An Introduction To Factor Markets

Every business deals with the factor markets, which broadly describes the elements needed to market goods and services. To the extent that a business relies on outside products (e.g., labor, raw materials, and facilities) every producer is also a consumer. For a manufacturer, reliance on suppliers of raw materials and on labor dominates the factor markets; for the retailer of products, suppliers are the most important factor market; for those providing services, the factor markets most often rely on intellectual or technical labor, or on the owner’s own labors.

The factor markets include all of the elements required by a business to create the goods or services offered to consumers. This includes raw materials and labor; facilities, equipment and other capital assets; and in many cases, the hiring of people with specialized technical skills.

The overall factor markets are described in many economics books or courses as factors of production. This goes back to the days when manufacturing dominated economic life in many countries and regions. Even though this is not always the case today, the term is applied even when no physical production of goods takes place. Production has taken on an expanded meaning referring to production of a supply over a broad range of products or services.

The business (the producer) purchases resources and pays a factor price. This applies to raw materials, labor, rent of facilities, purchase of specialized equipment, and even to the owner’s entrepreneurial ability. The process of making factor payments to create a marketable product or service is termed derived demand. This refers to the demand for resources on the part of the business and is derived from the demand for a final product by the consumer. The business owner (producer) is also a consumer who operates under the terms of derived demand.

The demand generated by a business owner is based on a need for these productive resources. Very few entrepreneurs can operate without derived demand. For example, an attorney or accountant may open a service and offer to provide expertise for a fee. Working from a home office initially, there is very little requirement for the factor markets. However, in addition to needing to purchase furniture, the professional entrepreneur will need case law books (attorney) or tax regulations (accountant) and eventually will need to hire other experts as the service business expands. Adding more employees means the professional will need to rent an office, not only to provide room for employees, but also as a place for clients to visit.

As expansion occurs, the attorney or accountant will need to purchase furniture, equipment, and other capital assets. The investment in assets, cost of facilities, and payments to employees are all forms of the factor markets. Even as far removed from manufacturing as a service business may be, the need for factor markets is unavoidable. Even a service provider faces a derived demand in one form or another. The traditional definition of production is the transformation of raw materials, labor, and capital investments into a finished product. For a service business, production is the transformation not into products, but into services. This applies to professional services such as those offered by attorneys or accountants, as well as contractors, landscapers, real estate brokers, or home inspectors. Everyone who starts a business must address the derived demand associated with production.

Labor represents a major part of this derived demand, both for goods and services. A question faced by every business owner is how many people to hire. A mistake often made by new business owners is hiring too many people too soon, which erodes profits. When derived demand is responded to excessively, it destroys profits and cash flow. The formula for properly addressing the need for labor may not be expressed specifically on the idea that a business owner somehow knows when to hire new people or when to expand other factors. In fact, however, the timing is properly based in analysis:

A firm will hire another worker when the marginal revenue product of that worker exceeds the marginal factor cost of the worker. In exactly the same way, a firm will decide to rent more building space or more equipment if the marginal revenue product of the additional capital exceeds the marginal cost factor.

Just as the producer must set prices for consumers based on the realities of supply and demand, the factor markets also operate based on supply (by the labor or materials market) and demand (from the producer). In the theoretical perfect market, a producer can buy as much as needed, either materials or labor, at the going rate in today’s market. However, competitive markets affect price. As a producer demands more materials or more labor, the prices rise. The perfect market may exist in the moment but will not endure.

Economic theories aside, this is the reality. The factor markets are as responsive to changing supply and demand as are the consumer markets. This is easily overlooked by new entrepreneurs, who may project assumptions of future revenue, profits, and cash flow based on today’s known prices of the factor markets and on today’s prices paid by consumers for finished goods. Both assumptions could prove to be misguided, especially if the factor market and its forces are overlooked.

In some economic systems outside of the market economy, this reality may be challenged but history has revealed that other economic systems, notably socialism, do not work. The idea under socialism is that factor markets can be replaced when prices rise, usually by some form of state-operated planning. The notorious failures of the USSR’s five-year plans were due to several factors, including the closed distribution associated with state control.

Closed distribution was meant to protect the working population from the worst consequences of shortages and link rations to employment. But it also quickly developed another function, which was to provide privileged supply for certain categories of privileged people. Special closed distributors were established for various elite categories of officials and professionals, supplying them with much higher-quality goods than were available in the normal closed stores and enterprise cafeterias.

The failure of state-planned economic ideas like socialism make the point that at its core, economics is not so much an idea to be controlled (especially by an inefficient mechanism such as the state), but one that operates on these two basic, logical principles:

  1. Consumers have specific wants and needs, which can never be fully satisfied.
  2. Poducers have a desire for maximum profits, which also can never be fully satisfied.

These two opposing forces represent the economy, both in producer-to-consumer marketing and in the factor markets. The entire matter is competitive in nature.

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