What you will learn
in this Module:
680 section 13 Factor Markets
- How factors of
production—resources like
land, labor, and capital—are
traded in factor markets - How factor markets
determine the factor
distribution of income - How the demand for a factor
of production is determined
Module 69
Introduction and
Factor Demand
The Economy’s Factors of Production
You may recall that we have already defined a factor of production in the context of the
circular-flow diagram; it is any resource that is used by firms to produce goods and
services, items that are consumed by households. The markets in which factors of pro-
duction are bought and sold are called factor markets,and the prices in factor markets
are known as factor prices.
What are these factors of production, and why do factor prices matter?The Factors of Production
Economists divide factors of production into four principal classes. The first is labor,
the work done by human beings. The second is land,which encompasses resources pro-
vided by nature. The third is capital, which can be divided into two categories: physical
capital—often referred to simply as “capital”—consists of manufactured resources such
as equipment, buildings, tools, and machines. In the modern economy, human capi-
tal,the improvement in labor created by education and knowledge, and embodied in
the workforce, is at least equally significant. Technological progress has boosted the
importance of human capital and made technical sophistication essential to many
jobs, thus helping to create the premium for workers with advanced degrees. The final
factor of production, entrepreneurship,is a unique resource that is not purchased in an
easily identifiable factor market like the other three. It refers to risk-taking activities
that bring together resources for innovative production.Why Factor Prices Matter: The Allocation of Resources
The factor prices determined in factor markets play a vital role in the important
process of allocating resources among firms.
Consider the example of Mississippi and Louisiana in the aftermath of Hurricane
Katrina, the costliest hurricane ever to hit the U.S. mainland. The states had an urgentPhysical capital—often referred to simply
as “capital”—consists of manufactured
productive resources such as equipment,
buildings, tools, and machines.
Human capitalis the improvement in labor
created by education and knowledge that is
embodied in the workforce.