What is Factor Market

A factor market is a marketplace for the services of a factor of production. A factor market facilitates the purchase and sale of services of factors of production, which are inputs like labor, capital, land and raw materials that are used by a firm to make a finished product. A factor market is distinct from the goods and services market, which is the market for finished products or services.

BREAKING DOWN Factor Market

As an example of a factor market, the market for refrigerators and dishwashers would be the kitchen goods market. The market for workers who are skilled in refrigerator and dishwasher assembly would be an example of a factor market. Another example of a factor market would be the market for raw materials like steel and plastic, which are two of the materials used for refrigerators and dishwashers.

Households and firms are a vital part of the economy. While households are essentially buyers and firms are sellers in the goods and services market, these roles are reversed in factor markets. In factor markets, households are the sellers of factors of production like their labor and capital (in the form of their savings), while firms are the buyers of these factors.

The combination of the factor markets, and the  goods and services market, forms a closed loop for the flow of money. Households supply labor to firms, which pay them wages and salaries that are then used to buy goods and services from the same firms. This is a symbiotic relationship that benefits the economy.

A factor's price represents an income to its owner, for example, wages received by a worker, or the rent on land. The price for each factor is based on supply and demand, and is "derived demand," in that it is based on the demand for output. In a booming economy with a tight labor market, wages will rise because demand for workers is high; conversely, in recessionary conditions where unemployment is high, wages will remain stagnant or even fall.

Factor Markets: a Key Element of a Market Economy

The existence of production-oriented factor markets, particularly for capital goods, is one of the defining characteristics of a market economy. In fact, traditional models of socialism were characterized by the replacement of factor markets with some kind of economic planning, under the assumption that market exchanges would be made redundant within the production process if capital goods were owned by a single entity representing society.