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Factors of Production Definition
What is the definition of factors of production? Let's start from the view of the whole economy. An economy's GDP is the level of output an economy produces in a given period. Output production is dependent on the available factors of production. Factors of production are economic resources used to create goods and services. In economics, there are four factors of production: land, labor, capital and entrepreneurship.
Factors of production are economic resources used to create goods and services. The four factors of production are: land, labor, capital and entrepreneurship.
Karl Max, Adam Smith, and David Ricardo, pioneers of various economic theories and concepts, were the masterminds behind the idea of factors of production. In addition, the type of economic system may be the deciding factor on how the factors of the production are owned and distributed.
Economic systems are the methods that society and the government use as a means to distribute and allocate resources and goods, and services.
Factors of production in a communist economic system are owned by the government and are valued for their usefulness to the government. In a socialist economic system, the factors of production are owned by everyone and valued for their usefulness to all the members of the economy. Whereas in a capitalist economic system, the factors of production are owned by individuals in the economy and are valued for the profit that the factors of production generate. In the last type of economic system, which is known as the mixed system, the factors of production are owned by both individuals and everyone else and are valued for their utility and profit.
Check out our article - Economic Systems to find out more!
The use of the factors of production is to provide utility to the members of the economy. Utility, which is the value or satisfaction received from the consumption of goods and services, is part of the economic problem - the unlimited needs and wants of the members of an economy against the limited factors of production available to satisfy those needs and wants.
Factors of production being economic resources are innately scarce. In other words, they are limited in supply. Due to them being scarce in nature, their use in effective and efficient measures in production is important to all economies. It is important to note that despite being scarce, some factors of production will be cheaper than others, depending on the level of scarcity. In addition, the characteristic of scarcity also indicates that the goods and services produced will be sold for a higher price given if the cost of the factors of production is high.
Utility is the value or satisfaction received from the consumption of goods and services.
The fundamental economic problem is resource scarcity paired with the unlimited needs and wants of individuals.
Furthermore, factors of production are used in combination to produce the desired good or service. All goods and services in any given economy have the factors of production employed. Thus, factors of production are considered the building blocks of an economy.
Factors of Production in Economics
There are four different types of factors of production in economics: land and natural resources, human capital, physical capital, and entrepreneurship. Figure 1 below summarizes all the four types of factors of production.
Fig. 1 - Factors of production
Factors of Production Examples
Let's go through each of the factors of production and their examples!
Land & Natural Resources
The land is the foundation of many economic activities, and as a factor of production, land can be in the form of commercial real estate or agricultural property. The other valuable benefit that is extracted from land is natural resources. Natural resources such as oil, minerals, precious metals, and water are resources that are factors of production and fall under the category of land.
Company X wants to build a new factory for its operations. The first factor of production they need to start their business is land. Company X works towards acquiring land by contacting business realtors and viewing listings for commercial property.
Physical Capital
Physical capital is resources that are manufactured and are man-made and used in the production of goods and services. Some examples of capital include tools, equipment, and machinery.
Company X has acquired the required land to build its factory. The next step is for the company to purchase physical capital such as machines and equipment needed to manufacture its goods. Company X looks for distributors that will have the best quality machines and equipment, as the company does not want to compromise on the quality of its goods.
Human Capital
Human capital which is also known as labor, is an accumulation of education, training, skills, and intellect that are used in combination to produce goods and services. It also refers to the general availability of the workforce.
Now that company X has both land and physical capital, they're eager to kick-start production. However, to start production, they need human capital or labor to produce the company's goods alongside managing the factory's business operations. The company has put out job listings for production and factory workers' roles, alongside listings for production supervisors and managers. The company will be providing competitive pay and benefits to attract the desired talent and number of workers needed for production.
Entrepreneurship
Entrepreneurship is the ideas, the ability to take the risk, and the combination of the other factors of production to produce goods and services.
Company X has been successfully able to start production after recruiting skilled workers to operate their machines and equipment, alongside operational management staff as well. The company is eager to grow its business and is working on developing strategies to increase revenue through innovative ideas.
Fig. 2 - Entrepreneurship is a factor of production
Factors of Production and their Rewards
Now that we know what the factors of production are let's see how they function in our economy and what are the resulting rewards of each of the factors of production.
A big food chain called Crunchy Kickin Chicken which is really popular in Europe, wants to expand into North America and open its franchise in the U.S. The chain has obtained a license to operate in the U.S. and has also acquired land to build its first branch. The rent that the chain will pay to the land resource owner is the reward for the acquisition or use of this factor of production.
Rent in economics is the price paid for the usage of land.
In addition, the machinery, equipment, and tools that the chain will be using for its business operations were acquired by paying the resource owner interest, which is the reward for this factor of production.
Interest in economics is the price paid or payment received for the purchase/sale of physical capital.
Now that Crunchy Kickin Chicken is ready to operate and has hired restaurant workers, it will pay wages that the workers will earn as their reward for the labor resource that they provide as a factor of production.
Wages in economics are the price paid or payment received for labor.
The chain has resulted in great success, the CEO of Crunchy Kickin Chicken will be earning a profit for his entrepreneurship as a reward for this factor of production.
Profit in economics is referred to as the income generated from employing all the other factors of production to produce output.
Factors of Production Labor
Oftentimes, labor, also known as human capital, is referred to as one of the main factors of production. That is because labor can impact economic growth - the increase in real GDP per capita resulting from the increase in sustained productivity over time.
Knowledgeable and skilled laborers can increase economic productivity, which in turn leads to economic growth. In addition, consumption expenditure and business investments impact labor, which also increases economic growth. As the wages or disposable income increases, consumption expenditure of goods and services also increases, which not only increases GDP but also increases the demand for labor.
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Fig. 3 - Labor increases economic growth
All these series of increases impact economic growth. Moreover, as consumption expenditure increases, businesses are more profitable and tend to invest more into the company through capital and labor investment. Where capital investments can lead to more efficiency and productivity, an increase in labor allows the company to meet their increasing consumption demand resulting from the increased consumption expenditure.
Economies are created for the need for human civilization to not only survive but thrive, and one of the means through which the members of the economy thrive is through employment. Employment is one of the greatest sources of income for members of an economy. Members of the economy earn an income through supplying their labor and, in turn, receive wages as their reward. The same member then uses these wages to purchase goods and services, further stimulating demand within the economy. As you can see, labor is very significant to an economy because it stimulates demand, which in turn stimulates output and, by extension, economic growth.
In economies where there is a shortage of labor as a factor of production, the resulting outcome is stagnation or negative growth in the GDP. For example, in the recent pandemic, many businesses and companies faced temporary closures as their workers contracted the virus. The series of closures resulted in a delay in every step of the production process, such as the delivery of material, production line, and delivery of final goods. The delay resulted in less output being produced in the overall economy, which led to negative growth in many economies.
Factors of Production - Key takeaways
- Factors of production are economic resources used to create goods and services.
- The utility is the value or satisfaction received from the consumption of goods and services.
- The four factors of production are land, physical capital, human capital, and entrepreneurship.
- The reward for land is rent, for capital is interest, for labor or human capital is wages, and for entrepreneurship is profit.
- Human capital or labor is known as one of the main factors of production as it impacts economic growth.
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Frequently Asked Questions about Factors of Production
What are the factors of production in economics?
Factors of production are economic resources used to create goods and services. The four factors of production are: land, physical capital, human capital and entrepreneurship.
Why is labor the most important factor of production?
That is because labor can impact economic growth - the increase in real GDP per capita, resulting from the increase in sustained productivity over time.
How does land affect factors of production?
Land is the foundation of many economic activities. A valuable benefit that is extracted from land is natural resources. Natural resources such as oil, minerals, precious metals, and water are resources that are factors of production and fall under the category of land.
What are examples of factors of production?
Some examples of factors of production are: oil, minerals, precious metals, water, machinery and equipment.
Why are the 4 factors of production important?
Because an economy's GDP is the level of output an economy produces in a given period. Output production is dependent on the available factors of production.
What reward is received by capital?
The reward for capital is interest.
How labour and entrepreneurship are rewarded?
Labour is usually compensated through wages or salaries, while entrepreneurship is rewarded through profits.
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