Factors of Production

The three types of factors of production (inputs) are:

1. Land.
Land includes land and other natural, non-man-made materials, such as raw materials, energy sources, and trees. The payment for the use of land is called “rent.”

2. Labor.
Labor includes all forms of human productive effort, from blue collar (manual labor) to white collar (office and management work) to professional athletes and entrepreneurial activities. Rewards for non-entrepreneurial labor are called wages, salaries, bonuses, or commissions. In this and future units, we will refer to all of these payments as “wages.” We will refer to payments for entrepreneurial activities as “profits.”

3. Capital goods.
Capital goods represent the man-made machines, equipment, buildings, and other tools used to produce products. When we use the term “capital” by itself, we refer to money used to finance the purchase of capital goods. When businesses borrow money to purchase capital goods, they pay “interest” to the lenders.

Factor Prices

Factor prices are the payments for land, labor, and capital goods. They include

1. Wages.
Wages are the payments and rewards for (the price of) non-entrepreneurial labor.

2. Rent.
Rent is the payment and reward for the use of land.

3. Interest.
Interest is the payment and reward for capital (money) used to purchase capital goods.

4. Profits.
Profits are the payments and rewards for entrepreneurial efforts.

Factor Prices in the Free Market

Without government interference, prices of labor and land are determined by the supply and demand of these factors of production. If the demand for land increases, then the price of land increases, and vice versa. If the demand for a particular type of labor increases, then the price of this labor (the wage) increases, and vice versa. The graph below illustrates that in this example market, the equilibrium wage rate in the market occurs at a value of $7. Just like the equilibrium price of a regular product, the equilibrium wage rate occurs at the intersection of the demand and the supply curve.


An increase in the demand for labor is illustrated by a rightward shift of the demand curve (see also Unit 2). This increases the equilibrium market wage. Conversely, a decrease in the demand for labor (a leftward shift of the curve) lowers the equilibrium wage. If we were to increase the supply of labor (a rightward shift of the supply curve), the wage rate would decrease, and vice versa. Famous athletes and television celebrities earn high wages because the demand for their services (labor) is very high, and the supply is limited.

Government Price-Setting

As is true for products such as apples, computers, and houses, free market prices lead to the most economically efficient allocation of resources. If the government sets a price above or below the free market equilibrium level, then a surplus or shortage of the factor of production will occur (see Unit 2). In a free market there are no long-run surpluses or shortages, and consumer and producer surplus are at their highest level. This is the definition of economic efficiency. Governments usually have good social intentions in controlling and setting the price different from the equilibrium price. A specific group may benefit in the short run, but economic efficiency suffers.

In addition to avoiding surpluses and shortages, a free market system provides businesses with the most incentive to produce as efficiently as possible. The profit motive encourages businesses to increase productivity. Greater productivity in the long run leads to more jobs, higher real wages, and better products.