Factor Demand and Factor Supply

Figure 1. shows you the relationship between producers and households in the factor market.

The factor market graph shows both the factor demand curve and factor supply curve as these two form the factor market. The factor demand curve is the graphical illustration of the relationship between factor price and the quantity demanded of a factor. The factor supply curve is the graphical illustration of the relationship between factor price and the quantity supplied of a factor.

The factor market graph is plotted with the factor price on the vertical axis and the quantity of the factor on the horizontal axis. The factor market graph, the factor demand curve, and the factor supply curve are all shown in Figure 2 below.

Fig 2. - Factor market graph showing the factor demand and factor supply curves

Factor Demand and Factor Supply and Marginal Analysis

Businesses make decisions using marginal analysis where they consider the benefits and costs of adding an extra unit of a factor of production.

From the above definition, we can say that the marginal revenue product of labor is the extra revenue derived from employing an extra unit of labor. According to the marginal-productivity theory of factor demand, the demand for a factor of production is dependent on the marginal product of that factor. Producers will add factors of production as long as the cost of adding any factor of production does not exceed the revenue it brings. Therefore, producers will stop adding factors of production at the point where the marginal revenue product equals the marginal factor cost. Mathematically, this is written as:

$MarginalRevenueProduct\left(MRP\right)=MarginalFactorCost\left(MFC\right)$

Change in Factor Demand and Factor Supply

There are things that can cause changes in factor demand and factor supply. These things are called the determinants of factor demand and factor supply.

While changes in factor price can cause movements along the factor demand curve and factor supply curve, changes in the determinants of factor demand and factor supply cause a complete shift in the factor demand curve and factor supply curve.

Changes in Factor Demand

Let's look at changes in factor demand. The determinants of factor demand are changes in the prices of products, the supply of other factors, and technology.

1. Product price change - If the production of a product depends on a given factor, a change in the price of that product, which is usually driven by a change in demand for that product, will result in a change in the marginal revenue of that product. This means that there will be a resulting change in the marginal revenue product of that factor, causing the factor demand curve to shift either left or right.Example: If the price of shoes increases, due to an increase in demand for shoes, a shoe company will want to make more shoes. This will lead to an increase in demand for shoemakers (labor).
2. Supply of other factors - The supply of other related factors, often driven by the price of those factors, can cause an increase or decrease in the demand of a factor. For example, if the price of leather declines, more shoes will be demanded due to a lower cost of production. This will lead to an increase in demand for shoemakers (labor).
3. Technology - An advancement in technology can either cause the factor demand curve to shift right or left. Two simple scenarios will show this.Scenario 1: The introduction of cars causes the demand for horses to go down since horses are no longer the primary form of transportation. This would be represented by a leftward shift of the demand curve for horses.Scenario 2: The introduction of cars means that a goods producer can produce more goods to be transported, so the producer hires more employees. This would be represented by a rightward shift in the demand curve for labor.Here, it becomes clear that an advancement in technology either increases or decreases the demand for a factor.

Look at Figure 3 for what a change in factor demand looks like.

Fig 3. - Change in factor demand

Changes in Factor Supply

Now, let's look at changes in factor supply. The determinants of factor supply are changes in preferences and social norms, population size, opportunities, and wealth.

1. Preferences and social norms - A change in preferences and social norms result in the increased supply of a factor as more households develop a norm to provide that specific factor. For instance, as the norm changes for women to work outside the home, the general labor supply increases.
2. Population size - As the population increases in size, there will be more workers available at a given factor price, this will cause the labor supply curve to shift to the right.
3. Opportunities - As a new employment opportunity emerges in a given field, the supply of labor also increases as more households want to benefit from this new opportunity.
4. Wealth - When people gain more wealth, they may prefer more leisure to work. For instance, if teachers became wealthier due to an investment they all made, they would prefer leisure, hence, the supply of teachers would decline.

Figure 4 shows you what the changes in factor supply look like.

Fig 4. - Changes in factor supply

Examples of Factor Demand and Factor Supply

Examples of factor demand include the demand for labor, the demand for farmland (land), the demand for farm equipment (capital), and the demand for entrepreneurship (business startups).

Examples of factor supply include the supply of labor, the supply of farmland (land), the supply of farm equipment (capital), and the supply of entrepreneurship (business startups).

You just made it to the end of this article! You should read our articles on Factor Markets, Labor Market, Land Market, and Market for Capital where we explain factor demand and factor supply in more detail!