Factors of production

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What are Factors Of Production

Factors of production is an economic term that describes the inputs used in the production of goods or services in order to make an economic profit. They include any resource needed for the creation of a good or service. The factors of production include land, labor, capital and entrepreneurship. These production factors are also known as management, machines, materials and labor, and knowledge has recently been talked about as a potential new factor of production.

BREAKING DOWN Factors Of Production

The modern definition of factors of production is primarily derived from a neoclassical view of economics. It amalgamates past approaches to economic theory, such as the concept of labor as a factor of production from socialism, into a single definition.

Land

Land has a broad definition as a factor of production and can take on various forms, from agricultural land to commercial real estate to the resources available from a particular piece of land. Natural resources, such as oil and gold, can be extracted and refined for human consumption from land. Cultivation of crops on land by farmers increases its value and utility.
While land is an essential component of most ventures, its importance can diminish or increase based on industry. For example, a technology company can easily begin operations with zero investment in land. On the other hand, land is the most significant investment for a real estate venture.

Labor

Labor refers to the effort expended by an individual to bring a product or service to the market. Again, it can take on various forms. For example, the construction worker at a hotel site is part of labor as is the waiter who serves guests or the receptionist who enrolls them into the hotel. Within the software industry, labor refers to the work done by project managers and developers in building the final product. Even an artist involved in making art, whether it is a painting or a symphony, is considered labor.
Production workers are paid for their time and effort in wages that depend on their skill and training. Labor by an uneducated and untrained worker is typically paid at low prices. Skilled and trained workers are referred to as human capital and are paid higher wages because they bring more than their physical capacity to the task. For example, an accountant’s job requires synthesis and analysis of financial data for a company. Countries that are rich in human capital experience increased productivity and efficiency. The difference in skill levels and terminology also helps companies and entrepreneurs arbitrage corresponding disparities in pay scales. This can result in transformation of factors of production for entire industries. An example of this is the change in production processes in the Information Technology (IT) industry after jobs were outsourced to countries with a trained workforce and significantly lower salaries.

Capital

In economics, capital typically refers to money. But money is not a factor of production because it is not directly involved in producing a good or service. Instead it facilitates the processes used in production by enabling entrepreneurs and company owners to purchase capital goods or land or pay wages.
As a factor of production, capital refers to the purchase of goods made with money in production. For example, a tractor purchased for farming is capital. Along the same lines, desks and chairs used in an office are also capital.
It is important to distinguish personal and private capital in factors of production. A personal vehicle used to transport family is not considered a capital good. But a commercial vehicle that is expressly used for official purposes is considered a capital good. During an economic contraction or when they suffer losses, companies cut back on capital expenditure to ensure profits. During periods of economic expansion, however, they invest in new machinery and equipment to bring new products to market.
An illustration of the above is the difference in markets for robots in China versus the United States after the financial crisis. China experienced a multiyear growth cycle after the crisis and its manufacturers invested in robots to improve productivity at their facilities and meet growing market demands. As a result, the country became the biggest market for robots. Manufacturers within the United States, which had been in the throes of an economic recession after the financial crisis, cut back on their investments related to production due to tepid demand.

Entrepreneurship

Entrepreneurship is the secret sauce that combines all the other factors of production into a product or service for the consumer market. An example of entrepreneurship is the evolution of social media behemoth Facebook Inc. (FB). Mark Zuckerberg assumed risk for the success or failure of his social media network when he began allocating time from his daily schedule towards that activity. At the time that he coded the minimum viable product himself, Zuckerberg’s labor was the only factor of production.
After Facebook became popular and spread across campuses, Zuckerberg realized that he needed help to build the product and, along with co-founder Eduardo Saverin recruited additional employees. He hired two people, an engineer (Dustin Moskovitz) and a spokesperson (Chris Hughes), who both allocated hours to the project, meaning that their invested time became a factor of production. Continued popularity of the product meant that Zuckerberg also had to scale technology and operations. He raised venture capital money to rent office space, hire more employees, and purchase additional server space for development.
At first, there was no need for land. However, as business continued to grow, Facebook built its own office space and data centers. Each of these required significant real estate and capital investments.
Another example of entrepreneurship is Starbucks Corporation (SBUX). The retail coffee chain needs all four factors of production: land (prime real estate in big cities for its coffee chain), capital (large machinery to produce and dispense coffee), and labor (employees at its retail outposts for service). The company’s founder Howard Schulz was the first person to realize that a market for such a chain existed and figured out the connections between the other three factors of production.
While large companies make for excellent examples, a majority of companies within the United States are small businesses started by entrepreneurs. Because entrepreneurs are vital for economic growth, countries are creating the necessary framework and policies in order to make it easier for them to start companies.

Ownership of Factors of Production

The definition for factors of production in economic systems presumes ownership lies with households, who lend or lease them to entrepreneurs and organizations. But that is a theoretical construct and is rarely the case in practice. With the exception of labor, ownership for factors of production varies based on industry and economic system. For example, a firm operating in the real estate industry typically owns significant parcels of land. But retail corporations or shops lease land for extended periods of time. Capital also follows a similar model in that it can be owned or leased from another party. Under no circumstances, however, is labor owned by firms. Labor’s transaction with firms is based on wages.
Ownership of the factors of production also differs based on the economic system. For example, private enterprise and individuals own most of the factors of production in capitalism. However, collective good is the predominating principle in socialism. As such, factors of production, such as land and capital, is owned by workers.

Role of Technology In Factors of Production

While it is not directly listed as a factor, technology plays an important role in influencing production. In this context, technology has a fairly broad definition and can be used to refer to software, hardware or a combination of both used to streamline organizational or manufacturing processes.
Increasingly, technology is responsible for the difference in efficiency between firms. To that end, technology, like money, is a facilitator of the factors of production. Introduction of technology into a labor or capital process makes it more efficient. For example, use of robots in manufacturing has the potential to improve productivity and output. Similarly, use of kiosks in self-serve restaurants can help firms cut back on their labor costs.
Typically, Solow Residual or Total Factor Productivity (TFP), which measures the residual output that remains unaccounted for from the four factors of production, increases when technological processes or equipment are applied to production. Economists consider TFP to be the main factor driving economic growth for a country. The more a firm or country’s total factor productivity, the more its growth.

In economics, factors of production, resources, or inputs are what is used in the production process to produce output—that is, finished goods and services. The utilized amounts of the various inputs determine the quantity of output according to the relationship called the production function. There are threebasic resources or factors of production: land, labor, and capital. The factors are also frequently labeled “producer goods or services” to distinguish them from the goods or services purchased by consumers, which are frequently labeled “consumer goods”.

There are two types of factors: primary and secondary. The previously mentioned primary factors are land, labor, and capital goods. Materials and energy are considered secondary factors in classical economics because they are obtained from land, labor, and capital. The primary factors facilitate production but neither becomes part of the product (as with raw materials) nor becomes significantly transformed by the production process (as with fuel used to power machinery). Land includes not only the site of production but also natural resources above or below the soil. Recent usage has distinguishedhuman 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 vary, depending on theoretical purpose, empirical emphasis, or school of economics.

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.

Physiocracy

Physiocracy (from the Greek for “government of nature”) is an economic theory developed by a group of 18th century Enlightenment French economists who believed that the wealth of nations was derived solely from the value of “land agriculture” or “land development” and that agricultural products should be highly priced

Classical

An advertisement for labor from Sabah and Sarawak seen in Jalan Petaling, Kuala Lumpur

The classical economics of Adam Smith, David Ricardo, and their followers focus on physical resources in defining its factors of production and discuss 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 like water, air, soil, minerals, flora, fauna and climate that are used in the creation of products. The payment given to a landowner is rent, loyalties, commission and goodwill.
  • 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 one’s 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).
  • Capital stock — human-made goods which are used in the production of other goods. These include machinery, tools, and buildings. They are of two types, fixed and working. Fixed are one time investments like machines, tools and working consists of liquid cash or money in hand and raw material

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.

Marxism

Marx considered the “elementary factors of the labor-process” or “productive forces” to be:

  • Labor
  • Subject of labor (objects transformed by labor)
  • 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

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 to create goods and services.
  • Fixed capital — this includes machinery, factories, equipment, new technology, 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 calledinventory. 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 changes 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 economic growth. This is reflected intotal 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 calledtechnological 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.

Ecological economics

Ecological economics is an alternative to neoclassical economics). It integrates, amongst other things, the first and second laws of thermodynamics (see: Laws of thermodynamics) to formulate more realistic economic systems that adhere to fundamental physical limitations. In addition to the neoclassical focus on efficient allocation, ecological economics emphasizes sustainability of scale and just distribution. Ecological economics also differ from neoclassical theories in its definitions of factors of production, replacing them with the following:

  • Matter — the material from which products are produced. Matter can be recycled or reused through refining or reforming, but it cannot be created or destroyed, placing an upper limit on the amount of material that can be withdrawn and used. Consequently, the total amount of available matter is fixed, and once all the available matter is used, nothing more can be produced without recycling or reusing matter from prior products.
  • Energy — the physical but non-material inputs of production. We can place different forms of energy on a scale of utility depending on how useful it is for creating a product. Due to the law of entropy, energy tends to decrease in utility over time. (e.g. electricity, a very useful form of energy, is used to run a machine that builds a stuffed bear. In the process, however, electricity is converted to heat, a less useful form of energy). Like matter, energy can neither be created nor destroyed and thus there is also an upper limit to the total amount usable energy.
  • Design intelligence — a factor that incorporates the knowledge, creativity, and efficiency of how goods are created – the better the design, the more efficient and beneficial the creation is. Designs are usually improvements on their predecessors since our store of accumulated knowledge grows with time. One possible neoclassical analogue of design intelligence is technological progress.

Integral to ecological economics is the following notion: at the maximum rates of sustainable matter and energy uptake, the only way to increase productivity would be through an increase in design intelligence. This provides the basis for a core tenet of ecological economics, namely that infinite growth is impossible.

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.

Entrepreneurship

In markets, entrepreneurs combine the other factors of production, land, labor, and capital, 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. Just as with market entrepreneurs, the benefits may mostly accrue to the entrepreneurs themselves.

The sociologist C. Wright Mills refers to “new entrepreneurs” who work within and between corporate and government bureaucracies in new and different ways.[11] 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.

In the book Accounting of Ideas, “intequity”, a neologism, is abstracted from equity to add a newly researched production factor of the capitalist system. Equity, which is regarded as part of capital, was divided into equity and intequity. Entrepreneurship was divided into network-related matters and creating-related matters. Network-related matters function in the sphere of equity, and creating-related matters in spheres of intequities.

Natural resources

Ayres and Warr (2010) 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

Exercise can be seen as individual factor of production, with an elastication larger than labor. A cointegration analysis support results derived from linear exponential (LINEX) production functions.

Cultural heritage

C. H. Douglas disagreed with classical economists who recognized only three factors of production. While Douglas did not deny the role of these factors in production, he considered the “Cultural heritage” as the primary factor. He defined cultural inheritance as the knowledge, techniques, and processes that have accrued to us incrementally from the origins of civilization (i.e., progress). Consequently, mankind does not have to keep “reinventing the wheel“. “We are merely the administrators of that cultural inheritance, and to that extent, the cultural inheritance is the property of all of us, without exception.[15] Adam Smith, David Ricardo, and Karl Marx claimed that labor creates all value. While Douglas did not deny that all costs ultimately relate to labour charges of some sort (past or present), he denied that the present labour of the world creates all wealth. Douglas carefully distinguished between value, costs and prices. He claimed that one of the factors resulting in a misdirection of thought in terms of the nature and function of money was economists’ near-obsession about values and their relation to prices and incomes. While Douglas recognized“value in use” as a legitimate theory of values, he also considered values as subjective and not capable of being measured in an objective manner.

Peter Kropotkin argued for the common ownership of all intellectual and useful property due to the collective work that went into creating it. Kropotkin does not argue that the product of a worker’s labor should belong to the worker. Instead, Kropotkin asserts that every individual product is essentially the work of everyone since every individual relies on the intellectual and physical labor of those who came before them as well as those who built the world around them. Because of this, Kropotkin proclaims that every human deserves an essential right to well-being because every human contributes to the collective social product: Kropotkin goes on to say that the central obstacle preventing humanity from claiming this right is the state’s violent protection of private property. Kropotkin compares this relationship to feudalism, saying that even if the forms have changed, the essential relationship between the propertied and the landless is the same as the relationship between a feudal lord and their serfs.