly wage. In the land market, the price is the monthly rent. In financial capital markets, the price is the interest that firms have to pay when they borrow money.

The quantity of a resource demanded by firms actually depends on several factors. It depends on the market price for that factor, but it also depends on the price of the firm's final product and the productivity of the resource. These two things together determine the marginal contribution to revenue.

Let's look at the labor market. The quantity of labor demanded or supplied depends on the wage rate at any given time. We can think of quantity as the number of hours, or as the number of laborers who are willing and able to supply hours at the given wage rate.

The labor supply curve is the graphical representation of the relationship between the wage rate and the quantity of labor supplied by households. Households and individuals are willing to divert more hours from leisure time into work time as the wage rate increases. Thus, labor supply is upward-sloping.

The labor demand curve is the graphical representation of the relationship between the wage rate and the quantity of labor demanded by firms. Firms are willing and able to purchase more labor as the wage rate decreases. Thus, labor demand is downward-sloping.

The wage rate in the labor market is determined by the point where the quantity of labor that firms want to hire equals the quantity of labor that households are willing and able to supply. This intersection between labor demand and labor supply is also known as the equilibrium point in the labor market. Figure 3 depicts the labor market, with equilibrium wage rate W*.

markets for factors of production equilibrium in labor market studysamrterFigure 3. Equilibrium in the Labor Market, StudySmarter Original

Examples of Markets for Factors of Production

Here is an example of how marginal productivity factors into firms' decision making about purchases in factor markets. When a firm that makes widgets wants to hire laborers, it has to ask, "How many widgets can each worker produce in a given length of time?" Consider the scenario below.

If a worker can produce 100 widgets in one hour, and two workers can produce 200 widgets in an hour and a half, and three workers can produce 300 widgets in two and a half hours, and widgets sell for $1 each, then how many workers should the firm hire if the market wage is $10/hr and there are no other materials or costs of production?

Answer: The key to answering this question is to compare productivity for a given amount of time. With one worker, the firm's productivity is 100 widgets per hour. With two workers, their combined productivity is 133 widgets per hour. With three workers, their combined productivity is 120 widgets per hour. For each hour of operation with two workers, the firm's net profit is $113 from selling 133 widgets at $1 each and paying $20 in wages. With one or three workers, the firm's net profit is only $90 (either $100-$10 or $120-$30). Therefore, profit is maximized by hiring two workers.

Hopefully this gives you a taste of how firms use marginal productivity in their decision making with regard to the factors of production. Firms purchase and hire only up to the point where the marginal contribution to revenue of the next resource unit equals the marginal cost.

The following are other real-world examples of markets for factors of production.

Labor Market – An online application for job listings and available job candidates can serve as a market for employees.

Land Market – An auction for industrial or agricultural land is an example of a factor market.

Market for Capital – Financial markets where firms borrow money or raise money through investment bankers are factor markets; in addition, auctions and sales of physical capital like tractors and machinery also represent factor markets.

Entrepreneurship Market – The business of connecting angel investors with early-stage startup companies and new innovations is an example of an entrepreneurship market.

Anything the firm needs to buy to make its products has a market. Therefore, the examples of markets for factors of production can go on and on!

You have made it to the end of this article! You should read our articles on Factor Markets, Land Market, Market for Capital, and Labor Market for a deeper understanding of how factor markets work.

Markets for Factors of Production - Key Takeaways

  • A factor of production is any resource (labor, capital, land, entrepreneurship) that is used by the firm in its production process.
  • Households are the suppliers in the markets for the factors of production, and they have upward-sloping supply; firms are the buyers and have downward-sloping demand.
  • The price of labor is the wage rate, the price of land is rent, and the price of financial capital is the interest rate on borrowing money.
  • These market-clearing prices are determined by the equilibrium point where labor demand and labor supply meet.

Frequently Asked Questions about Markets for Factors of Production

The markets for factors of production are the markets where factors of production are traded.

An example of a market for a factor of production is the labor market where employees are hired. Another example is an auction for industrial or agricultural land.

In the factor market, the firms are the buyers, and in the market for goods and services, the firms are the sellers, or suppliers. Households own the factors of production but are buyers and consumers of goods and services.

Yes, firms are buyers in the market for factors of production, and households are the suppliers.

The types of factor markets are the markets for each factor of production: land, capital, labor, and entrepreneurship.

Like any market, the market for factors of production can be competitive or they can suffer from imperfect competition. In factor markets, the firms are the buyers, so the most common market failure is monopsony. This is when there is only one buyer. In a geographic area with only one employer--say a mine or a factory, that firm has a local monopsony. 

Final Markets for Factors of Production Quiz

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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 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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What is the law of diminishing marginal returns of land?


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

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What is demand in the land market?

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Demand in the land market refers to the willingness and ability of firms to purchase or rent land at any given time.

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What is the factor price of land also called by economists?

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The rental rate.

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What is the rental rate of land?

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The rental rate of land is the price at which land is sold or rented at any given time. 

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Define the quantity of land demanded

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

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What is land supply?

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

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What is the quantity of land supplied?

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The quantity of land supplied is the quantity of land 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 land market

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Equilibrium in the land market simply refers to the point where the supply of land meets the demand for land.

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Land demand is the same as quantity of land demanded.

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False

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Marginal analysis applies in the land market.

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True

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Rental rate increases with an increase in quantity of land demanded.

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False

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What is labor?

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Labor refers to the work done by human beings.

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What is the labor market?

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The labor market refers to the market where labor is traded.

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What is labor demand?

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Labor demand is the willingness and ability of a firm to employ labor at any given time.

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What is the quantity of labor demanded?

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Quantity of labor demanded is the quantity of labor firms are willing to employ at a given wage rate at a given time.

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Define wage rate.

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The wage rate is the price of employing labor at a given time.

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