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What Are the Factors of Production?
The four factors of production are land, labor, capital, and entrepreneurship. They are important for economic growth because an economy cannot advance or grow without them.
Key Takeaways
- Economic growth is the increase in the production of goods and services over a period of time and is dependent on the four factors of production.
- Land is defined as agricultural land, commercial real estate, and natural resources, such as oil, gas, and other commodities.
- Labor is made up of the individuals who are responsible for the development of goods and services.
- Capital goods, such as tools, equipment, and machinery, are part of the capital category.
- Entrepreneurship includes the visionaries and innovators who are behind the production process.
Understanding the Factors of Production
The factors of production are inputs that companies need to develop goods and services. This enables them to earn profits. The concept of these factors dates back to neoclassical economics, combining historic economic theories with other ideas, such as the idea of labor. As noted above, the four factors of production are land, labor, capital, and entrepreneurship. As the Federal Reserve Bank of St. Louis puts it:
“Factors of production are resources that are the building blocks of the economy; they are what people use to produce goods and services.”
Below are highlights of what each of these means.
Land
When most people think of land, they automatically assume it means agricultural land. While that’s true, it isn’t the only thing that makes up this factor. Land doesn’t just refer to natural resources, but it can also include commercial real estate and renewable resources like forests. Producers also use natural resources, which fit into this category. These resources include:
- Oil and gas
- Coal
- Silver, copper, and other metals
- Other commodities
Land is generally considered one of the most important factors of production. Certain industries rely on land more than others. For instance, a real estate developer needs it to make good on its investments. But technology companies and those that rely on automation tend to rely less on land, making it a less significant factor of production.
Labor
Labor consists of the people who are responsible for the creation of goods and services (from beginning to end) and the effort they put forth. These individuals include factory workers, managers, salespeople, and engineers who design the machinery used in production. As such, it can take on many forms. For instance, the effort of construction workers who work on a building site and quality control workers who ensure products are ready to go to market make up this category.
Individuals are compensated for their time and effort, and the amount they are paid depends on the skills they bring to the table. People with fewer skills and training tend to earn lower wages, while people who are educated and highly skilled often get paid more.
However, innovation is changing the labor force. Automation, increased technology, and equipment have started reducing the need for certain workers. Companies that continue to innovate their production processes rely less on unskilled labor, although they still require technicians and other skilled workers. For instance, robotics has taken over many manufacturing processes, such as assembling cars. Skilled labor is still needed to maintain the equipment, but the many workers who were needed in the past to build automobiles are not necessary anymore.
Important
As an investor, you can identify investment opportunities in companies that are improving their factors of production.
Capital
Although most people think of capital as cash, the term actually describes a number of other assets. Capital goods include manufacturing plants, machinery, tools, or any equipment used in the production process. Capital may also refer to a fleet of trucks or forklifts, as well as heavy machinery.
When the economy is flourishing and expanding, corporations can access capital so they can spend, make investments, and continue making profits. However, when an economy is contracting, businesses must cut costs to preserve capital to ensure they are still profitable. All of this is necessary in order to ensure that they can continue bringing new products and services to market.
Keep in mind, though, that capital only refers to assets used for business purposes and for the production of goods and services. As such, it doesn’t apply to anything that is meant for personal use.
Entrepreneurship
Entrepreneurship includes the visionaries and innovators behind the entire production process. The entrepreneurs combine all the other factors of production to conceptualize, create, and produce the product or service. They are the drivers behind any technical change in the economic system, and are noted by economists as a significant source of economic growth.
Economists believe that entrepreneurship is one of the most integral parts of the production process. That’s because it uses all three of the other factors in the manufacturing of goods and services.
The success of entrepreneurs depends entirely on the development of a business plan. This is a document that business owners use to describe how their company operates, its objectives, and its short- and long-term goals. Once the business plan is developed, entrepreneurs should look for resources, hire personnel, and work to access financing.
Fast Fact
The Solow residual is the residual growth rate of output that cannot be attributed to this growth in inputs. Also known as total factor productivity, this residual includes things such as the state of technological progress and innovation.
The Importance of the Factors of Production
Economic growth has a snowball effect, which often leads to higher stock prices and a rise in employment. Companies have more capital to invest in new ventures, and consumers are able to spend more. Thus, economic growth is one of the most-watched indicators, if not the most important. Economists measure it in real terms, which factors in inflation, or in nominal terms, which doesn’t.
Aggregate growth is commonly measured using a nation’s gross domestic product (GDP). If businesses can improve the efficiency of the factors of production, it stands to reason that they can increase production and create higher quality goods at lower prices. Any increase in production leads to economic growth as measured by GDP. This metric merely represents the total production of all goods and services in an economy. Improved economic growth raises the standard of living by lowering costs and raising wages.
Capital goods include technological advances, from iPhones to cloud computing to electric cars. For example, the newer crude oil extraction technique, fracking, or horizontal drilling, has improved U.S. oil production, making it one of the world’s largest oil producers. This innovation couldn’t have occurred without the labor behind the process, from conceptualization to the finished product.
No economic growth occurs without entrepreneurs who create a vision and the action steps needed to design and bring their vision into being. Entrepreneurs combine all the factors of production, including buying the land or raw materials, hiring the labor, and investing in the capital goods necessary to bring a finished product to market.
How to Define Opportunity Cost?
Opportunity cost is what you might have gained from one option if you chose another. For example, imagine you were trying to decide between two new products for your bakery, a new donut or a new flavored bread. You chose the bread, so any potential profits made from the donut are given up—this is a lost opportunity cost.
What Does the Law of Supply Say?
The law of supply generally says that as the price of a good or service increases, the supply of the good or service also rises.
Is Money a Factor of Production?
In economics, money isn’t considered a factor of production, but it does help the production process. That’s because it isn’t actually a productive resource, so it isn’t directly involved in the production of goods and services. Instead, money is used to pay for raw materials, wages, and capital goods.
The Bottom Line
As Parmenides, a Greek philosopher, famously quipped, “Nothing comes from nothing.” Economic growth results from better production factors. This process is clearly demonstrated when an economy undergoes industrialization or other technological revolutions; each hour of labor can generate increasing amounts of valuable goods.
