In economics, factors of production means inputs and finished goods means output.
Input determines the quantity of output i.e. output depends upon input. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function. All factors of production like land, labour, capital and entrepreneur are required in combination at a time to produce a commodity. In economics, production means creation or an addition of utility. Factors of production (or productive 'inputs' or 'resources') are any commodities or services used to produce goods and services.
'Factors of production' may also refer specifically to the 'primary factors', which are stocks including land, labor (the ability to work), and capital goods applied to production. The primary factors facilitate production but neither become part of the product (as with raw materials) nor become significantly transformed by the production process (as with fuel used to power machinery). 'Land' includes not only the site of production but natural resources above or below the soil. The factor land may, however, for simplification purposes be merged with capital in some cases (due to land being of little importance in the service sector and manufacturing). Recent usage has distinguished human capital (the stock of knowledge in the labor force) from labor. Entrepreneurship is also sometimes considered a factor of production. Sometimes the overall state of technology is described as a factor of production. The number and definition of factors varies, depending on theoretical purpose, empirical emphasis, or school of economics.
Historical schools and factors
In the interpretation of the currently dominant view of classical economic theory developed by neoclassical economists, the term "factors" did not exist until after the classical period and is not to be found in any of the literature of that time.
Differences are most stark when it comes to deciding which factor is the most important. For example, in the Austrian view often shared by neoclassical and other "free market" economists the primary factor of production is the time of the entrepreneur, which, when combined with other factors, determines the amount of output of a particular good or service. However, other authors argue that "entrepreneurship" is nothing but a specific kind of labor or human capital and should not be treated separately. The Marxian school goes further, seeing labor (in general, including entrepreneurship) as the primary factor of production, since it is required to produce capital goods and to utilize the gifts of nature. But this debate is more about basic economic theory (the role of the factors in the economy) than it is about the definition of the factors of production.
In French Physiocracy, the main European school of economics before Adam Smith, the productive process is explained as the interaction between participating classes of the population. These classes are therefore the factors of production within physiocracy: capital, entrepreneurship, land, and labor.
The farmer labors on land (sometimes using "crafts") to produce f
The landlord is only a consumer of food and crafts and produces nothing at all.
The merchant labors to export food in exchange for foreign imports.
An advertisement for labour from Sabah and Sarawak, seen in Jalan Petaling, Kuala Lumpur. The classical economics of Adam Smith, David Ricardo, and their followers focuses on physical resources in defining its factors of production, and discusses the distribution of cost and value among these factors. Adam Smith and David Ricardo referred to the "component parts of price" as the costs of using:
- Land or natural resource naturally-occurring goods such as water, air, soil, minerals, flora and fauna that are used in the creation of products. The payment for use and the received income of a land owner is rent.
- Labor human effort used in production which also includes technical and marketing expertise. The payment for someone else's labor and all income received from ones own labor is wages. Labor can also be classified as the physical and mental contribution of an employee to the production of the good(s).
- The capital stock human-made goods (or means of production), which are used in the production of other goods. These include machinery, tools, and buildings.
The classical economists also employed the word "capital" in reference to money. Money, however, was not considered to be a factor of production in the sense of capital stock since it is not used to directly produce any good. The return to loaned money or to loaned stock was styled as interest while the return to the actual proprietor of capital stock (tools, etc.) was styled as profit. See also returns.
The Chapman Effect also known as diminished return, occurs when an employee is at fault for impeding the projected return of a company. Meaning that this employee distracts others, which causes output to decline (classical output function).
Marx considered the "elementary factors of the labor-process" or "productive forces" to be:
- Labor ("work itself")
- The subject of labor (objects transformed by labor)
- The instruments of labor (or means of labor).
The "subject of labor" refers to natural resources and raw materials, including land. The "instruments of labor" are tools, in the broadest sense. They include factory buildings, infrastructure, and other human-made objects that facilitate labor's production of goods and services.
This view seems similar to the classical perspective described above. But unlike the classical school and many economists today, Marx made a clear distinction between labor actually done and an individual's "labor power" or ability to work. Labor done is often referred to nowadays as "effort" or "labor services." Labor-power might be seen as a stock which can produce a flow of labor.
Labor, not labor power, is the key factor of production for Marx and the basis for Marx's labor theory of value. The hiring of labor power only results in the production of goods or services ("use-values") when organized and regulated (often by the "management"). How much labor is actually done depends on the importance of conflict or tensions within the labor process.
Neoclassical economics, one of the branches of mainstream economics, started with the classical factors of production of land, labor, and capital. However, it developed an alternative theory of value and distribution. Many of its practitioners have added various further factors of production (see below).
Further distinctions from classical and neoclassical microeconomics include the following:
Capital This has many meanings, including the financial capital raised to operate and expand a business. In much of economics, however, "capital" (without any qualification) means goods that can help produce other goods in the future, the result of investment. It refers to machines, roads, factories, schools, infrastructure, and office buildings which humans have produced in order to produce goods and services.
Fixed capital This includes machinery, factories, equipment, new technology, factories, buildings, computers, and other goods that are designed to increase the productive potential of the economy for future years. Nowadays, many consider computer software to be a form of fixed capital and it is counted as such in the National Income and Product Accounts of the United States and other countries. This type of capital does not change due to the production of the good.
Working capital This includes the stocks of finished and semi-finished goods that will be economically consumed in the near future or will be made into a finished consumer good in the near future. These are often called inventories. The phrase "working capital" has also been used to refer to liquid assets (money) needed for immediate expenses linked to the production process (to pay salaries, invoices, taxes, interests...) Either way, the amount or nature of this type of capital usually changed during the production process.
Financial capital This is simply the amount of money the initiator of the business has invested in it. "Financial capital" often refers to his or her net worth tied up in the business (assets minus liabilities) but the phrase often includes money borrowed from others.
Technological progress For over a century, economists have known that capital and labor do not account for all of economic growth. This is reflected in total factor productivity and the Solow residual used in economic models called production functions that account for the contributions of capital and labor, yet have some unexplained contributor which is commonly called technological progress. Ayres and Warr (2009) present time series of the efficiency of primary energy (exergy) conversion into useful work for the US, UK, Austria and Japan revealing dramatic improvements in model accuracy. With useful work as a factor of production they are able to reproduce historical rates of economic growth with considerable precision and without recourse to exogenous and unexplained technological progress, thereby overcoming the major flaw of the Solow Theory of economic growth.
A fourth factor?
As mentioned, recent authors have added to the classical list. For example, J.B. Clark saw the co-ordinating function in production and distribution as being served by entrepreneurs; Frank Knight introduced managers who co-ordinate using their own money (financial capital) and the financial capital of others. In contrast, many economists today consider "human capital" (skills and education) as the fourth factor of production, with entrepreneurship as a form of human capital. Yet others refer to intellectual capital. More recently, many have begun to see "social capital" as a factor, as contributing to production of goods and services.
Consider entrepreneurship as a factor of production, leaving debate aside. In markets, entrepreneurs combine the other factors of production, land, labor, and capital in order to make a profit. Often these entrepreneurs are seen as innovators, developing new ways to produce and new products. In a planned economy, central planners decide how land, labor, and capital should be used to provide for maximum benefit for all citizens. Of course, just as with market entrepreneurs, the benefits may mostly accrue to the entrepreneurs themselves.
The word has been used in other ways. The sociologist C. Wright Mills refers to "new entrepreneurs" who work within and between corporate and government bureaucracies in new and different ways. Others (such as those practicing public choice theory) refer to "political entrepreneurs," i.e., politicians and other actors.
Much controversy rages about the benefits produced by entrepreneurship. But the real issue is about how well institutions they operate in (markets, planning, bureaucracies, government) serve the public. This concerns such issues as the relative importance of market failure and government failure.
Non tangible forms of capital
Contemporary analysis distinguishes tangible, physical, or nonhuman capital goods from other forms of capital such as human capital. Human capital is embodied in a human being and is acquired through education and training, whether formal or on the job.
Human capital is important in modern economic theory. Education is a key element in explaining economic growth over time (see growth accounting). It is also often seen as the solution to the "Leontief paradox" in international trade.
A more recent coinage is intellectual capital, used especially as to information technology, recorded music, written material. This intellectual property is protected by copyrights, patents, and trademarks.
This view posits a new Information Age, which changes the roles and nature of land, labour, and capital. During the Information Age (circa 1971 1991), the Knowledge Age (circa 1991 to 2002), and the Intangible Economy (2002 present) many see the primary factors of production as having become less concrete. These factors of production are now seen as knowledge, collaboration, process-engagement, and time quality.
According to economic theory, a "factor of production" is used to create value and allow economic performance. As the four "modern-day" factors are all essentially abstract, the current economic age has been called the Intangible Economy. Intangible factors of production are subject to network effects and the contrary economic laws such as the law of increasing returns.
Social capital is often hard to define, but to one textbook - Microeconomics in Context - it is:
Knowledge, ideas, and values, and human relationships are transmitted as part of the culture. This type of capital cannot be owned by individuals and is instead part of the common stock owned by humanity. But they are often crucial to maintaining a peaceful society in which normal economic transactions and production can occur.
the stock of trust, mutual understanding, shared values, and socially held knowledge that facilitates the social coordination of economic activity.
Another kind of social capital can be owned individually. This kind of individual asset involves reputation, what accountants call "goodwill", and/or what others call "street cred," along with fame, honor, and prestige. It fits with Pierre Bourdieu s definition of "social capital" as:
an attribute of an individual in a social context. One can acquire social capital through purposeful actions and can transform social capital into conventional economic gains. The ability to do so, however, depends on the nature of the social obligations, connections, and networks, available to you.
This means that the value of individual social assets that Bourdieu points to depend on the current "social capital" as defined above.
Ayres and Warr (2009) are among the economists who criticize orthodox economics for overlooking the role of natural resources and the effects of declining resource capital. See also: Natural resource economics
Energy can be seen as individual factor of production, with an elasticity larger than labor. A cointegration analysis support results derived from linear exponentional (LINEX) production functions.
- Conditional factor demands
- Cost of production theory of value
- Diminishing returns
- Economics terminology that differs from common usage
- Factor payments (economics)
- Factor world
- Labor demand
- Labor theory of value
- Labour economics
- Means of production
- Pareto principle
- Production, costs, and pricing
- Production theory basics
- Productivity model
- Productivity world
- Resource-Based View
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