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Factor Markets

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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.

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

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 is the law of supply?

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The law of supply states that as the price of a good or service increases, the quantity of that good or service that producers are willing to offer will increase.

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What is the law of demand?

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The law of demand states that as the price of a good or service increases, the quantity of that good or service that consumers are willing to seek will decrease.

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What determines price elasticity of demand?

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Price elasticity of demand is determined by how responsive the quantity demanded of a good is to changes in its price.

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Which of the following is NOT a type of elasticity of demand?

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Marginal elasticity

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How does the law of diminishing marginal utility affect demand?

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The more of a good or service is consumed, the utility derived from each additional unit will decrease, which means that consumers will be less willing to pay more as quantity of a good or service consumed increases.

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Question

What is income elasticity of demand?

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Income elasticity of demand measures the responsiveness to changes in consumers' income in terms of the quantity of a good or service sought out by consumers. 

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Name three tools that the government may use to influence the economy.

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  • Regulations and policies
  • Subsidies
  • Taxes

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Where can equilibrium be found in a supply and demand model?

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Equilibrium is the point of intersection between the supply and demand functions.

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What is equilibrium?

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Equilibrium is the quantity-price point where quantity demanded equals quantity supplied, and thus produce a stabilized balance between the price and quantity of a resource in the market.

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Which of the following examples represent inelastic demand best?

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Emerging trend for a technology equipment the producer of which owns a patent on.

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What is a demand schedule?

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Demand schedule is a table of various quantities of a good or service that consumers are willing to seek out at various price levels.

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Question

Which of the following factors may affect price elasticity of supply?

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There are numerous factors that can affect price elasticity of supply, such as availability of resources needed for production, changes in demand for the product that the firm produces, and innovations in technology.

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Question

Which of the following is NOT a factor that may cause.a shift in demand for a good or service?

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Price of the good or service

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An increase in quantity demanded at every price level will translate on a graph as:

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Rightward shift of the demand curve

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A leftward shift of the demand curve means:

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Decrease in quantity demanded at each price level

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Shifts of the demand curve are described as:

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Leftward / rightward

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When the demand curve shifts rightward, all else held constant the price of the equilibrium point:

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Increases

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Which of the following is not an example of normal goods?

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Luxury cars

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If consumers' income falls, quantity demanded of normal goods will:

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Decrease

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Which of the following is NOT a category of related goods?

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Dependent goods

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If the price of a complement increases, the demand curve for a good that it complements will:

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Shift leftward

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What are substitute goods?

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Substitute goods or substitutes are goods that satisfy the same desires or needs for consumers as another good, thus serving as an alternative to the latter.

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Product B is a substitute for product A. Suppose that the price of product B falls below the price of product A. How will this affect the demand curve for product A?

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The demand curve for product A will shift leftward as the quantity demanded will decrease, since consumers will be more inclined to purchase product B instead.

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Which of the following is the best example of consumers' taste influencing a rightward shift in demand for a product?

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Fans of a popular celebrity purchasing a product after an endorsement by the celebrity

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If consumers expect prices for a certain product to decrease due to promises of future subsidies, the demand curve for that product will likely...

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Shift leftward, as consumers may prefer to postpone the purchase of that product in hopes to save money.

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Suppose a college experiences a sharp decrease in the number of students regularly attending classes in person in favor of online learning. Due to this decrease in population, the demand curve for parking spots on campus will:

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Shift leftward

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The extent to which quantity of any good or service demanded will fluctuate due to changes in any factors of influence depends on the measure of:

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Elasticity of demand

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Market disequilibrium occurs when...

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Quantity of a product or service demanded exceeds quantity supplied, or quantity supplied exceeds quantity demanded

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A shortage occurs when...

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Quantity demanded exceeds quantity supplied

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What does price elasticity of supply measure?

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PES measures the responsiveness of quantity of a good or service supplied to changes in market price.

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How do you calculate PES?

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PES is calculated by dividing percentage change in quantity supplied by the percentage change in price.

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When calculating price elasticity of supply, what would the result of your calculations have to be in order for supply to be considered price elastic?

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Price elasticity of supply would have to be greater than 1.

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What does it mean when supply is unit-elastic?

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Supply is unit elastic when PES equals 1, which means that quantity supplied changes proportionately to changes in price.

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Suppose you determine supply to be perfectly inelastic. What would the supply function look like on a graph?

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The function is a vertical line.

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Does the supply curve shift as a result of changes in price or quantity supplied?

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Supply curve does not shift when the price of a good changes. Supply curve shifts only if the economic factors other than the price change.

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If the supply curve shifts _____, quantity supplied at every price level will increase.

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Rightward

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If the supply curve for a certain product/service shifts leftward, this means that the quantity supplied...

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Decreases

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True or false: price of the product or service is one of the factors that directly cause sideward shifts of its' supply curve.

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False. Changes in price of the product/service do not reflect in sideward shifts of the supply curve.

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Which of the following is NOT one of the economic factors that may cause the supply curve to shift?

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Consumers' preferences

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Suppose there is a significant increase in the price of steel, which is one of the inputs that producers of cars use in their production. This increase in price of steel would likely shift the supply curve for cars...

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Leftward

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Suppose that the latest advances in technology allow producers of certain physical products to reduce their energy expenses in the production process. As a result, the supply curve of such producers would shift...

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Rightward

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When the price of a complementary good increases, quantity supplied of the complemented good will likely...

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Increase

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When the price of a substitute good decreases, the supply curve for the substituted good will likely shift...

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Rightward

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Since a higher number of producers in the market results in higher quantities of a good or service supplied, a decrease in the number of producers would shift the supply curve...

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Leftward

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If producers expect unfavorable market conditions for their good or service in the near future, what may happen to the quantity they supply and the respective supply curve?

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Supply curve will shift leftward causing the quantity supplied at every price level to decrease.

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Suppose producers have a reason to believe that the price for their good or service may increase in the near future. How will this affect the supply curve?

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Favorable market conditions would result in supply curve shifting rightward, resulting in more quantity supplied at every price level.

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If producers experience a raise in taxes on some of their inputs, the supply curve for their ultimate product will likely shift...

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Leftward

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If producers begin to receive subsidies for their product, this will likely compel them to...

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Increase quantity supplied

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If a supply curve shifts rightward, how will the shift affect the price value that corresponds to the market equilibrium, all other things held constant?

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The new equilibrium price will decrease from the initial value before the shift.

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Suppose you were to calculate price elasticity for a certain product and your result came out to be 1.2, what does this say about how price elastic the given supply is?

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Answer

Supply of the given product is price elastic.

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