The term “factors of production” refers to anything that is used by a firm in order to make a final product. Some examples of factors of production are labor (the work done by people), capital (the machines used to makes products), land, and so on. Labor markets are the most commonly discussed form of a factor market, but it’s important to remember that factors of production can take many forms.
In factor markets, households and firms play different roles than they do in the markets for goods and services. When households provide labor to firms, they can be thought of as the sellers of their time or work product. (Technically, employees can more accurately be thought of as being rented rather than being sold, but this is usually an unnecessary distinction.) Therefore, the functions of households and firms are reversed in factor markets as compared to in goods and services markets. Households provide labor, capital, and other factors of production to firms, and this is represented by the direction of the arrows on the “Labor, capital, land, etc.” lines on the diagram above.
In the other side of the exchange, firms provide money to households as compensation for the use of factors of production, and this is represented by the direction of the arrows on the “SSSS” lines that connect to the “Factor Markets” box.
