Why Are the Factors of Production Important to Economic Growth?

Economic growth is the increase in the production of goods and services from one period to the next. As such, the value of these goods and services increases, resulting in larger corporate profits. It has a snowball effect, which often leads to higher stock prices and a rise in employment. Companies have more capital to invest in new ventures and consumers are able to spend more.

As such, economic growth is one of the most-watched indicators, if not the most important. Economists measure it in real terms, which factors in inflation, or in nominal terms. Aggregate growth is commonly measured as a nation's gross national product (GNP) or gross domestic product (GDP).

But how does economic growth work and what factors affect it? It only comes by increasing the quality and quantity of the factors of production, which are the resources used in creating or manufacturing a good or service. Keep reading to learn more about these four factors—land, labor, capital, and entrepreneurship—and what makes them so important.

Key Takeaways

  • Economic growth is the increase in the production of goods and services over a period of time and is dependent on the four factors of production.
  • Land is defined as agricultural land, commercial real estate, and natural resources, such as oil, gas, and other commodities.
  • Labor is made up of the individuals who are responsible for the development of goods and services.
  • Capital goods, such as tools, equipment, and machinery, are part of the capital category.
  • The final factor of production is entrepreneurship, which includes the visionaries and innovators who are behind the production process.

Understanding the Factors of Production

The factors of production are inputs that companies need to develop goods and services. This enables them to earn profits. The concept of these factors dates back to neoclassical economics, combining historic economic theories with other ideas, such as the idea of labor. As noted above, the four factors of production are land, labor, capital, and entrepreneurship. The Federal Reserve Bank of St Louis defines the factors of production as:

"Resources that are the building blocks of the economy; they are what people use to produce goods and services."

We highlight what each of these means below.

Land

When most people think of land, they automatically assume it means agricultural land. While that's true, it isn't the only thing that makes up this factor. Land doesn't just refer to natural resources, but it can also include commercial real estate and renewable resources like forests. Producers also use natural resources that come from the earth, which also fit into this category. These resources include:

  • Oil and gas
  • Coal
  • Silver, copper, and other metals
  • Other commodities

Land is generally considered one of the most important factors of production. Certain industries rely on land more than others. For instance, a real estate developer needs it to make good on its investments. But technology companies and those that rely on automation tend to rely less on land, making it a less significant factor of production.

Labor

Labor consists of the people who are responsible for the creation of goods and services (from beginning to end) and the effort they put forth. These individuals include factory workers, managers, salespeople, and engineers who design the machinery used in production. As such, it can take on many forms. For instance, the effort of construction workers who work on a building site and quality control workers who ensure products are ready to go to market make up this category.

Individuals are compensated for their time and effort, and the amount they are paid depends on the skills they bring to the table. People with fewer skills and training tend to earn lower wages while people who are educated and highly skilled get paid more.

Innovation, though, is changing the labor force. Automation, increased technology, and equipment are putting a dent into the need for workers. Companies that continue to innovate their production processes rely less on human labor. For instance, the invention and availability of equipment cut out the need for physical laborers on farms.

As an investor, you can identify investment opportunities in companies that are improving their factors of production.

Capital

Although most people think capital is cash, the term here actually describes a number of other assets. Capital goods are also considered capital, which includes manufacturing plants, machinery, tools, or any equipment used in the production process. Capital may also refer to a fleet of trucks or forklifts as well as heavy machinery.

When the economy is flourishing and expands, corporations are able to access capital so they can spend and make investments and continue making profits. During times of economic contraction, though, they must cut costs to preserve capital to ensure they are still profitable. All of this is necessary in order to ensure that they can continue bringing new products and services to market.

Keep in mind, though, that capital only refers to assets used for business purposes and for the production of goods and services. As such, it doesn't apply to anything that is meant for personal use.

Entrepreneurship

Entrepreneurship is the fourth factor and includes the visionaries and innovators behind the entire production process. The entrepreneurs combine all the other factors of production to conceptualize, create, and produce the product or service. They are the drivers behind any technical change in the economic system which has been shown to be a major source of economic growth.

Economists believe that entrepreneurship is one of the most integral parts of the production process. That's because it uses all three of the other factors in the manufacturing of goods and services.

The success of entrepreneurs depends entirely on the development of a business plan. This is a document that business owners use to describe how their company operates, its objectives, and its short- and long-term goals. Once the business plan is developed, entrepreneurs should look for resources, hire personnel, and get access to financing.

The Solow residual is the residual growth rate of output that cannot be attributed to this growth in inputs. Also known as total factor productivity, this residual includes things like the state of technological progress and innovation.

The Importance of the Factors of Production

If businesses can improve the efficiency of the factors of production, it stands to reason that they can increase production and create higher quality goods at lower prices. Any increase in production leads to economic growth as measured by GDP. This metric merely represents the total production of all goods and services in an economy. Improved economic growth raises the standard of living by lowering costs and raising wages.

Capital goods include technological advances from iPhones, to cloud computing, to electric cars. For example, in the last several years, the technology of fracking or horizontal drilling has led to improved extraction of oil making the U.S. one of the world's largest oil producers. The innovation couldn't be done without the labor behind the process, from conceptualization to the finished product.

However, as technology helps to increase the efficiency of the factors of production, it can also replace labor to reduce costs as we highlighted above. For example, artificial intelligence and robotic machines are used in manufacturing boosting productivity, reducing costly errors from human beings, and ultimately reducing labor costs.

Of course, nothing gets started without the entrepreneurs who create a vision and the action steps needed to design the production process. Entrepreneurs combine all the factors of production, including buying the land or raw materials, hiring the labor, and investing in the capital goods necessary to bring a finished product to market.

What Are the 4 Factors of Economic Growth?

The four main factors of economic growth are land, labor, capital, and entrepreneurship.

How Does Technology Impact Economic Growth?

Technology is a key driver to economic growth by making production processes quicker and more efficient. Increased efficiencies translate to an increase in output. This means that companies are able to produce more goods and services in a shorter amount of time. Keep in mind, though, that technology often leads to automation in the production of goods and services, which often translates to a reduction in jobs.

Is Money a Factor of Production?

Money isn't considered a factor of production but it does help make the production process easier. That's because it isn't actually a productive resource so it isn't directly involved in the production of goods and services. Instead, money is used to pay for raw materials, wages, and other materials.

The Bottom Line

As Parmenides, a Greek philosopher, famously quipped, "Nothing comes from nothing." Economic growth results from better factors of production. This process is clearly demonstrated when an economy undergoes industrialization or other technological revolutions; each hour of labor can generate increasing amounts of valuable goods.

Article Sources

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  1. Federal Reserve Bank of St. Louis. "Factors of Production - The Economic Lowdown Podcast Series."

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