Product markets and factor markets

Overview

Price in a labour market called and land and capital also traded in factor markets.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is traded in a product market and what is traded in a factor market?

   Model answer

   A product market is where finished goods and services are exchanged, such as the market for coffee, haircuts or smartphones. A factor market is where the services of the factors of production are exchanged, such as the labour market, the market for commercial land and the market for loanable funds. Product markets trade output; factor markets trade the inputs used to make it.

2. 2

   Explain how the roles of households and firms are reversed between product and factor markets.

   Model answer

   In product markets households are the buyers and firms are the sellers: households demand goods and firms supply them. In factor markets the roles swap, because households own the factors of production and supply them, while firms demand them in order to produce. The same two groups therefore appear on opposite sides of the two markets.

3. 3

   What is the price in a labour market called, and what determines it?

   Model answer

   The price in a labour market is the wage rate. It is determined by the demand for labour from employers and the supply of labour from workers, exactly as any other price is determined by demand and supply. Wages differ between occupations because the demand for particular skills and the supply of people who have them differ.

4. 4

   Explain why the demand for labour is described as a derived demand.

   Model answer

   Firms do not want workers for their own sake; they want the output that workers produce. The demand for labour therefore comes from, and depends on, the demand for the good being made. If demand for new houses collapses, the demand for bricklayers falls with it even though nothing has changed about bricklayers themselves.

5. 5

   Describe how income earned in factor markets returns to firms through product markets.

   Model answer

   Firms hire land, labour, capital and enterprise and pay rent, wages, interest and profit to the households that own them. Households then spend that income on the goods and services firms produce. The payments made in factor markets become the income that finances demand in product markets, and the revenue from product markets finances the factor payments, so the two markets form a continuous circular flow.

6. 6

   A sharp increase in demand for electric cars occurs. Trace the effect through the relevant product and factor markets.

   Model answer

   In the product market for electric cars, demand shifts to the right, raising price and quantity. Higher output and higher profit lead manufacturers to hire more workers and buy more machinery, so demand shifts right in the factor markets for automotive labour and for capital equipment, raising wages in that sector and the price of the components involved. Demand for the raw materials used in batteries also rises, pushing up their prices. Higher wages then raise household income, which feeds back as extra demand in product markets generally.

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