Factor Market

Factor Market Definition

A factor market is a resource market that allows business firms to purchase factors of production such as land, labor, raw materials, with which they produce goods and service. In simple words, it is a market for factors of production.

For example, a pizza cafe is a product market selling finished products such as a pizza. Likewise, the factor market will be selling pizza raw materials such as cheese, olives, etc., with which we make a pizza. Together, they help understand the demand, supply and prices of the finished products and factors of production.

Key Takeaways
  • A factor market is where business firms purchase different resources or production factors needed to produce goods and services. Most business firms purchase these lucrative resources to be able to offer goods and services to the consumers.
  • In simple words, it is a market for factors of production such as land, labor, and raw materials. Some examples of factor market include a job fair, an owner selling his land to a shopping mall, or banks loaning money to entrepreneurs.
  • As opposed to that, a product market is where consumers are offered goods and services produced by producers or firms. Hence, producers purchase factors of production from the factor market to produce goods and services for consumers that are sold at the product market.
  • The demand for the factors of production depends on the demand for the finished products. If there is less demand for tea, the demand for the tea industry labor, plantation plots, and leaves will also go down.

How does the Factor Market in Economies work?

We are aware that the price of a finished product like tea is dependent on the market forces of demand vs supplyDemand Vs SupplySupply has a direct relationship with the price. Thus, if the price rises, the product's supply will also increase, and if the price falls, then supply will also decrease. In contrast, demand has an indirect relationship with price. Thus, if the price drops, demand will rise and vice-versa.read more. When the demand for tea increases, its supply falls short; together, they push up the tea price. The supply increases after the price rise to make most of it for higher profits.

The price of the factors of production is depended on the demand for the finished products. If the price of houses is on the rise, the price of cement will also go up. Similarly, if tea is getting costly, the cost of tea leaves and plantation grounds will go up. As such, the demand of the factors of production is a derived demand being dependent on the demand of another item.

Let us look at some important aspects to understand its working. Below is a graphical representation of how a firm arrives at the wage of the labor it employs in perfect competitionPerfect CompetitionPerfect competition is a market in which there are a large number of buyers and sellers, all of whom initiate the buying and selling mechanism. Furthermore, no restrictions apply in such markets, and there is no direct competition. It is assumed that all of the sellers sell identical or homogenous products.read more.

Factor Market Graph

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Source: Factor Market (wallstreetmojo.com)

  1. The wage is fixed at W, which is the equilibrium in the market based on demand and supply of labors. W becomes the wage rate, and every firm will be required to hire workers at this particular rate for a given industry, say tea plantation.
  2. The supply curveSupply CurveSupply curve represents the relationship between quantity and price of a product which the supplier is willing to supply at a given point of time. It is an upward sloping curve where the price of the product is represented along the y-axis and quantity on the x-axis.read more is a straight line in the second image because the firms will hire the labor at one fixed rate. The fixed-rate will be MRC = MRP.
  3. MRP is the additional revenue generated by each worker. MRC is the wage paid to each worker.
  4. So, how many workers does a firm hire? As long as the MRP is greater than MRC, the firm can hire more workers. When MRP < MRC, the firm needs to stop hiring more workers.
  5. Let us understand this with a simple example. The fixed-wage = $ 30. The price for one box of tea = $20
Workers (Quantity of labour)The total number of tea boxes made.Marginal Productivity (MP) -Additional output generated by each worker.MRP (MP x Price)MRC (Wage = $30)
1101010 x 20 = 200$30
21999 x 20 = 180$30
32233 x 20 = 60$30
42311 x 20  = 20$30

The firm will stop hiring after 3 because the number 4th worker is bringing in marginal revenue of $20 while the company pays $30 in wages, which is higher. So, MRP = $20 and MRC = $30, which makes MRP < MRC. Also, the 5th one had negative productivity, so that option was gone anyway. As such, it should stop hiring after the 3rd point.

In the factor market, the demand of a factor of production is also dependent on the requirement of the firms. When there are recessionary conditions, the demand for goods will be low, unemployment will be high, so the wages will probably fall. With this condition, most business firms will stop hiring and even lay off employees, which will reduce the demand for labor.

Real-World Examples

Remember the circular flow of income? In a circular flow of income, households provide factors of production to the firms. The firms employ these factors by paying rent, wages and salaries in return. Using these factors of production, they produce goods and services. Households then purchase goods and services with the money paid by firms as wages or rent. That is how money flows in a circular motion in society. Both the markets of finished products and factors of production depict this circular flow of money.

Factor Market

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Source: Factor Market (wallstreetmojo.com)

Every person around the globe primarily takes part in a wide- range of factor market. The simplest example will be the brands seeking a piece of land to set up their factories or showrooms. The land will be purchased or taken at lease from a household or the government if it is state-owned. Recently, smartphone giant Samsung Electronics decided to provide $492.31 million to set up a display unit in India. Another example is of the job-seekers.

Factor Market vs Product Market

The product market is where goods and services are sold and bought, while the factor market is where different factors of production like land, capital, labor are bought and sold.

#1 – Product market 

  • Different business firms offer goods and services for sale to consumers.
  • They acquire factors of production such as land, machinery, raw materials, labor, etc., to produce goods and services.
  • The needs and wants of the consumers are fulfilled in the product market.
  • Examples include the farmers market, Amazon selling various products, a Lenovo showroom, a bakery, a movie theatre, etc.

#2 – Factor markets  

  • This is a great place where all production factors such as capital, labor, land are sold and purchased.
  • In most scenarios, the demand for capital and labor is usually referred to as the derived demand. Business firms mainly employ more workers where there is an extensive demand for their manufacturing product. For example, whenever the demand for takeaway tacos increases, the company will be forced to employ more workers.
  • Some examples of factor market include – a community leasing out its community land to a builder of shopping complex, ad listing out vacancies for labor and workers, a bank lending capital to entrepreneurs, etc.

This has been a guide to Factor Market in Economics and its definition. Here we discuss how does it work along with a graphical example. You can learn more from the following articles –