Factor Markets

Factor markets (or resource markets) are markets for the inputs to production. A producer is typically a seller in the market for a product (supply S_G in the graph below). Simultaneously, producers are also buyers in the markets for its factors of production (demand D_F below).

Economic systems comprise many markets that are interlinked with one another.  For example, the market for cars depends on the markets for raw materials such as steel, rubber and glass. It also hinges on labor markets for people to design and assemble the cars. 

Therefore, what is happening in one market can have a “ripple effect” on surrounding markets. If the price of steel increases, then it should not take long for the supply of cars to lower, pushing up their price. On the other hand, if the price of fuel increases, demand for cars will fall (see cross elasticity of demand). This would result in the demand for steel by car producers to reduce.

When deciding how much of a production factor to employ, producers weigh its marginal cost (MC) against its marginal revenue product (MRP). MC is derived from prices in the factor market. MRP depends on the market for the final product. As long as the last unit of input adds more to revenue than it does to cost (MRP > MC), it still makes economic sense to employ it.

If there were perfect competition in all markets, then the effects of a supply or demand shock from one market onto another’s prices would be relatively easy to calculate.  However, in reality, most markets exist in some state of imperfect competition. This means that power is not equally balanced between buyers and sellers. 

The labor market is a factor market where prices (i.e. wages) are often affected by collective bargaining through trade unions. It could also be influenced by a government’s decision to implement a minimum wage or some other regulation. Producers can then find themselves squeezed between a high degree of competition in the markets for their final products and monopsony pressure in their factor markets.

Interdependencies between factor and product markets sometimes provide good reason for producers and suppliers to merge along the supply chain (so-called vertical integration). In effect, sales contracts are then replaced by employment contracts and free, internal transactions between departments. 

While such changes in ownership structure can help producers to control risk and increase efficiency, they also tend to reduce competition. This can lead to market failure and issues of antitrust. By definition, ceteris paribus partial-equilibrium analysis is insufficient to understand the impact of a change in equilibrium in a factor market on the equilibria in related markets.  A general-equilibrium approach that encompasses knock-on effects and changes across multiple markets is thus required.

Further reading

John Dunlop and Benjamin Higgins discuss how different forms of competition in factor markets can affect wages and prices across the economy. They use a general-equilibrium approach in their early paper, “‘Bargaining Power’ and Market Structures” (Journal of Political Economy, 1942).

Good to know

A sound understanding of factor markets is imperative for making successful investments in the stock market.  When assessing a firm’s future potential it is important not just to consider direct competition in its final-product market but also to look at the trends in its factor markets and their effects on its future performance. Generally speaking, the higher the degree of competition in factor markets and the lower the degree of competition in the final-product market, the higher the value of a producer firm.