Human activity can be broken down into two component parts; producing and consuming. Where there is production, a process of transformation takes place. Inputs are converted into outputs. The inputs are classified individually as, land, labour, and capital and collectively as the factors of production.

When the factors of production are combined in order to produce something, a fourth factor is required. Goods and services do not produce themselves but need some conscious thought process in order to plan and implement manufacture. This thought process is often called entrepreneurship. Bill Gates, the founder of Microsoft is an entrepreneur. It is hard to measure what it is that makes Bill Gates more financially successful than say the local seller of computers, and this difficulty of classifying and quantifying entrepreneurship leads some economists to leave it out when listing the factors of production. Others prefer to include entrepreneurship as a factor, whilst recognizing the problems that doing so presents.

Land includes the land itself, and raw materials such as oil and minerals beneath it. Trees grown by foresters are not classed as land because they have been deliberately grown. Trees in a natural rainforest are a natural resource and thus classified as land.

Labour is human effort, mental or physical. Labour is often confused with enterprise. A manager of a bank is not an entrepreneur because he is not risking his own money.

Capital is man-made goods used to produce other goods, e.g., a tractor, a factory, or an industrial robot. Note carefully that money is not a factor of production, money is used to buy factors of production, it is not a factor itself.

Enterprise (Entrepreneurship) is the risk-taking activity that utilizes land, labour and capital to produce goods or services in the expectation of a future reward.

It is tempting to believe that companies can own things. However a company is a specific type of legal construction, or ‘legal entity’ as they are sometimes called. Shareholders own companies like British Airways, and the shareholders ultimately own anything the company owns. So whilst it might at first appear that a business might own a factor of production, in reality someone owns them somewhere. People therefore let companies use the factors of production temporarily and in return companies give people rewards.

In the everyday use of English we hear people say that they are renting an apartment or renting a shop. The economist reserves the word rent to mean the reward for letting others use your land. The physical buildings that sit upon the land are examples of capital goods, and the reward for this we call interest. Interest in this context does not mean the amount you get when you save money in a bank.

The reward for physical and mental work is called wages. Historically wages are the pay that unskilled or semi-skilled labour gets at the end of the week. In the economic meaning wages are any form of payment to labour, so this includes wages, salaries and bonuses. Salary is a business term that means an annual sum paid to professional workers on a monthly basis. Profit, thankfully, is used in the same way in business, everyday language and in economics. It is the reward for entrepreneurship.

In summary, the rewards to the factors of production are: rent for land, wages for labour, interest for capital, and profit for enterprise.

Because goods and services are scarce they have a value. To get these goods or services we must sacrifice something, usually time and money. However in economics we use the concept of opportunity cost rather than money to explain this sacrifice. To get a good or service this means giving up, or forgoing - as we like to say, something. For example to buy a new computer you might have to give up going on holiday. For me, going on holiday is the next-best decision to buying the computer, although for you it might be something else. This giving-up or sacrifice of something is referred to specifically as opportunity cost. The precise definition of opportunity cost is; the benefit foregone from the next best alternative to a particular economic decision. Strictly speaking then, the opportunity cost of my computer is not the holiday but the benefit from the holiday. Examiners may not be so precise!

A free good is a good that has no opportunity cost. This means nothing has to be foregone. I live by the sea and for me seawater is a reasonable example of a free good because I can have as much of it as I like, and I don’t have to give up anything else to get it. On the other hand I would like a new car, but to get this I would have to give up the idea of buying a bigger house, so a car is an example of what we call an economic good. In economics we are not interested in studying free goods but only goods that involve a choice. Another way of explaining this choice is with the phrase ‘trade-off’. A trade-off happens when one thing is forgone for another, as in the example of a computer and a holiday but it could be a trade off over time too. By spending more time staying at school now, you hope for a better job and salary in the future.

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factors of production