Understanding the meaning, types and factors of production is very necessary for any business as it aids your decision making with regards to different ways to establish and promote your business successfully.
Let us make an in-depth study of the meaning, definition, types and factors of production.
Meaning of Production
Since the primary purpose of economic activity is to produce utility for individuals, we count as production during a time period all activity which either creates utility during the period or which increases ability of the society to create utility in the future.
Business firms are important components (units) of the economic system. They are artificial entities created by individuals for the purpose of organizing and facilitating production.
The essential characteristics of the business firm is that it purchases factors of production such as land, labour, capital, intermediate goods, and raw material from households and other business firms and transforms those resources into different goods or services which it sells to its customers, other business firms and various units of the government as also to foreign countries.
Definition of Production
According to Bates and Parkinson:
“Production is the organized activity of transforming resources into finished products in the form of goods and services; the objective of production is to satisfy the demand for such transformed resources”.
According to J. R. Hicks:
“Production is any activity directed to the satisfaction of other peoples’ wants through exchange”. This definition makes it clear that, in economics, we do not treat the mere making of things as production. What is made must be designed to satisfy wants.
What is not Production?
The making or doing of things which are not wanted or are made just for the fun of it does not qualify as production. On the other hand, all jobs which do aim at satisfying wants are part of production.
Those who provide services Such as hair-dressers, solicitors, bus drivers, postmen, and clerks are as much a part of the process of satisfying wants as are farmers, miners, factory workers and bakers.
The test of whether or not any activity is productive is whether or not anyone will buy its end-product. If we will buy something we must want it; if we are not willing to buy it then, in economic terms, we do not want it.
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Importance of Exchange:
So from our above definition it is clear that many valuable activities such as the work done by people in their own houses and gardens (the so-called do it yourself exercise) and all voluntary work (such as free coaching, free-nursing, collection of subscription for a social cause such as flood-relief or earthquake- relief) immensely add to the quality of life but there is no practical way of measuring their economic worth (value).
This being so, and because in economics an important task is to measure changes in the volume of production, it is necessary to add the qualifying clause ‘through exchange’, i.e., in return for money, to the definition of production.
Three Types of Production
For general purposes, it is necessary to classify production into three main groups:
1) Primary Production
Primary production is carried out by ‘extractive’ industries like agriculture, forestry, fishing, mining and oil extraction. These industries are engaged in such activities as extracting the gifts of Nature from the earth’s surface, from beneath the earth’s surface and from the oceans.
2) Secondary Production
This includes production in manufacturing industry, viz., turning out semi-finished and finished goods from raw materials and intermediate goods— conversion of flour into bread or iron ore into finished steel.
They are generally described as manufacturing and construction industries, such as the manufacture of cars, furnishing, clothing and chemicals, as also engineering and building.
3) Tertiary Production
Industries in the tertiary sector produce all those services which enable the finished goods to be put in the hands of consumers. In fact, these services are supplied to the firms in all types of industry and directly to consumers.
Examples cover distributive traders, banking, insurance, transport and communications. Government services, such as law, administration, education, health and defense, are also included.
Any activity connected with money earning and money-spending is called an economic activity. Production is an important economic activity. It results in the output (creation) of an enormous variety of economic goods and services.
Factors of Production
Production of a commodity or service requires the use of certain resources or factors of production. Since most of the resources necessary to carry on production are scarce relative to demand for them they are called economic resources.
Resources, which we shall call factors of production, are combined in various ways, by firms or enterprises, to produce an annual flow of goods and services.
Each factor gets a reward on the basis of its contribution to the production process, as shown in the table.
In fact, the resources of any community, referred to as its factors of production, can be classified in a number of ways, but it is common to group them according to certain characteristics which they possess.
If we keep in mind that the production of goods and services is the result of people working with natural resources and with equipment such as tools, machinery and buildings, a generally acceptable classification can readily be derived.
The traditional division of factors of production distinguishes labor, land and capital, with a fourth factor, enterprise, some-times separated from the rest.
The people involved in production use their skills and efforts to make things and do things that are wanted. This human effort is known as labor. In other words, labor represents all human resources.
The natural resources people use are called land. And the equipment they use is called capital, which refers to all man-made resources.
The first three factors—land; labor and capital do not work independently or in isolation. There is need to combine these factors and co-ordinate their activities. This two-fold function is performed by the organizer or the entrepreneur.
But this is not the only function of the entrepreneur. In fact, production can never take place without some risk being involved; the decision to produce something has to be taken in anticipation of demand and there must be some element of uncertainty about that demand materializing.
Thus, risk taking or enterprise can be considered as a fourth factor of production, and those responsible for taking these risks are usually referred to as entrepreneurs (see the box below which is self-explanatory).
We may now study the nature and characteristics of four factors against this backdrop. But before we proceed further we may make a passing reference to factor mobility.
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(1) Land and Natural Resources
In economics the term land is used in a broad sense to refer to all natural resources or gifts of nature. As the Penguin Dictionary of Economics has put it:
“Land in economics is taken to mean not simply that part of the earth’s surface not covered by water, but also all the free gifts of nature’s such as minerals, soil fertility, as also the resources of sea. Land provides both space and specific resources”.
From the above definition, it is quite clear that land includes farming and building land, forests, and mineral deposits. Fisheries, rivers, lakes, etc. all those natural resources (or gifts of nature) which help us (the members of the society) to produce useful goods and services.
In other words, land includes not only the land surface, but also the fish in the sea, the heat of the sun that helps to dry grapes and change them into resins, the rain that helps farmers to grow crops, the mineral wealth below the surface of the earth and so on.
Characteristics of Land
Land has certain important characteristics:
1) Fixed supply
The total land area of earth (in the sense of the surface area available to men) is fixed. Therefore, the supply of lands is strictly limited. It is, no doubt, possible to increase the supply of land in a particular region to some extent through reclamation of land from sea areas or deforestation.
But this is often offset by various kinds of soil erosion. The end result is that changes in the total area are really insignificant. Of course, the effective supply of agricultural (farm) land can be increased by drainage, irrigation and use of fertilisers.
In consequence, the prices of land and natural resources tend to be extremely sensitive to changes in consumer demand, rising sharply if they become more desirable. In this context, we may refer to the sharp increase in the price of building land in Bombay in the last five decades.
However, new discoveries are often stimulated by high prices (as in the case of Calcutta’s Salt Lake area), and like that of oil in the U.K.’s North Sea, which tend to moderate price increases.
2) Alternative uses
Although the total supply of land is fixed, land has alternative uses. The same plot of land can be used to set up factories or to grow wheat or sugarcane or even to build a stadium.
This means that the supply of land to a particular use is fairly (if not completely) elastic. For example, the amount of land used for growing tomato can be increased by growing less of some other crop (e.g., cauliflower).
The supply of building land can be increased by reducing the area under agricultural operation.
3) No cost of production
Since land is a gift of nature, it has no cost of production. Since land is already in existence, no costs are to be incurred in creating it.
In this sense, land differs from both labor (which has to be reared, educated and trained) and capital (which has to be created by using labor and other scarce resources or by spending money).
So, it logically follows that the entire return from land—called rent—is a surplus income (at least from society’s point of view). As Stanlake has rightly put it, “any increase in the value of natural resources due to rising populations and rising incomes accrues to the owners of these resources as a windfall gain—it does not arise from any efforts on their part”.
However, the above argument is not valid today. In fact, much of the services of land required expenditure of resources to obtain or maintain them and hence they are often called capital (i.e. produced means of production). So is land, as a factor of production, ‘really distinct’ from capital.
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4) Differences in fertility
Another important feature of land is that it is not homogeneous. All grades (plots) of land are not equally productive or fertile. Some grades of land are more productive than others.
And Ricardo argued that rent arises not only due to scarcity of land as a factor but also due to differences in the fertility of the soil.
5) Operation of the law of diminishing return
Finally, we may refer to a special feature of land, not shared by other factors. In fact, production on land is subject to the operation of the law of diminishing return.
As Alfred Marshall has put it “while the part which nature plays in production shows a tendency to diminishing return, the part which man plays shows a tendency to increasing return”.
This simply means that as more and more workers are employed on the same plot of land, output per worker will gradually fall (because each additional worker will make less and less contribution to total product). The law of diminishing return refers to diminishing marginal product of the variable factor.
Land is not geographically mobile. But, it is occupationally mobile. In most parts of India, for example, land has many alternative uses. It might be used for farmland, roads, railways, airlines, public parks, playgrounds, residential housing, office buildings, shopping complex, and so on.
Some of the land, for example, in hill area, of say, Shillong, or Darjeeling, has an extremely limited degree of occupational mobility, being useful perhaps for sheep grazing, golf course or as a center of tourism.
The income received by the owner of land is known as rent. It may be noted that rent is usually paid for something more than the use of land or another natural resource, but includes also an element of payment for another factor which is involved in making the resource available in a usable form.
An example of this is the labor which assists in the process of bringing minerals to the surface. Iron ore is of no use while it is still under the ground.
Productivity and value of land can be increased if it is improved with fertilizers, irrigation and the erection of fences and buildings. So rent paid for this kind of fertile land is rather a mixed type of factor income.
Like land, labour is also a primary factor of production. The distinctive feature of the factor of production, called labour, is that it provides a human service.
It refers to human effect of any kind—physical and mental— which is directed to the production of goods and services. ‘Labour’ is the collective name given to the productive services embodied in human physical effort, skill, intellectual powers, etc.
As such, there are different types of labour input, varying in effort and skill content, and in particular types of skill content. Thus, like ‘land’, labour is not homogeneous. The term covers clerical, managerial and administrative functions as well as skilled and unskilled manual work.
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Land and Labour:
Labour differs from land in an important way. While land is a stock, labour is a flow. The term ‘labour’ is used to refer to the flow of labour service per unit of time. So labour is perishable.
If we do not make use of today’s labour power, a correspondingly large amount is not made available tomorrow (and in future).
A related, but important point should be noted in this context. The worker sells his services in the market, but retains his capital (working ability).
In other words, what is bought and sold is the service of labour, not labour itself. A firm cannot buy and sell labour in the same way that it can buy land and capital.
Another important point to note is that labour is not only a factor of production. The supplier of labour—the worker—is also a consumer. Thus, labour plays a dual role in a modern economy. Labour is both the subject and the object of production.
This means two things:
(1) That the production of anything requires the use of labour as a factor, and
(2) That almost everything is produced to satisfy the needs of the workers, who are the main consumers.
In fact, any economic activity takes place to satisfy the consumers. And, consumption demand provides the business people with the incentive to undertake production.
Peculiarities of Labour as a Factor:
In examining labour markets, it is important to recognise that labour has a number of special characteristics which distinguish it from ordinary commodities.
1. First, labour market transactions are particularly significant for:
First, labour market transactions are particularly significant for the individual worker. Much of a person’s life style and relations with other people depend on the job he or she does.
Furthermore, the employment of labour involves a continuing personal relationship between employers and employees, whereas transactions in market for goods are often brief and impersonal.
2. Labour is an end and means in itself:
A commodity is only a means of production and the object of production is its consumption by labour. Labour, therefore, becomes a means to its own end.
3. Thirdly, the individual sells his services but not himself:
The employer, however, must be able to exert some control or authority over the actions of employees. This is not a very simple matter, which can be covered unambiguously by a contract of employment.
A great deal of energy has been devoted to planning systems for the direction of employees, and even a brief examination of the state of industrial relations in most countries shows that still much remains to be done.
4. Labour is inseparable from the labourer:
In other words, labour and the labourer go together. When the seller sells a commodity he does not necessarily go with the commodity. But the labour can supply his labour only when he goes with it.
Moreover, when a seller sells a commodity he parts with it. But when a labourer sells his labour, he retains the quality with him. He may gain the satisfaction of his services, but he cannot be separated from the labour.
5. Fifthly, the individual must be present when the labour services are used and thus a fifth feature is that labour services are not transferable:
For example, a person who has agreed to carry out certain tasks cannot transfer his services to someone else to do the work, while he does something else. This contrasts with commodities which can be transferred among individuals.
One consequence of having to ‘deliver’ the services personally is that employees have strong views on how their services should be used. Working conditions are of central importance to workers. It also means that workers must live near their place of work. The location may significantly affect labour market decisions.
6. Sixthly, labour services cannot be stored:
Labour cannot be ‘saved’ or stored for future use (although rest may enhance performance to some extent).
7. Labour is perishable:
A commodity, if it is not disposed off today, can be disposed off the next day and it may not lose its value. Labour, however, is perishable in this that if the labourer is not able to sell his services for a day he cannot get the value for that day. It is lost forever; it is because of this that labour has a weak bargaining power.
8. Labour is affected by surroundings:
A commodity is usually very much affected by its surrounding; a labourer is very much affected by the surroundings because he is a living being. Therefore, any change in atmosphere has an effect on his health feelings etc.
9. The supply of labour is independent of its demand:
In case of most commodities we see that supply usually varies with demand but in case of labour its supply is in no way related to demand. Both are determined by different factors.
10. Finally, labour services are enhanced by training:
Skill acquisition is often a lengthy and costly process. However, adjustments in the labour market, such as increasing the supply of a particular skill, often requires a long time.
This also means that individuals do not usually train for more than one occupation as they only have a limited working life over which to justify the investment.
Mobility of Labour:
The mobility of labour has two aspects:
(a) The spatial or geographical mobility of labour, which relates to the rate at which workers move between geographical areas and regions in response to differences in wages and job availability (e.g., a worker from West Bengal moving to Mumbai) and
(b) The occupational mobility of labour which relates to the extent to which workers change occupations or skills in response to differences in wages or job availability (e.g., a jute mill worker joining a tea garden).
It may apparently seem that labour is the most mobile of all factors—both occupationally and geographically. Workers can move both freely from one industry to another and from one region to another.
The reward or price that is paid to labour in return for the services it performs is known as a wage or salary. A man’s wages are associated with his productivity or efficiency and this, in its turn, depends on a variety of factors including the education and job training he has received, his innate skill and the extent to which he is motivated to put his best effort in the work he is doing.
In general, the supply of labour varies directly with wages and compensation. Normally, when wages are relatively low, increases in wages will tend to lead to an increase in the supply of labour. However, as wages continue to rise a stage ultimately comes when higher wages (incomes) make leisure more attractive.
When incomes are relatively high, therefore, higher wage rates may actually lead to a fall in the number of hours worked (and, thus, in the amount of labour offered by an individual worker.)
This is why the supply curve of labour bends back to the left and this is often cited as an important exception to the (empirical) law of supply.
Capital, the third agent or factor is the result of past labour and it is used to produce more goods. Capital has, therefore, been defined as ‘produced means of production.’ It is a man-made resource. In a board sense, any product of labour-and-land which is reserved for use in future production is capital.
To put it more clearly, capital is that part of wealth which is not used for the purpose of consumption but is utilised in the process of production. Tools and machinery, bullocks and ploughs, seeds and fertilizers, etc. are examples of capital. We have already identified certain things described as capital in our discussion on producers’ goods.
Even in ancient times, capital was created for producing food, hunting animals and for the transportation of goods. At that stage capital goods consisted of simple tools and implements.
Even in the least developed countries some capital is used. In such countries people make use of simple ploughs, axes, bows and arrows, and leather bags to carry water.
It may be pointed out in this context that the same article may, at one time, be a consumption good and, at another time, capital, depending on the use to which it is put. Thus, if a doctor goes out in his motor car to examine a patient he is using his car as capital.
But if he goes out for a joy ride in his motor car, he is using it as a consumption good. Similarly, when coal is used in a factory, it is capital, but when coal is used as domestic fuel, it is a consumption good.
Economists use the term capital to mean goods used for further production. In the business world, however, capital is always expressed in terms of money. If a businessman is asked, “What is your capital?” he will always mention a sum of money. But money is not capital because money, by itself, cannot produce anything.
The business-person thinks of money as capital because he can easily convert money into real resources like tools, machines and raw materials, and use these resources for the production of goods.
Also capital is measured in terms of money. So the amount of resources used or possessed by a business-person is conveniently expressed as a sum of money.
Classification of Capital:
Capital can be classified in two broad categories that which is used up in the course of production and that which is not.
Fixed and Circulating Capital:
Fixed capital means durable capital like tools, machinery and factory buildings, which can be used for a long time. Things like raw materials, seeds and fuel, which can be used only once in production are called circulating capital.
Circulating capital refers to funds embodied in stocks and work-in- progress or other current assets as opposed to fixed assets. It is also called working capital.
Two Features of Capital:
Two important features of capital are:
Firstly, it entails a sacrifice, since resources are devoted to making non-consumable capital goods instead of goods for immediate consumption. Secondly, it enhances the productivity of the other factors, viz., land and labour.
In fact, it is this enhanced productivity which represents the reward for the sacrifice involved in creating capital. Hence we can predict that new capital is only created so long as its productivity is at least sufficient to compensate those who make the sacrifices involved in its creation. These two features may now be discussed in detail.
People use capital goods like machines, equipment, etc. because capital goods are the creators of other goods. But this is not the whole truth.
People use capital for another important reason to produce goods with less effort and lower costs than would be the case if labour were not assisted by capital. But in order to use capital goods people must first produce them. This calls for a sacrifice of current consumption.
When people use their labour to produce capital goods like textile producing machines, they can use the same labour for producing consumer goods like textiles.
As Stanlake has put it “The opportunity cost of the capital goods is the potential output of consumer goods which has to be foregone in order to produce that capital, the production of capital demands abstinence from current consumption.”
Factors Affecting Capital Formation:
The creation of capital depends on two things:
(a) Savings and (b) a diversion of resources (from the production of consumption goods to meet current needs to the production of capital goods to meet future needs). Saving is the difference between current income and current consumption. In other words, it is the act of foregoing current consumption.
It means that resources otherwise used to produce consumer goods are set aside for producing capital goods. If people choose not to buy some consumer goods, with some part of their current income, they refrain from buying (utilising) the services of the factors required to make those goods.
These factors might, therefore, remain idle. But these savings may be borrowed and utilised by business firms (entrepreneurs) to finance the construction of capital goods.
This is the second step—the diversion of resources for the production of consumer goods to the production of capital (producers) goods. It may be noted that savings make possible capital accumulation. It does not cause it.
In short, capital formation depends on savings, which, in its turn, depends on two things:
(1) The capacity to save and
(2) The desire to save.
The capacity to save depends on income and the existence of savings institutions like banks, insurance companies, post offices, stock exchanges, etc. If income is low, savings will also be low. Even if income is high savings will be low in the absence of the above-mentioned savings institutions.
The desire to save depends on
(1) the rate of interest and (2) stability in the value of money (i.e., the rate of inflation).
If the rate of interest is high people will be eager to save more by curtailing their current consumption. People will also be eager to save more if they expect that there will exist reasonable price stability in the economy in future.
Mobility of Capital:
Capital is both geographically and occupationally mobile. However, a certain portion of a nation’s capital stock which consists of such things as railway networks, blast furnaces and shipyards are highly specialised equipment and are virtually immobile in the geographical sense.
It is physically possible to dismantle them and move them to different sites or locations, but the cost of doing so will be so great that it will not be economically feasible to do so.
Such equipment are not even occupationally mobile. Each such equipment can only be used for a specific purpose. Many buildings however, can be put to better uses. Many of the old buildings used as cinema house or god-owns in northern area of Calcutta have been dismantled and converted into multi-storeyed buildings.
Some capital equipment is mobile in both the geographical and occupational sense. Examples of such capital equipment are electric motors, machine tools, hand tools, typewriters, and lorries.
Such equipment can be used effectively in a wide variety of industries and are capable of moving from one location to another at very little cost.
The earning of capital, i.e., the price that has to be paid for it, is known as interest. If it stated as percentage of the principal, representing the sum paid by a borrower who needs finance to purchase a piece of capital equipment.
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(4) Enterprise (Organisation)
Organisation, as a factor of production, refers to the task of bringing land, labour and capital together. It involves the establishment of co-ordination and co-operation among these factors.
The person in charge of organisation is known as an organiser or an entrepreneur. So, the entrepreneur is the person who takes the charge of supervising the organisation of production and of framing the necessary policy regarding business.
Functions or Role of the Entrepreneur
The entrepreneur in modern business performs the following useful functions:
The primary task of an entrepreneur is to decide the policy of production. An entrepreneur is to determine what to produce, how to produce, where to produce, how much to produce, how to sell and so forth.
Moreover, he is to decide the scale of production and the proportion in which he combines the different factors he employs.
In brief, he is to make vital business decisions relating to the purchase of productive factors and to the sales of the finished goods or services.
2. Management Control:
Earlier writers used to consider management control one of the chief functions of the entrepreneur. Management and control of the business are conducted by the entrepreneur himself.
So the latter must possess a high degree of management ability to select the right type of persons to work with him. But the importance of this function has declined, as the business nowadays is managed more and more by paid managers.
3. Division of income:
The next major function of the entrepreneur is to make necessary arrangement for the division of total income among the different factors of production employed by him.
Even if there is a loss in the business, he is to pay rent, interest; wages and other contractual income out of the realised sale proceed.
4. Risk-taking and uncertainty-bearing:
Risk-taking is perhaps the most important function of an entrepreneur. Modern production is very risky as an entrepreneur is required to produce goods or services in anticipation of their future demand. Broadly, there are two kinds of risk which he has to face.
Firstly, there are some risks, such as risks of fire, loss of goods in transit, theft, etc., which can be insured against. These are known as measurable and insurable risks.
Secondly, some risks, however, cannot be insured against because their probability cannot be calculated accurately. These constitute what is called uncertainty (e.g., competitive risk, technical risk, etc.). The entrepreneur undertakes both these risks in production.
Another distinguishing function of the entrepreneur as emphasised by Schumpeter, is to make frequent inventions- invention of new products, of new techniques and discovering new markets—to improve his competitive position, and to increase earnings.
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Importance of Enterprise:
The above description indicates the supreme position of the entrepreneur in production. This is particularly true in the capitalistic or even mixed economy which is based on the price-profit system.
In the socialistic economy, the state becomes the entrepreneur; the scope of private entrepreneur is extremely limited in such an economy.
It is to be noted that the importance of the entrepreneur has been declining with the growth of joint-stock business and state-undertakings. This is due to the fact that risk is borne by the shareholders and the day-by-day control of the business is generally in the hands of salaried managers or managing directors.
A Separate Factor:
Some economists feel that the above entrepreneurial functions are no different from those of a particular and specialised form of labour. They point out that risk- bearing is not something peculiar to the entrepreneur.
Many types of labour have to take risk. For example, the miner or the air- hostess runs the risk of personal injury and life and most forms of labour run the risk of unemployment.
But enterprise is a separate factor because the first three factors are substitutable to some extent, but the fourth factor is a specific factor and cannot be substituted by any other factor.
Enterprise seems to be the most mobile of all the four factors. There is need to train labour for some specific task to be performed in a particular industry (say, road transport service, hotel business or computer operation).
Once labour is trained for some specific task appropriate to some particular industry, it cannot be easily and quickly transferred to some other industry to do a completely different job. But the basic functions of the entrepreneur organisation, management and risk-taking are the same in all industries.
Whatever the nature, duration and extent of economic activity and entrepreneur has to raise capital to organize the factors of production, and take certain fundamental decisions on what, how and where to produce.
The efficient operation of an enterprise, irrespective of its nature and form, depends on certain human relations and human qualities such as initiative, leadership organizational ability and controlling capacity.
Very few people have these rare qualities. But those who have such qualities are able to operate effectively and efficiently in almost any industry.
The return to the entrepreneur is profit. Profit is the reward for successful conduct of business.