Factors of Production in Economics

The term 'factors of production' in economics is used to describe the different types of inputs that are used to create goods and services. It is a simple term that is sometimes used interchangeably with 'economic  inputs' or just factors or inputs. You may read slightly different interpretations of how factors are classified, but the standard textbook treatment is to define four broad types.

The reasons for the different interpretations usually come down to how we describe land and labor, and because there is often some overlap between one factor and another. See below for details.

The four factors of production that I will explain come from mainstream economics as it stands today. There are some different ideologies that may regard these inputs in the production process somewhat differently, e.g. Marxism or early (classical) schools of thought in economics, but I am not concerned with these ideologies with regard to factors.

This is not to say that they are not interesting ideologies, just that the classification of factors of production can get a little pedantic when what is important is the concept. From that we can build up our model of production and then start to deal with ideological differences where they have more interesting and controversial insights to offer.

The 4 Factors of Production, with Examples

Land (and Natural Resources)

As a factor of production, land is the term used to describe all of the resources provided to us by nature. It is not just farmland, and it is not just dry land. Fishing resources are included under the land classification as are all sorts of commodities and raw materials.

Oil, gas, coal, timber, base metals, precious metals, gems, rare Earth metals, chemical elements and so on all come under the broad definition of land in economics.

It doesn't stop there; since natural resources are included within the land definition, we also include renewable resources like wind, water, and solar energy from the sun.

Labor (skilled & unskilled)

Labor in economics refers to all people who provide their work to employers for the production of goods and services. We needn't concern ourselves here with whether or not a particular person is included within the labor-force in the way that we do when defining whether or not that person counts as unemployed or economically inactive, that distinction has no relevance here as we are simply noting that labor is one of the factors of production.

Managers and executives of large public companies are still counted as labor since their tasks are usually restricted to the efficient operation of existing facilities. The board of directors, however, are not counted as labor, their duties are more closely aligned with entrepreneurs (see below).

Where some disagreement does arise is with business owners. Business owners do provide their labor as a factor of production, but it is standard practice to count this particular input as a separate factor of production. This is not always done, and we should be aware some commentators fail to separate 'entrepreneurship' from the definition of labor in economics.

Capital (fixed and financial)

The definition of capital in economics is more or less universally agreed upon, but there is still some potential for confusion due to the limitations of our language. For example, the term 'human capital' may lead us to incorrectly assume that this would belong under the classification of capital, but human capital (i.e. skilled workers) are human first and foremost, and so should be classified under labor.

Similarly, in finance the term capital more commonly relates to a sum of money rather than a factor of production.

In economics, the term 'capital' relates to machines, tools, factories, offices, computer hardware and software, intellectual property and productive technology. In some cases animals may be classed as capital e.g., workhorses and racehorses. Oxen are still used to pull ploughs in some countries, and are therefore capital. At other times, animals may better be regarded as being the product, rather than a productive resource e.g., livestock.

Public infrastructure like roads, rail, and ports are also included within the classification of capital, because they all contribute to the productive capacity of an economy.

There may be some confusion as to the correct classification of inventory, because an accumulation of inventory is sometimes referred to as capital accumulation, but inventory is not actually a factor of production - it is a good/service that has already been produced.

There are also many intangible things that also increase productivity and that could therefore be described as capital, but which are not commonly discussed as factors of production. These include institutions like the rule of law, property rights, personal freedoms and so on.

Entrepreneurship

Entrepreneurship is the factor that brings the other factors together and organizes them into an effective system of production. Entrepreneurs may or may not also contribute some manual labor to the production process, especially with regard to small businesses where every pair of hands matters, but we are not concerned with labor here.

Top level strategic decision making is the purpose of entrepreneurship e.g., whether or not to expand the business by investing in new plant or equipment, whether to cut short-run costs by reducing production levels and laying off workers, whether to invest in research and development to improve the product range and so on.

Entrepreneurs control the financing of businesses and decide how to make use of profits i.e., by reinvesting in the business or by paying dividends to shareholders. If growing the business is a priority, profits will be reinvested and perhaps a business loan may be sought. The sale of corporate bonds may be another pathway for raising funds, or perhaps a new issue of shares in the business can be arranged.

Entrepreneurs are not managers, but they may perform management duties in the same way that they may carry out some basic labor duties.

The biggest Factor in terms of Costs

In terms of the biggest factor of production, it's worthwhile to note that labor accounts for a much larger proportion of the overall costs of production. In the developed world labor costs usually amount to something like 60-65% of total costs. The other 35-40% is divided across the other inputs with capital usually being the largest.

Depending upon the nature of a developed economy, i.e., does it retain a relatively large manufacturing sector or has it moved towards a heavily dominant service sector (as often happens), the share of costs accounted for by capital will vary significantly. Germany and Japan have both maintained relatively large manufacturing sectors compared to other developed economies and so capital expenditures are higher in those countries.

In service dominant countries like the UK, human capital is more significant than physical capital, and so labor costs tend to form a larger proportion of overall costs (because human capital is attributed to labor).

Land costs are more dominant in poorer countries where industry is relatively more concentrated on agriculture, but land abundance is also important. Countries with highly concentrated populations on a relatively small landmass e.g., the UK and Japan, find that the higher scarcity of land makes those costs more significant. Competitive advantages and international trade will then naturally favor those countries with abundant cheap land to produce those goods for which land costs are more significant. However, where land is a significant cost for goods that are not tradable, e.g., real estate, those goods will be relatively more expensive in countries with higher land scarcity.

Entrepreneurship costs account for a much smaller proportion of overall costs simply because entrepreneurs are relatively few in number. It is more difficult to give a good approximation of entrepreneurship costs because many entrepreneurs pay themselves a salary rather than pocketing the profits from their businesses. The resulting overlap with labor costs does confuse matters somewhat, but entrepreneurship costs are certainly small compared to the costs of the other factors of production.

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