5.1 Introduction to Factor Markets

What are factor markets?

Factor markets are where firms demand and households supply the resources used to produce goods and services: labor, land, capital, and entrepreneurship. Roles are reversed here versus product markets — households are sellers/suppliers and firms are buyers/demanders of resources. Prices in factor markets are wages, rent, and interest.

Derived demand

The demand for a factor is a derived demand — it comes from the demand for the product the factor helps produce. If consumer demand for a good rises, firms need more of the input to make it, so demand for that factor increases too. Factor demand curves slope downward, reflecting diminishing marginal returns.

Circular flow connection

Factor markets link to product markets through the circular flow model. Households earn income (wages, rent, interest, profit) by supplying resources to firms; firms use that income to pay for resources, then sell output back to households in product markets. This flow shows the interdependence of the two market types.

Key terms

Factor market

A market where firms buy and households sell resources (land, labor, capital, entrepreneurship) used in production.

Derived demand

Demand for a factor of production that comes from the demand for the good/service it helps produce.

Factors of production

Land, labor, capital, and entrepreneurship — the inputs used to produce goods and services.

Role reversal in factor markets

Households are suppliers (sellers) of resources; firms are demanders (buyers) — opposite of product markets.

Circular flow model

A diagram showing how money, resources, and goods/services flow between households and firms through factor and product markets.

Try an AP-style question

Demand for labor is a derived demand because it…

1. depends on workers' wishes
2. depends on demand for the output
3. never changes
4. is set by government