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Factors of Production

An economic concept that refers to the inputs needed to produce goods and services

What are Factors of Production?

Factors of production is an economic concept that refers to the inputs needed to produce goods and services. The factors are land, labor, capital, and entrepreneurship. The four factors consist of resources required to create a good or service, which is measured by a country’s gross domestic product (GDP).

 

Factors of Production

 

In factors of production, the word “production” refers to a process of transforming inputs into outputs, which are finished products that can be sold as a good or service. In order to do so, the input will go through a production process and various stages to reach the hands of consumers.

 

Land as a Factor of Production

Land is a broad term that includes all the natural resources that can be found on land, such as oil, gold, wood, water, and vegetation. Natural resources can be divided into renewable and non-renewable resources.

  • Renewable resources are resources that can be replenished, such as water, vegetation, wind energy, and solar energy.
  • Non-renewable resources consist of resources that can be depleted in supply, such as oil, coal, and natural gas.

All resources, whether it is renewable or non-renewable, can be used as inputs in production in order to produce a good or service. The income that comes from using land and its natural resources is referred to as rent.

Besides using its natural resources, land can also be utilized for various purposes, such as agriculture, residential housing, or commercial buildings. However, land differs from the other factors of production because some natural resources are limited in quantity, so its supply cannot be increased with demand.

 

Labor as a Factor of Production

Labor as a factor of production refers to the effort that individuals exert when they produce a good or service. For example, an artist producing a painting or an author writing a book. Labor itself includes all types of labor performed for an economic reward, such as mental and physical exertion. The value of labor also depends on human capital, which is determined by the individual’s skills, training, education, and productivity.

Productivity is measured by the amount of output someone can produce in each hour of work. The income that comes from labor is referred to as wages. Note that work performed by an individual purely for his/her personal interest is not considered to be labor in an economic context.

The following are several characteristics of labor in terms of being a factor of production:

  • First, labor is considered to be heterogeneous, which refers to the idea of how the efficiency and quality of work are different for each person. It differs because it depends on an individual’s unique skills, knowledge, motivation, work environment, and work satisfaction.
  • Additionally, labor is also perishable in nature, which means that labor cannot be stored or saved up. If an employee does not work a shift today, the time that is lost today cannot be recovered by working another day.
  • Also, another characteristic of labor is that it is strongly associated with human efforts. It means that there are factors that play an important role in labor, such as the flexibility of work schedules, fair treatment of employees, and safe working conditions.

 

Capital as a Factor of Production

Capital, or capital goods, as a factor of production, refers to the money that is used to purchase items that are used to produce goods and services. For example, a company that purchases a factory to produce goods or a truck that is purchased to do construction are considered to be capital goods.

Other examples of capital goods include computers, machines, properties, equipment, and commercial buildings. They are all considered to be capital goods because they are used in a production process and contribute to the productivity of work. The income that comes from capital is referred to as interest.

Below are several defining characteristics of capital as a factor of production:

  • Capital is different from the first two factors because it is created by humans. For example, capital goods like machines and equipment are created by individuals, unlike land and natural resources.
  • Additionally, capital is also a factor that can last a long time, but it depreciates in value over time. For example, a building is a capital good that can endure for a long period of time, but its value will diminish as the building gets older.
  • Capital is also considered to be mobile because it can be transported to different places, such as computers and other equipment.

 

Entrepreneurship as a Factor of Production

Entrepreneurship as a factor of production is a combination of the other three factors. Entrepreneurs use land, labor, and capital in order to produce a good or service for consumers.

Entrepreneurship is involved with establishing innovative ideas and putting that into action by planning and organizing production. Entrepreneurs are important because they are the ones taking the risk of the business and identifying potential opportunities. The income that entrepreneurs earn is called profit.

 

More Resources

If you would like to gain valuable skills that can help develop your journey in corporate finance, CFI is the official provider of the Financial Modeling & Valuation Analyst (FMVA)® certification program. CFI also offers a variety of courses and related readings for you to continue learning, including:

  • Economics of Production
  • Physical Capital
  • Externality of Production
  • Remuneration

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!