Factors of production are the resources used in the ongoing production of goods or services.
An adequate supply of the factors of productionis essential to building a sustainable business. The factors of production include labor, capital, land, and entrepreneurship. Countries with an abundance of all the factors of production should thrive. Those countries with limited factors of production will normally specialize in industries to take advantage of the factors they possess.
Land is one factor of production. Economists lump all natural resources into the "land" category, such as water, diamonds, timber, gold, farmland, and crude oil. Many countries, like Japan, are constrained by a limited supply of resources and depend on importation. Other countries may have an abundance of a valuable resource and exploit it. Kuwait has taken advantage of its enormous crude oil deposits.
Labor is another factor of production. Labor includes everyone except the entrepreneur (who is put in a separate category). Quantity and quality of labor are important considerations when evaluating the contribution this factor makes to a country's economy. Countries with a large labor pool may specialize in manufacturing. China, India, and Japan are countries that have taken advantage of a large available workforce to establish manufacturing plants. Education improves the quality of a country's labor pool. Many companies may require a specialized labor force and locate in an area where these highly educated or trained individuals live. Silicon Valley in California attracts many technology companies because of the large number of highly educated people.
Capital is another factor of production. Capital can be broken into several categories. The machinery and tools used to produce a good or service are capital. Money used to purchase other factors of production is considered financial capital. Intellectual capital includes the intellectual property a business develops including technological expertise and trade secrets. Increasing capital pushes out a country's production possibility frontier. In other words, it enables a country to increase its production capacity.
Land, labor, and capital alone will not produce a good or service. The entrepreneur needs to acquire and manage the other factors of production. This is why most economists consider entrepreneurship a factor of production. Countries may be blessed with an abundance of natural resources, labor, and even capital, but they may fail to be conducive to business because the political climate discourages entrepreneurship. The entrepreneur requires a profit incentive to assume the time and risk to begin a business. This is a reason China has embraced the profit motive and has begun to encourage entrepreneurship.
Businesses purchase the factors of production in the factor market. The law of supply and demand determines the price and quantity produced for each factor of production. However, it is still the end-users who determine the demand for a factor of production when they purchase an item in the goods and services market. If the demand for shirts increases, businesses will meet the demand by purchasing more cotton, hiring more workers, and purchasing an additional loom. The demand for these factors of production is derived from the demand for the final product. Economists refer to the demand for factors of production as a "derived demand" because it is directly related to the demand for the final good or service being sold in the goods and services market.