Factors of Production (Encyclopedia of Business and Finance)
Land, labor, capital, and entrepreneurship: These are four generally recognized factors of production. Of course, in a literal sense anything contributing to the productive process is a factor of production. However, economists seek to classify all inputs into a few broad categories, so standard usage refers to the categories themselves as factors. Before the twentieth century, only three factors making up the "classical triad" were recognized: land, labor, and capital. Entrepreneurship is a fairly recent addition.
The factor concept is used to construct models illustrating general features of the economic process without getting caught up in inessential details. These include models purporting to explain growth, value, choice of production method, income distribution, and social classes. A major conceptual application is in the theory of production functions. One intuitive basis for the classification of the factors of production is the manner of payment for their services: rent for land, wages for labor, interest for capital, and profit for entrepreneurship. A discussion of each of the factors follows.
This category sometimes extends over all natural resources. It is intended to represent the contribution to production of nonhuman resources as found in their original, unimproved form.
For the French physiocrats led by Francois Quesnay in the 1750s and 1760s, land was the only factor yielding a reliable gain to its owner. In their view, laborers and artisans were powerless and in excess supply, and hence they earned on average only a subsistence-level income; and in the same way what they produced outside of agriculture fetched enough to cover only their wages and input costs with no margin for profit. Only in agriculture, due to soil fertility and other "gifts of nature," could a laborer palpably produce more than required to cover subsistence and other costs, so only in agriculture could proprietors collect surplus. Thus the physiocrats explained land rent as coming from surplus produced
by the land. They recommended taxes on land as the only sound way to raise revenue and land-grabbing as the best means to increase the government's revenue base.
In 1821 David Ricardo, in The Principles of Political Economy and Taxation, stated what came to be known as the classical view: that rent reflects scarcity of good land. The value of a crop depends on the labor required to produce it on the worst land under cultivation. This worst land yields no rents long as some of it remains unusednd rent collected on better land is simply its yield in excess of that on the worst land. Ricardo saw rent as coming from differences in land quality (including accessibility) and scarcity. The classical economists assumed only landnderstood as natural resourcesould be scarce in the long term.
Marginalism, as expounded in 1899 by John Bates Clark in The Distribution of Wealth, takes a different approach. It declares that rent reflects the marginal productivity of landot, as with Ricardo, the productivity of good versus marginal land. Marginal productivity is the extra output obtained by extending a constant amount of labor and capital over an additional unit of land of uniform quality. Marginalists held that any factor of production could be scarce. Their theory is based on the possibility of substituting among factors to design alternative production methods, whereby the optimal production method allocates all the factors to equalize their marginal productivity with their marginal costs.
Long thought of as a self-sustaining input, land might depreciate just like produced assets do. In 1989 Herman Daly and Jonathan Cobb, in For the Common Good, distinguished between nonrenewable resources that are consumed or depreciate irretrievably, and renewable resources where the rate of natural renewal is important. One consequence of this work in environmental economics is that natural resource accounting increasingly resembles capital accounting.
The classical "labor theory of value" was an innovative theory in response to the physiocratic doctrine that only land could yield surplus. In 1776 Adam Smith, in The Wealth of Nations, observed that with expansion of production and trade, enterprises were making profits over long periods of time, although they either had nothing to do with agriculture or else as agricultural enterprises. Classical economists tried to answer the question: Where does profit come from? Their answer was that it came from labor. At prevailing prices, labor can yield a surplus over subsistence costs in many industries.
The question arises of why proprietors, but not laborers, earn profit. Ricardo arrived at one answer: Technical innovation increases labor productivity. Owners of innovative equipment, until its general adoption, get the premium from reduced costs. In 1867 Karl Marx in Capital, added that wages reflect the cost of subsistence, not what laborers can produce, and that profit is the difference between the two. Even without innovation proprietors would reap surpluses, Marx held, since laborers lack market power and cannot afford their own equipment.
Why do wages differ for different types of labor? Marx's answer was that higher wages cover costs, beyond personal subsistence, of training and cultivation of skills, acknowledging that one kind of "equipment," now known as human capital, was available at least to some laborers.
Marginalist economists noticed the advance of technology, which according to classical and Marxist views made labor ever more productive, continually throws laborers out of work. This led them to attribute productivity to equipment rather than only to labor. Referring to equipment as capital, they developed production functions featuring labor and capital as substitutes for each other. Choice among production techniques involving different combinations of labor and capital became a major theme in marginalist growth theory.
This most controversial of factors is variously defined as produced equipment; as finance used to acquire produced equipment; as all finance used to begin and carry on production, including the "wage fund"; and as the assessed value of the whole productive enterprise, including intangibles such as "goodwill." In 1960 Piero Sraffa, in Production of Commodities by Means of Commodities, showed that capital in the sense of produced equipment can fail to behave as expected in marginalist production functions when an entire economy is modeled. Specifically, equipment adopted to replace labor after wages rise from a low level, relative to interest on capital, may be abandoned again in favor of labor as wages rise still higher. This counterintuitive "reswitching" can happen because the equipment used is itself a product of labor and equipment, and because the ratio of labor to equipment varies for different products.
Frequently capital is treated as finance, associated with the payment of interest. Yet the connection with equipment, in spite of Sraffa's demonstration, has never been severed entirely. One still studies capital depreciation, distinguishing wear-and-tear from obsolescence, and from the present value of investments in capital. Increasingly, theory has come to treat any investment as a capital investment. Furthermore, acquired skills (as opposed to "know-how," an attribute of society rather than individuals) have come to be viewed as analogous to physical equipment, capable of yielding their owners a return. This analogy suggests their current designation as human capital. Thus capital is a concept still mired in confusion, and care must be taken in its use to be sure what it means.
Until the twentieth century, this function was assigned to the capitalist and frequently conflated with capital. In the classical view, profit rather than interest was attributed to ownership of capital. In the marginalist view, capital earned interest, and profit was a mere residual after all the factors of production were compensated. In his Principles of Economics, first published in 1890, Alfred Marshall made extensive references to "organization" and "management," referring to the coordination function of entrepreneurship but to neither risk-assuming nor innovation. But in 1912 Joseph Schumpeter, in The Theory of Economic Development, featured the revolutionary role of organizer and innovator and contrasted it with that of the conservative financier, thus vividly distinguishing the entrepreneur from the capitalist. The entrepreneur's role in this view is not merely that of manager and risk-taker, but also of visionaryomeone who seeks as much to destroy the old order as to create something new. Since innovation usually requires destroying old ways of doing things, Schumpeter gave it the name "creative destruction." Profit is now assigned to entrepreneurship, to innovation. With the rise of "venture capitalists" and other financiers willing to take on more risk and do more for innovation in the hope for supernormal returns, the distinction between capitalist and entrepreneur has again become fuzzier. Now there are entrepreneurial financiers as well as entrepreneurial producers and distributors.
Although in business usage stock dividends are distributed profits, in economic analysis they figure as returns to capital, a kind of interest payment, since they are a return to finance rather than to entrepreneurship. The fact that stocks are legally equity rather than debt shares is thereby ignored. Similarly, salaries of corporate executive officers are treated as profit, a return to entrepreneurship, rather than as wages for labor services.
Clark, John Bates (1899/1966). The Distribution of Wealth. Clifton, NJ: Augustus M. Kelley.
Daly, Herman E., and Cobb, Jonathan. (1989). For the Common Good: Redirecting the Economy Toward Community, the Environment, and a Sustainable Future. Boston: Beacon Press.
Marshall, Alfred. (1920). Principles of Economics. New York: Macmillan.
Marx, Karl. (1867/1977). Capital, vol. I. New York: Vintage Books.
Ricardo, David. (1821/1965). The Principles of Political Economy and Taxation. London: Everyman's Library.
Schumpeter, Joseph. (1934/1912). The Theory of Economic Development. Cambridge, Mass.: Harvard University Press.
Schumpeter, Joseph. (1954). History of Economic Analysis. New York: Oxford University Press.
Smith, Adam. (1776/1965). An Inquiry into the Nature and Causes of the Wealth of Nations. New York: Modern Library.
Sraffa, Piero. (1960/1963). Production of Commodities by Means of Commodities. London: Cambridge University Press.