Factor market (economics)
In economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

 a '"Factor market'" refers to markets where services of the factors of production (not the actual factors of production) are bought and sold such as the labor markets, the capital market, the market for raw materials, and the market for management or entrepreneurial resources.

Firms buy productive resources in return for making factor payments at factor prices. The interaction between product and factor markets involves the principle of derived demand
Derived demand
Derived demand is a term in economics, where demand for one good or service occurs as a result of demand for another. This may occur as the former is a part of production of the second. For example, demand for coal leads to derived demand for mining, as coal must be mined for coal to be consumed....

. Derived demand refers to the demand for productive resources, which is derived from the demand for final goods and services or output. For example, if consumers demand for new cars rose, producers will respond by increasing their demand for the productive inputs or resources used to produce new cars.

Production is the transformation of inputs into final products. Firms obtain the inputs or factors of production in the factors markets. The goods are sold in the products markets. In most respects these markets are the same. Price is determined by the interaction of supply and demand, firm's attempt to maximize profits, factors can influence and change the equilibrium price and quantities bought and sold and the laws of supply and demand hold.

Market price and can "purchase" as many inputs as they need at the market rate. Because labor is the most important factor of production the discussion will focus on the competitive labor market although the analysis applies to all competitive factor markets.

Competitive factors markets

Assume the structure of the both the product and factor markets are perfectly competitive. In both markets firms are price takers. The price is set at the market level through the interaction of supply and demand. The firms can sell as much of the product they want at the set price since they are price takers.

Resource demand

The buyers in the factors markets are the firms that produce the final goods for the products markets. Each firm must decide how much labor to hire to maximize its profits. The decision is made through marginal analysis. The firm will hire a worker if the marginal benefits exceed the marginal costs. The marginal benefit is the marginal revenue product of labor or MRPL. The MRPL is the MPL times marginal revenue or in a perfectly competitive market structure simply the MPL times price. The marginal revenue product of labor is the "amount of which [the manager] can sell the extra output [form adding an additional worker]". The marginal costs is the wage rate. The firm will continue to hire additional units of labor as long as MRPL > wage rate and will stop at the point that MRPL = the wage rate. Following this rule the firm is maximizing profits since MRPL = MCL is equivalent to the profit maximization rule of MR = MC.

Determinants of resource demand

The demand for inputs is a derived demand. That is the demand is determined by or originates from the demand for the product the inputs are used to produce.

The labor market demand curve is the MRPL curve. The curve shows the relationship between the quantity demanded and the wage rate holding the marginal product of labor and the output price constant. The units of labor are on the horizontal axis and the price of labor, w (the wage rate) on the vertical axis. The price of labor and the quantity of labor demanded are inversely related. If the price of labor goes up the quantity of labor demanded goes down. This change is reflected in a movement along the demand curve. The curve will shift if either of its components MPL or MR change. Factors that can affect a shift of the curve are changes in (1) the price of the final product or output price '(2) the productivity of the resource (3) the number of buyers of the resource and (4) the price of related resources.
  • Changes in the output price -the MRPL is the MPL x the output price thus if the price of the output increases due to an increase in demand for the product the value of the marginal product of labor increases at every price and the resource demand curve shifts out. For example if the price of the output increases firms will react by producing more to meet the demand and that will cause the demand for the inputs to increase.
  • Changes in Productivity -Productivity changes affect the resource demand in several ways. Technological changes increase the marginal product of labor which makes labor more valuable and causes the demand curve to shift out . The quantity of other resources can affect productivity. The more machines labor has to work with the greater the marginal product of labor which will cause the resource demand curve to shift out. The quality of the resource is an important factor in determining the value of labor as a resource. For example, a highly educated and experienced labor force is generally more productive.
  • Changes in the number of buyers of the resource - as with any market additional buyers will cause the demand curve to shift out.
  • Changes in the price of related resources - Related resources include complementary and substitute resources. A change in the price of a related resource will effect the demand for labor. For example, automobiles can be assembled with varying combinations of labor and machinery. If the price of machinery falls firms will tend to substitute machines for labor and the demand for labor will fall. If labor and machinery are used as complementary resources and the price of machinery falls then more machinery will be bought and more workers will be needed to run the new machines causing the labor demand curve to shift out.

Price elasticity of resource demand (PERD)

As with the product market a manager must not only know the direction of a change in demand but the magnitude of the change. That is the manager must know how much to alter a resource’s use if its price changes.

Determinants of PERD

The price elasticity of resource demand is the percentage change in the demand for a resource in response to a 1% change in the price of the resource. PERD for a resource depends on:
  • The PED of the product that the input is used to produce - the higher the PED for the product the higher the PERD for the resource. Cocoa Cola has a relatively high PED. if the price of Coke rises will induce a substantial decline in the quantity of cocoa Cola demanded. The decline in quantityt demanded for Coke will reduce the demand for all inputs used in the production of Coke.
  • The importance of factor in production process - the more important the factor the less elastic is the PERD.
  • The number of substitutes for the resource the more substitutes the higher the PERD.
  • The time period time to discover other resources. The more time to adjust the higher the PERD.
  • The rate of decline of the MPP of the factor = the more rapidly the MPP declines the more elastic the demand for the factor.

Resource supply

Resources are supplied to the market by resource owners. The market supply curve is the summation of individual supply curve. The resource supply curve is similar to the products supply curve. The market supply curve is the summation of individual supply curves it is upward sloping. It shows the relationship between the resource price and the quantity of the resource sellers resource providers are willing to sell and able to sell.

Factors that will cause a shift in the factor supply curve include changes in tastes, number of suppliers and the prices of related resources.

Price elasticity of resource supply

The price elasticity of resource supply PERS equals the percentage change in the quantity of resource supplied induced by a percent change in price of the resource.

Monopolist factor demand

If the producer of a good is a monopoly the factor demand curve is also the MRPL curve. The curve is downward sloping because both the marginal product of labor and marginal revenue fall as output increases. WIth a competitive firm marginal revenue is constant and the downward slope is due to the decreasing marginal product of labor. Therefore, the MRPL curve for a monopoly lies below the MRPL for a competitive firm. The implications are that a monopoly or any firm operating under imperfect market conditions will produce less and hire less labor than a perfectly competitive firm at a given price.
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