Factor Market: Definition, Types, and Examples

What Is a Factor Market?

"Factor market" is a term economists use for all of the resources that businesses use to purchase, rent, or hire what they need in order to produce goods or services. Those needs are the factors of production, which include raw materials, land, labor, and capital.

The factor market is also called the input market. By this definition, all markets are either factor markets, where businesses obtain the resources they need, or goods and services markets, where consumers make their purchases.

Understanding a Factor Market

A factor market is also termed an input market, while the market for finished products or services is called the output market. This can be viewed as a closed-loop flow: In the factor market, households are sellers and businesses are buyers, while in the goods and services market, businesses are sellers and households are buyers.

Workers participate in the factor market when they make their services available to businesses. An individual member of a household who is looking for a job is participating in the factor market. An employee's wages are a component of the factor market, but the money will be spent in the goods and services market.

The factor market provides every component required to produce goods and services.

In the appliance manufacturing industry, workers who are skilled in refrigerator and dishwasher assembly are considered to be part of the factor market when they are available for hire. In the modern world, job search websites are part of the factor market.

Similarly, raw materials like steel and plastic—both of which are used to build refrigerators and dishwashers—are also examples of factor market products. When the refrigerators and dishwashers are sold, they are part of the output market.

Flow of a Factor Market

The combination of the factor markets and the goods and services market forms a closed loop for the flow of money. Households supply labor to companies, which pay them wages that are then used to buy goods and services from companies.

The goods and services market drives the factor market. When consumers demand more goods and services, manufacturers increase their purchases of the resources used to make those goods and services. Factor market producers, in turn, step up production of the raw materials that the manufacturers need.

Free Markets in a Factor Economy

The factor market is one of the defining characteristics of a market economy.

Traditional models of socialism are characterized by the replacement of factor markets, which respond to the dictates of supply and demand, with central economic planning, which dictates supply and assigns resources accordingly.

The assumption of socialism is that market exchanges are redundant within the production process if capital goods are owned by a single entity representing the interests of the society as a whole.

Monopoly and Monopsony in the Factor Economy

A monopoly exists when there is only a single producer or seller of a product or service to serve many buyers. A monopsony is the opposite: there are many producers but only one buyer.

Both are considered examples of market failures. The law of supply and demand can't work efficiently in either situation because of a lack of competition.

This has particular relevance to the labor component of the factor market. An employee has no bargaining power in a town where there is only one possible employer. Moreover, a consumer faced with one brand has no choice but to pay the price demanded and accept the quality offered.

A monopoly has an equally destructive effect in the factor market. A single supplier is under no pressure to cut prices, innovate, or even excel.

Monopoly and monopsony are seen as disturbing the equilibrium of a factor market, which depends on competition to work efficiently.

The Bottom Line

The factor market refers to the costs of all the different inputs that are used in economic activity, such as raw materials, machinery, investments, and labor. Whenever a person earns a salary or saves it in the bank, they are effectively participating in the factor markets.