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Economics Terms A-Z

Factor Markets

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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 SG in the graph below) while simultaneously being a buyer in the markets for its factors of production (demand DF below).
Factor MarketsEconomic 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, electronic components, as well as labour markets for people to design and assemble the cars. 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 reduce, pushing up their price.  On the other hand, if the price of fuel increases, demand for cars will fall (see cross elasticity of demand), thus reducing demand for steel by car producers.

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 while 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 in one market on prices in the other markets would be relatively easy to calculate.  However, in reality, most markets exist in some state of imperfect competition, which means that power is not equally balanced between buyers and sellers. The labour market is a factor market where prices (i.e. wages) are often affected by collective bargaining through trade unions, or the decision by a government to implement a minimum wage or intervene with 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 tend also to reduce competition which 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 using 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 the likely effects of these 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.