Product markets get most of the attention, but factor markets — where labor, capital, and land are bought and sold — are equally important. They determine wages, interest rates, and rents, which together account for all income in the economy.
Labor demand is derived from the demand for the goods that workers produce. A firm hires workers up to the point where the marginal revenue product of labor (MRPL) — the additional revenue from hiring one more worker — equals the wage. If a worker generates 25 dollars per hour in revenue and the wage is 20 dollars, hire them. If the wage rises to 30 dollars, do not. This gives labor demand its downward slope.
Labor supply reflects workers' trade-off between work and leisure. Higher wages make work more attractive (the substitution effect), encouraging more labor supply. But higher wages also make workers richer, and richer people value leisure more (the income effect). For most wage ranges, the substitution effect dominates and labor supply slopes upward. At very high wages, the income effect can dominate, creating a backward-bending supply curve.
Wage determination in a competitive labor market follows the same logic as any market: the intersection of labor demand and supply determines the equilibrium wage and employment level. But real labor markets have complications: minimum wages, unions, monopsony power (when a single employer dominates a local market), and differences in human capital all affect wages.
These concepts explain income inequality, the effects of immigration on wages, why education increases earnings, and how minimum wage policies work in practice.