Factor Markets and Derived Demand

The four factors of production – labor, capital, land and entrepreneurship – are bought and sold in the factor markets. In these markets we reverse the buyer and seller pattern seen in the goods markets; in goods markets firms sell and households buy, but in factor markets firms buy and households sell.

1. Labor: the effort: workers put into producing goods and services such as constructing a house, building a car on an assembly line, designing a new computer, researching a new drug. Laborers are paid wages.

2. Capital: technically, capital refers to the facilities, equipment, inventories and other physical resources to produce goods and service. In the interest of clarity we will call this physical capital to distinguish it from financial capital – the funds necessary to start or maintain the business. Financial capital must be available before a firm can acquire its physical capital. Providers of financial capital are paid interest.

3. Land: Land is a shorthand term that stands for plots of ground and the natural resources contained within. Land can be used to provide housing, agricultural production or raise livestock, just to name a few uses. Land is paid economic rent.

4. Entrepreneurship: Entrepreneurship is the ability to see economic opportunities and organize the other three factors to exploit that opportunity. They are paid profit.

Households own or control these factors and sell them to the producers. They provide the labor; their savings flows into the financial markets and finances physical capital; they own the land; they are the entrepreneurs. Businesses buy the factors from the households and use the inputs to produce goods and services which they then sell to the households. The expenditures of the households are financed by the income they earned selling the factors of production. This makes a giant rotating circle of income and spending. We refer to the interaction between buyers and sellers of inputs as the factor markets.

The factor markets are driven by supply and demand just as any other market. However, there are some differences in the motivation of the sellers and buyers in the factor markets from those in the goods markets, the most obvious of which is the motivation of buyers. In a goods market the buyers want the good based on utility – the benefit consumers enjoy from having and using a good. Buyers of the four factors of production do not gain benefit from having a factor of production; it is a means to an end not the end itself. Buyers of factors of production gain a benefit only if the factor of production adds to their profit; we therefore say that the demand for a factor of production is a derived demand – it is determined by or derived from consumer demand for the final good.

Firms will weigh the cost versus benefit of acquiring each unit of a factor of production; they will expand use of a factor only so long as it is profitable to do so. As with the other economic decisions we have examined, the analysis is conducted at the margin.