What a Factor Market Is

In the market for a good, like welding services sold to customers, households demand and firms supply. Flip to the market for the welder's labor itself, and the roles reverse. Firms demand labor because hiring a worker helps produce something they can sell. Households supply labor because working is how they earn income. The price in this market is the wage, and it gets determined the same way any price does: where supply meets demand.

Firm demand for a worker isn't arbitrary. A firm hires based on how much revenue that worker's output brings in, called marginal revenue product. This is derived demand: nobody wants labor for its own sake, they want what the labor produces. On the supply side, households decide how much labor to offer based on wages, other opportunities, and how pleasant or unpleasant the work is. A nasty job shrinks the pool willing to do it, shifting supply left and pushing the wage up, but the wage itself is still set by where supply and demand cross, not by unpleasantness directly.

This is the same supply and demand machinery from the goods market, just relabeled and run with firms and households swapping sides. Prices still equilibrate a market, curves still shift with underlying conditions, and shortages or surpluses still get resolved by price movement. What's new in factor markets is that demand is derived from the value of output, which sets up the next idea: how a firm decides exactly how many workers to hire by comparing marginal revenue product to the wage.