# Factor Market: Definition, Types, and Examples

![Young family shopping for stoves in appliance store](https://www.investopedia.com/thmb/vJTmROup-f281hVY3gCimN7HX9s=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/young-family-shopping-for-stoves-in-appliance-store-664658131-7e5ed09e3fdc4538bd26b8a617119a7c.jpg)

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> **Definition**
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> The term "factor market" refers to the inputs used in economic activity and production to generate income.

## What Is a Factor Market?

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

The factor market is also referred to as the input market. All markets are either factor markets where businesses obtain the resources they need, or goods and services markets where consumers make their purchases.

### Key Takeaways

*   There are only two markets in the view of economists: the factor market (or input market) and the goods and services market (or output market).
*   The three main factor markets are the labor market, the capital market, and the land market which refers to all natural resources.
*   The input market supplies the resources necessary to make finished products.
*   The output market buys and uses the finished products.
*   The factor market is driven by demand in the goods and services market.

## How a Factor Market Works

A factor market is also referred to as an input market. The market for finished products or services is called the output market. This can be viewed as a closed-loop flow. Households are sellers and businesses are buyers in the factor market. Businesses are sellers and households are buyers in the goods and services market.

Workers participate in the factor market when they make their services available to businesses. An individual member of a household who's 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.

Workers in the appliance manufacturing industry who are skilled in refrigerator and dishwasher assembly are considered part of the factor market when they're available for hire. Job search websites are part of the factor market.

Raw materials like steel and plastic, both of which are used to build refrigerators and dishwashers, are also examples of factor market products. They're part of the output market when the refrigerators and dishwashers are sold.

> **Important**
>
> Most people participate in the factor markets in at least two ways. You're effectively part of the labor market if you work for wages or a salary. You're also participating in the capital market if you save or invest your income.

## Flow of a Factor Market

The combination of factor markets and the goods and services market forms a closed loop for the flow of money. Households supply [labor](https://www.investopedia.com/articles/economics/09/labor-mobility.asp) 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. Manufacturers increase their purchases of the resources used to make those goods and services when consumers demand more goods and services. Factor market producers then 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](https://www.investopedia.com/terms/m/marketeconomy.asp). 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.

Socialism assumes 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.

> **Fast Fact**
>
> A market economy has three components: the factor market at one end, the consumer market at the other end, and the producers in between. These are the companies that create the products we use.

### Monopoly and Monopsony in the Factor Economy

A monopoly exists when there's 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](https://www.investopedia.com/terms/m/marketfailure.asp). 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's only one possible employer. A consumer faced with just one brand has no choice but to pay the price demanded for that brand 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 that depends on competition to work efficiently.

## Why Are Factor Markets Important?

A market economy can't exist without three interdependent components: the factor market at one end, the goods and services market at the other end, and the producers, the companies that create the products we use, in between.

The producers obtain what they need in the factor market, produce finished products, and sell them to end-users. The end-users create and sustain demand for raw materials that are then made available by the factor market to supply the producers. This is known as derived demand.

The factor market responds to demand and the cycle continues.

## How Do Supply and Demand Impact Factor Markets?

The factor market is driven by demand in the product market. The resources needed to produce goods and services are created or obtained in sufficient quantities to satisfy demand in the product market. The consumer market effectively dictates the factor market.

## What Transactions Take Place in a Factor Market?

Businesses are the buyers in the factor market. They may buy, rent, or hire raw materials, land, or labor. Whatever a business needs to build, package, and deliver the products or services they provide must be obtained in the factor market.

The sellers include producers of raw materials. Every individual who has a job is a participant in the factor market, however. The skills and labor the person is offering in return for compensation is a product that's made available in the factor market.

## What Are the Types of the Factor Market?

Economists generally divide the factor market into three components:

*   The labor market in which people make themselves available for hire
*   Capital or money which is available as business loans or investment
*   The land market that's widely defined to include all the natural resources

These are the factors of production.

## 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 an individual earns a salary or saves that money in the bank, they are effectively participating in the factor markets.

> **Article Sources**
>
> 1.  Higher Rock Education. "[Factor Market](https://www.higherrockeducation.org/glossary-of-terms/factor-market)."
>     
> 2.  Your Article Library. "[How to Determine the Factor Prices under Monopsony Market](https://www.yourarticlelibrary.com/economics/theory-of-distribution/how-to-determine-the-factor-prices-under-monopsony-market/37379)."
>     
> 3.  Economics Help. "[Derived Demand](https://www.economicshelp.org/blog/glossary/derived-demand/)."