The following is an adapted excerpt from my book Microeconomics Made Simple: Basic Microeconomic Principles Explained in 100 Pages or Less.
In economics, “factors of production” are the inputs used to create finished goods (i.e., the actual products we buy). In other words, these are the scarce resources that we, as a society, must choose how to allocate. Ideally, we would do so in a way that maximizes our wellbeing. Traditionally, the factors of production are:
- Land (which includes land itself as well as other natural resources and phenomena — water, forests, fossil fuels, weather, etc.),
- Labor (the human work necessary to produce and deliver goods), and
- Capital (manmade goods used to produce other goods — factories, machinery, highways, electrical grid, etc.).
More recently, human capital — the knowledge and skills that make workers productive — has been considered a fourth factor of production.
How should a society allocate its factors of production? One desirable criterion is to use all resources to their fullest capacity or, to put it another way, to use the fewest possible resources for any given level of output (e.g., if a set of kitchen cabinets only requires 100 nails, a carpenter shouldn’t pound in more). “Productive efficiency” is the term used to describe a situation in which this is achieved.
Another desirable criterion is that the factors of production are all used to make the quantities and types of goods that society most highly values. For example, if a society values the arts more highly than sports, it should invest more resources in the former than in the latter. “Allocative efficiency” is the term used to describe a situation in which productive resources are being used in their most valuable way.