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” in economics.
2. Labor.
Labor includes all forms of human productive effort, from blue collar (manual labor) to white collar (office and management work) to entrepreneurial activities (organizing resources, coming up with ideas, taking risks) to professional athletes and celebrities. 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 (ceteris paribus), 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 other celebrities earn high wages because the demand for their services (labor) is very high, and the supply is low because their talent is unique.
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 and competitive 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 and well intended short run gains can backfire in the long run.
In addition to avoiding surpluses and shortages, a free competitive market system, in the long run, provides businesses with the most incentive to produce as efficiently as possible. The profit motive encourages businesses to increase productivity. Greater productivity leads to more jobs, higher real wages, better products, and a higher standard of living.
Would intellectual property be considered a capital good in your model? I feel like that’s the most important input in many business models.
Good question, Eric. Intellectual property is not the capital good itself. It is the idea or the formula or the list of secret ingredients or the production process that allows our factors of production to more efficiently make the product. Our brains are really the creators of this intellectual property, so the factor of production generating the intellectual property is labor, or more precisely, entrepreneurial efforts. So it is a component of a factor of production. You are right that intellectual property has taken on an increased role as technology advances have taken off. However, the production of steel, cars and food, etc. also contain intellectual properties that were patented at the time and these have been around for a long time.