Factor Market: Definition, How It Works, and Why It Matters

What is a factor market?

A factor market (also called an input market) is where businesses obtain the resources needed to produce goods and services. These resources—known as the factors of production—include:

• Labor (human work and skills)
• Capital (machinery, equipment, financial capital)
• Land and natural resources (including raw materials)

Economists typically view the economy as having two broad types of markets: factor (input) markets and goods and services (output) markets.

How factor markets work

Factor and goods markets form a circular flow:

• Households supply factors (labor, capital, land) to firms through the factor market.
• Firms pay wages, rent, interest, and profits in exchange for those factors.
• Households use that income to buy goods and services in the product market.
• Consumer demand for products creates derived demand for the factors needed to produce them, which drives firms’ purchases in the factor market.

Examples
* A worker offering time and skills on job platforms participates in the labor market.
* Steel and plastic suppliers sell raw materials to manufacturers via the factor market.
* Banks and investors supplying financing are part of the capital market.

Who participates and what transactions occur

• Buyers: Firms buy, rent, or hire labor, capital, and land to produce goods and services.
• Sellers: Individuals offering labor or capital (savings/investments) and producers of raw materials and natural resources.

Key characteristics
* Derived demand: Demand for factors depends on consumer demand for final goods.
* Interdependence: Factor markets, producers, and consumer markets continuously influence one another.
* Dual participation: Most people act as sellers in factor markets (workers, savers) and buyers in product markets (consumers).

Market failures: monopoly and monopsony

• Monopoly: A single seller in a factor market can reduce competition, limit innovation, and keep prices high for buyers.
• Monopsony: A single buyer (for example, the only large employer in a town) can suppress wages and reduce workers’ bargaining power.
  Both conditions distort supply-and-demand outcomes and can reduce economic efficiency.

Types of factor markets

Economists commonly divide factor markets into three categories:
* Labor market — hiring and selling of workforce skills
* Capital market — loans, equity, and investment capital
* Land market — allocation of natural resources and land use

Why factor markets matter

Factor markets are essential for a functioning market economy. They supply the inputs firms need to produce goods and services. Because factor demand is derived from consumer demand, changes in the product market quickly transmit to the factor side, influencing employment, investment, and resource allocation.

Bottom line

The factor market determines how labor, capital, and natural resources are allocated and priced. It connects households and firms through the exchange of inputs and income, and its health is central to production, employment, and economic growth.