Factor Market
What is Factor Market?
A factor market is a market where firms buy the factors of production (land, labor, capital, entrepreneurship) from households.
In a factor market, firms demand the inputs they need for production, while households supply these factors in exchange for payments (wages, interest, rent, profit). The interaction of demand and supply determines the price and quantity of each factor.
Factor Market: a worked example
A bakery employs 4 bakers for 35 hours a week at $18 an hour, so its weekly wage bill is 18 x 35 x 4 = $2,520. It also pays $400 a week to rent the storefront and $150 a week in interest on an equipment loan. Total factor payments come to 2,520 + 400 + 150 = $3,070 a week. Every one of those dollars leaves the firm and lands in a household as income, and a good share of it returns to the bakery and other firms when those same households go shopping.
The mistake students make with factor market
On the circular flow diagram students keep firms on the selling side in both markets. In the factor market the roles flip: households own the labor, land and capital, so they are the sellers, and firms are the buyers. The habit forms easily because nearly every market a student meets in daily life has a business behind the counter. Ask who owns the resource before deciding who supplies it and the arrows come out pointing the right way.
Factor Market questions
What is the difference between a factor market and a product market?
A factor market trades inputs while a product market trades finished output, and the buyer and seller swap places between them. A software company is a seller in the product market when it licenses its app and a buyer in the factor market when it hires engineers. Money flows from firms to households in the factor market and back from households to firms in the product market.
Is the labor market a factor market?
The labor market is the biggest and most studied factor market. Markets for loanable funds, farmland and rented equipment count as factor markets too, because what changes hands is an input rather than a finished good. A quick test: if a firm buys something to produce with rather than to resell as is, that trade happened in a factor market.
Why do factor markets matter for income inequality?
Factor markets set almost every household's income, since wages, rent, interest and profit are all prices determined there. A worker whose skills are scarce relative to demand for them commands a high wage, and a worker whose skills are widely available does not. That is why economists studying inequality look first at what is happening in factor markets rather than at the prices of goods.
This is the live Factor Markets sandbox. Drag the curves, or open the full version.
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