What are Factors of Production?

Factors of production are like everything that goes into baking a cake…

From the sugar to the flour, all the ingredients came from crops (land). Even the eggs came from chickens that ate grains or corn grown in the soil. You expend time and energy to mix the ingredients together (labor). You need a bowl, a whisk, a cake pan, and an oven (capital) to bake the cake. Someone used innovation and imagination to come up with the recipe, and you put in the effort to bring the other factors of production together (entrepreneurship).

In the 18th century, classical economists like Adam Smith observed that the market price of products could be broken down into different components. They called these the three factors of production: land, labor, and capital. Later economists added a fourth factor called enterprise (or entrepreneurship).

Initially, land referred to the soil in which crops grow. The term now includes all natural resources humans take from the earth and seas, unchanged from their original condition. That gold, iron, oil, water, and all the other raw materials used to produce goods. The income that owners of land earn for its use is called rent.

Labor transforms the land (including the resources extracted from it) into goods and services. Traditionally, labor referred to the effort exerted to work the land. A modern definition of labor includes all work in exchange for wages (not profits, which are reserved for entrepreneurs). When a musician is composing for money, it’s labor. When he or she does it for fun, it’s not. This broader definition of labor also captures the work that does not directly contribute to a final product. That includes project management, supervision, human resources, and all the other roles that don’t fit the traditional definition.

Although “capital” in business and economics often refers to financial capital (money), that’s not the case here. As a factor of production, capital refers to all the tools and equipment used in the process of making other goods. Buildings, office equipment, machinery, and software programs are considered capital. Money is used to purchase those things, but it’s not used directly to make products.

Capital is itself a product of other factors of production. For example, buildings are made of wood, steel, concrete, and other construction materials that are assembled with labor and equipment. Altogether, a finished product can represent the efforts of thousands of workers transforming materials into incrementally higher-value products. Things built with the end-user in mind are called consumer goods, whereas items created to produce other products are called capital goods.

Capital, often called fixed capital, tends to be durable and used by a business over several years. In accounting, a capital asset must be depreciated (the value of the asset erodes over time on the company’s books) over its useful life. It usually gets tracked as property, plant, and equipment (PP&E) on a company’s balance sheet.

That contrasts with the term “working capital,” which is a financial measure of a company's liquid assets. In general, working capital and financial capital don’t fall under the definition of capital as a factor of production. Other forms of capital described in the field of microeconomics — such as social capital (benefits from relationships and networks) or human capital (education and technical skills) — also fall outside the scope.

It is worth noting that capital is commonly a substitute for labor. Tools can make workers more productive, reducing the need for labor. For example, it might take 10 people an hour to dig a hole that one person with a backhoe can dig in five minutes. Equipment can also replace labor entirely through automation. The income owners of capital earn is called interest.

People can work their land until the cows come home and still not make any money. Business requires more than just making a product. It involves finding out what consumers want, inventing new ways to transform materials and labor into things that satisfy those wants, and then getting products and services to those customers.

Modern economic thought tries to capture these intangible activities as a fourth factor of production: a catch-all category called enterprise, or entrepreneurship.

Enterprise includes the willingness of someone to risk time and money to open a small business. It also refers to the ability to attract customers, invent new products, and improve on existing processes. In short, enterprise is all of those invisible things people do in the background that propel the economy forward. The money entrepreneurs earn is called profit.

All of the factors of production contribute to economic growth. No product can be made without raw materials (land). Those materials can’t be extracted, refined, and transformed without people working (labor). Those people can’t accomplish their work without tools and equipment (capital). And an entrepreneur must combine all of the above in new ways and get products to customers.

One could argue that land is most important, since all physical products originate from the resources it provides. However, professional services and software are increasingly important in the modern economy.

Therefore, you could argue that labor is the most crucial factor of production. For example, German philosopher Karl Marx puts human effort squarely at the center of economic production — with materials acting as the object of labor and equipment acting as its instrument. However, automation is increasingly replacing the need for workers.

Others might argue that capital is the most critical factor. Capital enhances the other factors, and it can increasingly replace labor completely. Of course, one might point out that you can’t have machinery (capital) without the materials (land) to make it. And capital is static without human ingenuity.

Consequently, entrepreneurship is sometimes considered the most vital factor of production. After all, innovation is the heart of all business, and trailblazers are responsible for all technological advancement. But what is the value of an idea without a way to bring it to life?

In the end, all of the factors of production are important. If any of them were missing, nothing could be produced and the economy would grind to a halt.

In modern societies, a person's labor cannot be owned by anyone other than the individual. All of the other factors of production can be owned by people, groups, corporations, or governments, depending on the economic system.

On a small farm in the US, the farmer might own the land and the equipment used to grow crops. In a modern capitalist economy, businesses often own the land and capital they need to do business. Many individual property owners in places like North Dakota and Texas own land but lease their ownership rights to the oil below.

In socialist and communist economic systems, natural resources and capital are usually collectively owned, while private entrepreneurship is limited or prohibited. The government typically decides how to combine land, labor, and capital.

Entrepreneurship is more challenging to pin down. Intellectual property ownership originates with an individual, but can be purchased by companies. If a person gets a patent or copyright, he or she can sell that intellectual property to a corporation. In many cases, a business pays for intellectual property through the wages of the inventor. If making process improvements, spearheading marketing efforts, or increasing the efficiency of workers is your job, you are in some ways selling your entrepreneurship as your labor.

Although technology is becoming ever more important to business and economic growth, it is not generally considered a separate factor of production. Instead, like entrepreneurship, technology plays a key role in putting the other factors of production to work. Technology changes the way all the other factors operate. For example, farmers can now use cutting-edge machine learning tools to predict which crops to plant and when, while automation has transformed the way factories manufacture goods. Entrepreneurs (enterprise) are the ones developing and deploying new technologies.