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Lesson Explainer: Factors of Production Economics

In this explainer, we will learn how to define land, labor, capital, and entrepreneurship as factors of production and understand their characteristics.

We begin by recalling that limitless and diverse human needs are the driving forces behind economic activities. Needs can be satisfied by consuming suitable resources. While some of these resources may already exist in nature, such as air or sunshine, other resources require human effort before they can be consumed to satisfy needs. For instance, while water is an abundant resource that exists in nature, it needs to be filtered and sanitized before we can consume water to wash or to drink.

Definition: Production

Production is the process through which existing resources are utilized to obtain new goods and services.

Filtering and sanitizing water from seas, rivers, or lakes to obtain clean drinking water is an example of production. Fertilizing farmland to harvest rice and wheat is also an act of production. While some resources used for production exist in nature, other resources that are used during a production process have themselves been manufactured. For instance, leather and car parts are produced using natural resources, but they are capital resources that enter into the production stage another time to produce new goods. These are examples of capital goods, which indirectly satisfy needs, while clean water, rice, and wheat are consumption goods, which directly satisfy human needs. Hence, capital goods serve as both inputs and outputs of production.

Resources that are used to produce new goods and services are called factors of production. Recall that resources can be categorized according to their present form as natural, human, and capital resources. When resources are used to produce new goods and services, we will refer to the respective types as land, labor, and capital. While land, labor, and capital are common words used broadly in everyday language, in economics, we use them to specifically label categories of resources as factors of production. The following diagram incorporates these terms to represent different types of inputs and outputs of production.

The diagram above portrays the factors of production as inputs in the production process, and new goods and services as the outputs of production. The new goods and services can be consumption goods, which are used directly to satisfy needs. Alternatively, new goods and services can be capital goods, which are used to produce other goods or services. We also note that entrepreneurship is listed as a factor of production. This refers to the organizing efforts or risk taking in order to enable the production process.

Definition: Factors of Production

Factors of production are the inputs needed to produce new goods and services. They are categorized as land, labor, capital, and entrepreneurship.

Let us consider each factor of production in detail.

As a factor of production, land refers to natural resources that can be utilized for the production of new goods and services. Land includes Earth’s surfaces that can be used for farming, building, and mining, as well as the resources that can be found below, on, or above the surface such as minerals, water, agricultural goods, animals, and so on. Physical pieces of land, such as farmland or a lot to build a house or factory on, are certainly examples of land as a factor of production. But we define the term land to also include other natural resources, such as coal, water, and sunshine, when they are used for production. Since the production of goods always requires raw materials, we can see that land is the principal factor of production.

In our first example, we will identify an example of land as a factor of production.

Example 1: Identifying Land as a Factor of Production

Which of the following is not an example of land as a factor of production?

  1. Paper
  2. A factory lot
  3. Farmland
  4. Petroleum
  5. Sunshine

Answer

In this example, we need to identify a resource that is not an example of land as a factor of production. Recall that factors of production are resources that are utilized to produce new goods and services. In other words, factors of production are the inputs to the production process. Factors of production are categorized as land, labor, and capital as shown in the diagram below:

As a factor of production, land refers to natural resources (i.e., resources existing in nature in their present forms) that can be utilized for the production of new goods and services. While we consider the listed options, we should keep in mind that land does not only refer to physical areas of Earth’s surface, but it represents the category of natural resources that can be found below, on, or above the surface.

Let us consider each example to determine whether it satisfies this definition:

  1. When used as a factor of production, paper can be used to make books, which makes it a factor of production. This is portrayed in the following diagram:
    However, paper is not found in nature, so it is not an example of land as a factor of production.
  2. A factory lot refers to a physical area on which a factory can be built. This is portrayed in the following diagram:
    Since the lot refers to an area of Earth’s surface, it is an example of land as a factor of production.
  3. Farmland is a physical area of Earth’s surface that can be used to produce crops such as rice and wheat. This is portrayed in the following diagram:
    Since farmland refers to an area of Earth’s surface, it is an example of land as a factor of production.
  4. Petroleum, also known as crude oil, can be used to produce fuel such as gasoline or diesel, as portrayed in the diagram below:
    Since petroleum can be found naturally below Earth’s surface, it is an example of land as a factor of production.
  5. Sunshine can be used to produce crops in farms or to produce electricity via solar panels, as shown below:
    Since sunshine is a naturally occurring resource, we classify it as land as a factor of production.

Option A, paper, is not an example of land as a factor of production.

In the previous example, we considered various examples of land as a factor of production. Let us discuss the characteristics of land as a factor of production.

An inherent characteristic of land as a factor of production is that humans do not produce it. Land exists and has always existed in nature without anyone’s help or effort. Humans simply utilize land for production without having to first produce it. In some texts, this characteristic of land is referred to as “gifts of nature,” since it seems like these resources are simply given to us as if they were gifts.

Recall that resources can be categorized with respect to their scarcity as free and scarce, where free resources exist in excess relative to the needs for them. Some examples of land are free resources, such as sunshine, air, and the ocean. These are seemingly endless and nonperishable. In this regard, since some land resources are free resources, permanence is one of their characteristics.

On the other hand, many examples of land as a factor of production are scarce. For instance, there are limited supplies of coal, petroleum, and farmland that exist in nature, and they can be depleted quickly if individuals consume them at will as if they were free resources. Scarcity of land as a factor of production necessitates an authority, or a government, to regulate their utility. Utilization of scarce resources is often established by a legal authority, and an individual’s rights to consume them are limited by law. Since some land resources are scarce, legal rights are one of their characteristics.

Hence, the characteristics of land as a factor of production can be summarized using the terms gifts of nature, permanence, and legal rights.

In the next example, we will identify an example of land that demonstrates the characteristic of permanence.

Example 2: Characteristics of Land as a Factor of Production

Which of the following examples represents the permanence of land as a factor of production?

  1. The construction of a factory on a certain lot requires a legal permit from the government.
  2. A farmer can expect sunshine throughout the year to aid the growth of crops.
  3. Wild mushrooms are collected to be used as an ingredient.
  4. Petroleum is discovered underground, which leads oil companies to harvest the resource.

Answer

We recall that land as a factor of production refers to natural resources that can be utilized for the production of new goods and services. The characteristics of land can be summarized using the terms gifts of nature, permanence, and legal rights, which are defined as follows:

  • Land as a factor of production is said to be a “gift of nature” since these resources exist in nature without anyone’s effort.
  • Free resources of land as a factor of production, such as air, water, and sunshine, enjoy the characteristic of permanence, which refers to their limitless and nonperishable nature.
  • Scarce resources of land as a factor of production, such as farmland, coal, and petroleum, are subject to legal rights, which means that an individual’s rights to consume them are limited by law.

To identify an example representing the permanence of land, it should describe the limitless and nonperishable characteristics of a free resource. Let us consider each example.

  1. The example of land as a factor of production in this scenario is a factory lot, which is a scarce resource. This example describes the characteristic of legal rights, which applies to scarce resources. In this case, the legal rights control the usage of the factory lot through a system of permits.
  2. The example of land as a factor of production in this scenario is sunshine, which is a free resource. The farmer can expect sunshine throughout the year since it is limitless and nonperishable. Hence, this example describes the permanence of land as a factor of production.
  3. The example of land as a factor of production in this scenario is wild mushrooms, which are scarce resources. This example describes how this resource is given as a gift without anyone’s efforts to produce it. Hence, this example describes the characteristic of land referred to as “gifts of nature.”
  4. The example of land as a factor of production in this scenario is petroleum, which is a scarce resource. This example describes how this resource is given as a gift without anyone’s efforts to produce it. Hence, this example describes the characteristic of land referred to as a “gift of nature.”

Option B describes the permanence of land as a factor of production.

In the previous example, we examined the characteristics of land as a factor of production. Let us now turn to another factor of production.

Definition: Labor as a Factor of Production

As a factor of production, labor refers to the human efforts utilized for the production of new goods and services.

While land is the principal factor of production, labor is also necessary for production. For instance, farmland and sunshine are two land resources that can be utilized to produce rice, but they may not be sufficient by themselves. Often, a farmer needs to irrigate and fertilize the land and harvest the rice. In this case, the farmer’s efforts, in addition to land, are a factor for the production. This is portrayed in the diagram below:

Labor as a factor of production can also lead to new services. A doctor can provide services related to healthcare needs, and a pianist can provide services to satisfy the need to enjoy music. Any effort exerted by humans that leads to the creation of new services is an example of labor as a factor of production.

However, we should keep in mind that activities that do not contribute to the production of new goods and services are not considered to be labor. Such activities represent the consumption of resources rather than the production of resources. For example, while recreational swimming certainly requires human efforts, it does not lead to new goods or services. Hence, recreational swimming is not an example of labor as a factor of production.

Labor as a factor of production can be characterized as voluntary, painful, and endless activities, which are defined as follows:

Labor is a conscious and voluntary activity. The individual exerting efforts is aware of the work and is a willing participant in the production of new goods and services. Often, there are financial incentives for individuals who provide their labor for production that motivate the individual to continue adding labor as a factor of production. For instance, a hairstylist willingly and consciously gives a haircut and is then compensated for his or her service. This motivates the hairstylist to volunteer again for the same task.

Another characteristic of labor as a factor of production is that it is a painful and exhausting activity. While the contributors of labor do so willingly, production often requires much effort to be exerted toward the goal. The pain in this characterization does not necessarily point to physical pain, which certainly could be a part, but it represents the mental and physical burden of work in general. While work itself is inherently “painful,” contributors of labor may also find enjoyment and fulfillment in their work. Along with the compensation, the enjoyment in their work is another motivator for individuals to continue to provide their labor.

Lastly, labor is also characterized as an endless activity. Since human needs are limitless and diverse, the amount of labor needed for production is also unlimited. In other words, there is always a need for labor to aid with the production of new goods and services. Types of work needed for production are also divers; some focus primarily on physical work, while others primarily use mental knowledge-based faculties.

In the next example, we will consider examples of labor as a factor of production.

Example 3: Identifying Labor as a Factor of Production

Which of the following is not an example of labor as a factor of production?

  1. Managing an assembly line in a factory
  2. Playing chess as a hobby
  3. Playing the violin in a concert
  4. Painting a portrait for an art gallery

Answer

In this example, we need to identify a resource that is not an example of labor as a factor of production. Recall that factors of production are resources that are utilized to produce new goods and services. In other words, factors of production are inputs in the production process. Factors of production are categorized as land, labor, and capital as shown in the diagram below:

As a factor of production, labor refers to the human efforts utilized for the production of new goods and services. While we consider the listed options, we should keep in mind that activities that do not contribute to the production of new goods and services are not considered labor.

Let us consider each example to determine whether it satisfies this definition:

  1. This example describes human effort that is utilized to produce goods in a factory; thus, it is an example of labor as a factor of production.
  2. This example describes an activity that is purely for one’s enjoyment. This activity does not lead to the production of new goods or services. This is an example of consumption of resources, rather than a factor of production.
  3. This example describes human effort that is utilized to produce a service in the form of a concert; thus, it is an example of labor as a factor of production.
  4. This example describes human effort that is utilized to produce a good in the form of a painting; thus, it is an example of labor as a factor of production.

Option B, playing chess as a hobby, is not an example of labor as a factor of production.

In the previous example, we considered examples of labor as a factor of production. The third factor of production is capital. While capital is a term used to refer to money, this is not a factor of production. Money is not directly used to produce new goods or services but is indirectly used as a medium of exchange to obtain the factors of production. However, money itself is not an input in the production process. Capital as a factor of production is defined as follows:

Definition: Capital as a Factor of Production

As a factor of production, capital refers to the capital resources utilized for the production of new goods and services.

Capital as a factor of production includes tools, such as shovels and machines, as well as materials, such as paper and leather, used to aid in the production of goods and services. A hairstylist uses scissors, which are capital resources, to provide a haircut, so scissors are examples of capital as a factor of production. Previously, we saw that factors involved in the production of rice are land resources, such as farmland and sunshine, as well as labor resources, such as a farmer’s efforts. But a farmer also needs to use farming tools or machines in order to work more efficiently, and these are capital resources. Hence, this example of production uses all three factors of production.

In terms of durability, capital as a factor of production can be classified as fixed or circulating capital. Fixed capital is a capital resource that can be used multiple times. Examples of fixed capital include factory machines that can be used repeatedly to produce a large number of goods or a shovel that can be used many times until it wears out. On the other hand, circulating capital can only be used once and is consumed as a result of its use to produce one good or service. Examples of circulating capital include gasoline, paper, and leather.

In the next example, we will identify an example of circulating capital.

Example 4: Distinguishing between Fixed and Circulating Capital

Which of the following is an example of circulating capital?

  1. A computer
  2. A car part
  3. Machinery
  4. A forklift truck

Answer

We recall that capital as a factor of production refers to the capital resources utilized for the production of new goods and services. Capital resources can be categorized as either fixed or circulating capital. Fixed capital can be used multiple times in the production of goods and services, while circulating capital is consumed after one usage. Hence, we need to identify an example of a capital resource that can be used only once.

Let us consider each example:

  1. A computer is a capital resource that can be used to produce services such as teaching lessons. Hence, this is an example of capital as a factor of production. Since a computer can be used multiple times to provide services on different occasions, it is an example of fixed capital.
  2. A car part is a capital resource that can be used to produce a car. That means it is an example of capital as a factor of production. Since a car part can only be used once, it is an example of circulating capital.
  3. Machinery is a capital resource that can be used to produce goods in factories, so it is an example of capital as a factor of production. Since machinery can be used multiple times to provide a large number of goods, it is an example of fixed capital.
  4. A forklift is a capital resource that can be used to produce services such as moving heavy objects. Hence, this is an example of capital as a factor of production. Since a forklift can be used multiple times to provide services on different occasions, it is an example of fixed capital.

Option B, a car part, is an example of circulating capital.

In the previous example, we considered examples of capital as a factor of production and their classification as fixed or circulating capital. Capital as a factor of production can be characterized as capital and depreciable resources.

An inherent characteristic of capital is that it is manufactured. This is evident since capital resources are also referred to as manufactured resources. This characteristic separates capital from land as factors of production. Land resources are “gifts of nature,” while capital resources are manufactured by humans.

Another characteristic of capital as a factor of production is that it is depreciable. Depreciation of capital resources can occur through their capital consumption or economic consumption. Capital consumption is consumption of fixed or circulating capital during the production process. Circulating capital is consumed after one usage. Although fixed capital is more durable than circulating capital, it also can be consumed after a period of time. For instance, a shovel is an example of fixed capital since it can be used more than once, but it will eventually break or become unusable due to wear and tear from its usage. Consumption of either fixed or circulating capital is defined as capital consumption.

On the other hand, economic consumption refers to the decreased value of capital resources due to the development of more efficient technologies or the changing appetites of consumers. For instance, a medical imaging machine may become less valuable if a more accurate imaging technology becomes available. Also, as more consumers are using smartphones in place of desktop computers, the computers become less valuable. Unlike capital consumption, economic consumption does not physically consume the resources.

Let us now consider the fourth and final factor of production, which is entrepreneurship.

Definition: Entrepreneurship as a Factor of Production

As a factor of production, entrepreneurship refers to the organization of resources, risk taking and innovation by individuals known as entrepreneurs for the production of new goods and services.

Recall the diagram representing factors of production as inputs.

In this diagram, we can see that the other three factors of production all flow into the entrepreneurship factor. This indicates the fact that entrepreneurship is an organizing effort of the other three factors of production. In order to produce goods and services on a large scale, an entrepreneur is needed to collect all necessary factors, take the risk of producing new goods and services, and innovate the production process. This factor resembles the labor factor, which represents human efforts needed for the production process. While labor refers to mental and physical efforts to directly produce the goods and services, entrepreneurship only refers to the organizing and innovative human efforts for production.

For instance, we can consider different inputs of the production process for manufacturing computers. Firstly, the lot for a factory is the land factor, while computer parts and factory machinery are the capital factor necessary for this production. Factory workers assembling the computer, monitoring factory machinery, and supervising workers would all fall under the labor factor of production. However, this process would not be possible without an entrepreneur or entrepreneurs who take the initiative to collect each of these factors of production, take the risk of running the factory, and innovate the production process. This is summarized in the following diagram.

In the next example, we will consider the entrepreneurship factor of production.

Example 5: Entrepreneurship as a Factor of Production

Which of the following is an example of entrepreneurship as a factor of production?

  1. A factory worker assembling computer parts
  2. A supervisor overseeing workers
  3. A chef opening a new restaurant
  4. A teacher instructing classes at a school
  5. A student organizing a soccer game with friends

Answer

Recall that entrepreneurship as a factor of production refers to the organization of resources, risk taking and innovation by individuals known as entrepreneurs for the production of new goods and services. This factor of production resembles labor, which is represented as a different category in factors of production. While labor refers to mental and physical efforts to directly produce the goods and services, entrepreneurship only refers to the organizing and innovative human efforts for production.

Let us consider each option to determine whether or not it is an example of entrepreneurship.

  1. A factory worker assembling computer parts exerts his or her efforts in the production of new computer parts. Since this effort does not involve any organization or innovation, it is an example of labor rather than entrepreneurship.
  2. While a supervisor overseeing workers does appear to resemble entrepreneurship in the first glance, this work does not involve the organization of resources or innovation in the production process. Instead, the supervisor is only ensuring that the production process is progressing smoothly. Hence, this is an example of labor rather than entrepreneurship.
  3. In order for a chef to open a new restaurant, he or she needs to collect all necessary resources including land (lot of the restaurant and ingredients), labor (other cooks and waiters), and capital (cooking utensils, kitchen, and tables). This requires the efforts to organize resources, innovate the production process, and take the risk of opening a new restaurant. Hence, this is an example of entrepreneurship.
  4. A teacher instructing classes at a school is exerting his or her efforts to directly produce new services for the students. Since this work does not involve organization of resources, it is an example of labor rather than entrepreneurship.
  5. Astudent organizing a soccer game with friends appears to share some characteristics of entrepreneurship since the student is organizing resources. However, since this soccer game is among friends, it can be assumed that it is purely for the enjoyment of persons involved. In other words, no new goods or services are produced as a result of this efforts, so this effort cannot be considered as a factor of production.

Option C, a chef opening a restaurant, is an example of entrepreneurship.

So far, we have discussed the definitions and characteristics of the factors of production: land, labor, capital, and entrepreneurship. In return for the provision of these factors, households receive income. Compensation for providing land, labor, capital, and entrepreneurship is known as rent, wage, interest, and profit, respectively, which will be discussed in detail in future lessons. Let us turn our attention to how the factors of production affect economic growth and development.

Definition: Economic Growth and Economic Development

Economic growth refers to the increase in the total output of production from the economy.

Economic development refers to the improvement in the quality of life, or living standards, for individuals in the economy.

We have discussed examples and characteristics of the three factors of production: land, labor, and capital. In return for the provision of these factors, households receive income. Compensations for providing land, labor, and capital are known as rent, wage, and interest, respectively, which will be discussed in detail in future lessons. These factors lead to production of new goods and services, so their increased availability can lead to economic growth. Land as a factor of production is a fixed element for which a nation can do little to increase its availability. However, a country’s priorities and policy can greatly affect the amount of available labor and capital resources, which leads to the development of the nation’s economy.

In particular, in order to increase the amount of capital resources available in a nation’s economy, the government can encourage the production of capital goods over consumption goods. The production of capital goods is called investment. While consumption goods are necessary for survival as well as enjoyment of life, production of capital goods will increase the economy’s capacity to produce more goods and services. Hence, investment leads the economy to grow in size.

The amount of capital resources is not the only factor that determines economic growth. Labor as a factor of production is also a significant resource that contributes to the nation’s capacity to produce goods and services, thus increasing the size of a nation’s economy. Suitable training and education of citizens (or human development) will prepare them for the nation’s workforce, hence increasing the amount of available labor resources. Hence, capital resources and human development are the pillars of economic growth.

In our final example, we will consider the mechanism of economic growth.

Example 6: Understanding the Mechanism of Economic Growth

Which of the following can lead to economic growth?

  1. Investment
  2. Capital consumption
  3. Consumption goods
  4. An increase in human resources

Answer

In this example, we need to identify the factors that cause economic growth. Recall that factors of production lead to production of new goods and services and their growth leads to a nation’s economic development. There are three types of factors of production: land, labor, and capital. Out of the three, it is unlikely that a nation can control the availability of land resources; hence, economic growth is caused by the increased availability of labor and capital as factors of production.

Let us consider each of the terms that are provided in the list:

  1. Investment refers to the production of capital goods. Capital goods are resources that we use to produce new goods or services. Production of capital goods will increase the availability of capital resources, thus increasing the economy’s capacity to produce new goods and services. Hence, investment leads to economic growth.
  2. Capital consumption refers to the physical consumption of capital resources. Consumption of capital resources in the production process leads to new goods or services, but it also consumes an existing capital resource, which is a factor of production. Hence, capital consumption can lead to a reduction in the factors of production and it does not necessarily lead to economic growth.
  3. Consumption goods are the goods that directly satisfy human needs. Consumption goods are not used to produce new goods and services, so they are not factors of production. Hence, consumption goods do not lead to economic growth.
  4. An increase in human resources is directly tied to the growth in available labor resources in a nation’s economy. Since labor is a factor of production, increasing this factor leads to an increased capacity of the economy to produce new goods and services. Hence, an increase in human resources leads to economic growth.

Options I and IV, investment and an increase in human resources, lead to economic growth.

Let us finish by recapping a few important concepts from this explainer.

Key Points

  • Production is the process through which existing resources are utilized to obtain new goods and services.
  • Factors of production are resources that are used to produce new goods and services, and their types are land, labor, and capital.
  • Land as a factor of production refers to natural resources that can be utilized for the production of new goods and services. The characteristics of land can be summarized using the terms gifts of nature, permanence, and legal rights.
  • Labor as a factor of production refers to the human efforts utilized for the production of new goods and services. Labor can be characterized as a voluntary, painful, and endless activity.
  • Capital as a factor of production refers to the capital resources utilized for the production of new goods and services. Capital can be characterized as manufactured and depreciable resources.
  • Fixed capital is a capital resource that can be used multiple times, while circulating capital can only be used once and is consumed as it is used to produce one good or service.
  • Capital consumption is consumption of fixed or circulating capital during the production process, while economic consumption refers to the decreased value of capital resources due to the development of more efficient technologies or the changing appetites of consumers.
  • Entrepreneurship as a factor of production refers to the organization of resources, risk taking and innovation by individuals known as entrepreneurs for the production of new goods and services.
  • Economic growth refers to the increase in the total output of production from the economy, while economic development refers to the improvement in the quality of life, or living standards, for individuals in the economy.

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