Factor market

In economics, a factor market is a market where factors of production are bought and sold. Factor markets allocate factors of production, including land, labour and capital, and distribute income to the owners of productive resources, such as wages, rents, etc.^[1]

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. A firm's factors of production are gotten from its economic activities of supplying goods or services to another market.^[2] 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 consumer demand for new cars rises, 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.^[3] Firms obtain the inputs (factors of production) in the factor markets. The goods are sold in the products markets. In most respects these markets work in the same manner as each other. Price is determined by the interaction of supply and demand; firms attempt to maximize profits, and factors can influence and change the equilibrium price and quantities bought and sold, and the laws of supply and demand hold. In the product market, profit or cost is defined as a function of output. The equilibrium condition is that MR=MC, i.e. the marginal equality of benefits and costs. Since the goods produced are made up of factors, output is seen as a function of factor in factor markets.^[4]

In perfectly competitive markets firms can "purchase" as many inputs as they need at the market rate. Because labor is the most important factor of production, this article will focus on the competitive labor market, although the analysis applies to all competitive factor markets. Labour markets are not quite the same as most other markets in the economy since the demand of labour is considered as a derived demand. It is important to note that as the number of workers increases, the marginal product of labour decreases, which implies that the process of output expresses diminishing marginal product. Each additional worker contributes less and less to output as the number of workers employed increases.^[5]

The existence of factor markets for the allocation of the factors of production, particularly for capital goods, is one of the defining characteristics of a market economy. 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.^[6]

Factor markets play a crucial role in the modern economy, as they enable the allocation of factors of production, such as labor, land, and capital, to their most efficient uses. A well-functioning factor market ensures that resources are allocated efficiently, which leads to higher productivity and economic growth. According to a study by Acemoglu and Restrepo,^[7] the efficient allocation of factors of production can account for up to 60% of the differences in productivity levels across countries. For example, in the United States, factor markets are relatively competitive, which has contributed to the country's economic success. In contrast, some developing countries may have less developed factor markets, which can hinder their economic growth.

^ Rose and Marquis (2006). Money and capital markets. Boston: McGraw-Hill. p. 4.
^ Mankiw, N. Gregory (2015). Principles of economics. Cengage Learning. p. 374. ISBN 978-1285165875.
^ Boyes and Melvin (2002) p.
^ Samuelson & Nordhaus (2010). Economics 19th ed. McGraw-Hill. p. 29. ISBN 978-0073511290.
^ Mankiw (2015). Principles of economics. Cengage Learning. p. 376. ISBN 978-1285165875.
^ Steele, David Ramsay (September 1999). From Marx to Mises: Post Capitalist Society and the Challenge of Economic Calculation. Open Court. pp. 175–177. ISBN 978-0875484495. Especially before the 1930s, many socialists and anti-socialists implicitly accepted some form of the following for the incompatibility of state-owned industry and factor markets. A market transaction is an exchange of property titles between two independent transactors. Thus internal market exchanges cease when all of industry is brought into the ownership of a single entity, whether the state or some other organization...the discussion applies equally to any form of social or community ownership, where the owning entity is conceived as a single organization or administration.
^ Acemoglu, D., & Restrepo, P. (2018). The race between man and machine: Implications of technology for growth, factor shares and employment. American Economic Review, 108(6), 1488-1542.

[1] Rose and Marquis (2006). Money and capital markets. Boston: McGraw-Hill. p. 4.

[2] Mankiw, N. Gregory (2015). Principles of economics. Cengage Learning. p. 374. ISBN 978-1285165875.

[3] Boyes and Melvin (2002) p.

[4] Samuelson & Nordhaus (2010). Economics 19th ed. McGraw-Hill. p. 29. ISBN 978-0073511290.

[5] Mankiw (2015). Principles of economics. Cengage Learning. p. 376. ISBN 978-1285165875.

[6] Steele, David Ramsay (September 1999). From Marx to Mises: Post Capitalist Society and the Challenge of Economic Calculation. Open Court. pp. 175–177. ISBN 978-0875484495. Especially before the 1930s, many socialists and anti-socialists implicitly accepted some form of the following for the incompatibility of state-owned industry and factor markets. A market transaction is an exchange of property titles between two independent transactors. Thus internal market exchanges cease when all of industry is brought into the ownership of a single entity, whether the state or some other organization...the discussion applies equally to any form of social or community ownership, where the owning entity is conceived as a single organization or administration.

[7] Acemoglu, D., & Restrepo, P. (2018). The race between man and machine: Implications of technology for growth, factor shares and employment. American Economic Review, 108(6), 1488-1542.

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