What Is a Factor Market?
A factor market is the place where companies buy what they need to produce their goods and services. This market is also referred to as the input market.
A factor market is different from the goods and services, or output, market—the market for finished products or services. In the latter, households are buyers and businesses are sellers. But in a factor market, the reverse is true—households are sellers and businesses are buyers.
[Important: Anything used in making a finished product—labor, raw materials, capital, and land—make up a factor market.]
Understanding Factor Markets
Every individual takes part in the factor market. People who are looking for jobs take part in the factor market. Employee wages that are paid by firms are part of the factor market. Investors who receive any form of compensation like a dividend or rental payments also takes part in this market. Therefore, households become sellers because they are selling their services for money paid for by the buyers, who are the businesses.
The combination of the factor markets along with the goods and services market, forms a closed loop for the flow of money. Households supply labor to firms, which pay them wages that are then used to buy goods and services from the same firms. This is a symbiotic relationship that benefits the economy.
The price for each factor is based on supply and demand. But that demand is derived because it's based on the demand for output. So the amount of input depends on how much a company will produce. In a booming economy with a tight labor market, wages will rise because demand for workers is high. So when there's high demand for a product, a company will increase its workforce. Conversely, in recessionary conditions where unemployment is high and demand for goods is low, wages will remain stagnant or even fall. Companies may cut back on hiring, and may even lay off workers to deal with the drop in demand.
Examples of Factor Markets
Factor markets are everywhere. In the appliance manufacturing industry, the market for workers who are skilled in refrigerator and dishwasher assembly would be examples of a factor market. Similarly, the market for raw materials like steel and plastic—which are two of the materials used for refrigerators and dishwashers—are also considered examples of a factor market. In the modern world, job search websites and apps are also considered examples of a factor market.
Factor Markets in 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.