Factors of Production

Factors of production are the basic inputs used to produce goods and services. Economists traditionally group them into land (natural resources), labor (human effort), capital (produced tools, machines and buildings) and, in many textbooks, entrepreneurship (the organizing and risk-taking that combines the others). The framework is used to explain what an economy can produce, how income is divided and why some countries are richer than others. In many introductory textbooks and school courses, the same inputs are called productive resources or simply economic resources.

Each factor earns a characteristic income: land earns rent, labor earns wages, capital earns interest and entrepreneurs earn profit. Capital in this sense means real capital goods, not money; a bank deposit is financial capital that may be used to buy them. The factors are also distinct from intermediate inputs such as raw materials and components, which are used up in production and counted separately when measuring value added.

Think of a small pizza shop. It needs a place to stand and ingredients that come from farms (land), people to make and serve the pizzas (labor), ovens, tables and a delivery scooter (capital), and someone who decides to open the shop, chooses the menu and takes the risk that customers may not come (the entrepreneur).

Take away any one and there is no pizza. Add more of one, say a second oven, and output may rise, but only if there are enough cooks to use it. Production is about combining these ingredients in the right proportions.

• Land. All natural resources: ground, water, minerals, forests and energy sources. Its supply is essentially fixed, and the surplus it earns is often economic rent.
• Labor. The time and effort of workers. Its quality depends on human capital, the skills, education and health that make people more productive.
• Capital. Produced means of production, such as factories, machines, vehicles, software and infrastructure, built by saving and investment.
• Entrepreneurship. The work of the entrepreneur, who spots opportunities, organizes the other factors and bears uncertainty. Alfred Marshall called this fourth factor "organization".

The triad of land, labor and capital comes from classical economics; Jean-Baptiste Say linked each factor to its form of income in the early 19th century. Karl Marx rejected the idea that capital creates value, holding to the labor theory of value and treating profit as unpaid labor, a central argument of Marxism. Modern economists sometimes add knowledge, data, energy or institutions as separate factors, though there is no agreed list.

Economists describe how factors turn into output with a production function. A widely used form, popularized by Charles Cobb and Paul Douglas in 1928, is:

• $Y$ is output.
• $K$ is capital and $L$ is labor.
• $A$ is total factor productivity, capturing technology and efficiency.
• $\alpha$ is capital's share of income, a number between 0 and 1.

Suppose $A = 1$, $K = 100$, $L = 100$ and $\alpha = 0.3$. Output is $100^{0.3} \times 100^{0.7} = 100$. Doubling both capital and labor to 200 doubles output to 200, which is called constant returns to scale. Doubling only capital, however, raises output to about 123, because each extra unit of one factor adds less when the others are held fixed, the law of diminishing returns. Robert Solow used this framework in the 1950s to show that much of long-run growth in output per worker comes not from more capital or labor but from technological progress, measured by the residual $A$.

Factors are bought and sold in factor markets: labor markets, rental markets for land and buildings, and capital markets. In competitive theory, each factor is paid roughly the value of what its last unit adds to output. How total income splits between labor and capital is measured by the labor share of national income, and many studies have reported a decline in that share in advanced economies since the 1980s, with explanations ranging from technology and globalization to market power and weaker trade unions.

The mix of factors also shapes trade. Countries tend to export goods that use their abundant factors intensively, an idea developed by Eli Heckscher and Bertil Ohlin, which builds on comparative advantage. Growth in productivity raises the output from a given set of factors, while the division of labor and economies of scale explain why organizing factors well can matter as much as having more of them.

The four-factor scheme is a simplification. Capital is a mix of very different goods and is hard to add up in a single number, a problem at the center of the "Cambridge capital controversy" of the 1950s and 1960s. Factors are not always distinct: human capital blends labor and investment, and land improvements blend land and capital. Intangible inputs such as software, brands and organizational know-how are now a large share of business investment and are difficult to measure, which complicates estimates of GDP and productivity.

• OpenStax, Principles of Economics 3e: Production in the Long Run