Why Factor Prices Matter: The Allocation of Resources

Factor markets and factor prices play a key role in one of the most important processes that must take place in any economy: the allocation of resources among producers.

Consider the example of Williston, North Dakota. Formerly a sleepy agricultural town, the population has more than doubled from 12,000 to 30,000 as Williston is the site of a boom in fracking for natural gas and oil. It is estimated that there are four drills every square mile.

PITFALLS: WHAT IS A FACTOR, ANYWAY?

PITFALLS

WHAT IS A FACTOR, ANYWAY?
Imagine a business that produces shirts. The business will make use of workers and machines—that is, of labor and capital. But it will also use other inputs, such as electricity and cloth. Are all of these inputs factors of production? No: labor and capital are factors of production, but cloth and electricity are not.
The key distinction is that a factor of production earns income from the selling of its services over and over again but an input cannot. For example, a worker earns income over time from repeatedly selling his or her efforts; the owner of a machine earns income over time from repeatedly selling the use of that machine.
So a factor of production, such as labor and capital, represents an enduring source of income. An input like electricity or cloth, however, is used up in the production process. Once exhausted, it cannot be a source of future income for its owner.

What ensured that the oil field workers came to Williston? The factor market: the high demand for workers drove up wages. In the oil fields starting pay can easily exceed $100,000. People who can’t work in the oil fields also move there, to do things that the oil workers don’t have time to do—such as cook meals and do laundry. In other words, the markets for factors of production—oil field workers and cooks in this example—allocate the factors of production to where they are needed.

In this sense factor markets are similar to goods markets, which allocate goods among consumers. But there are two features that make factor markets special. Unlike in a goods market, demand in a factor market is what we call derived demand. That is, demand for the factor is derived from the firm’s output choice. The second feature is that factor markets are where most of us get the largest shares of our income (government transfers being the next largest source of income in the economy).