Economists have long recognized the three distinct factors that people use to create the things they want. Land, labor, and capital are referred to as "factors of production. Each factor is plays a unique role in the production of goods, and each factor is clearly distinguishable from the other two.

Land is defined as everything in the universe that is not created by human beings. It includes more than the mere surface of the earth. Air, sunlight, forests, earth, water and minerals are all classified as land, as are all manner of natural forces or opportunities that are not created by people. Labor uses capital on land to produce wealth. Every tangible good is made up of the raw materials that come from nature -- and because all people (and other living things) have material needs for survival, everyone must have access to some land in order to live.

Land is the passive factor in production. As such, land simply exists. To make the gifts of nature satisfy our needs and desires, human beings must do something with the natural resources; they must exert themselves, and this human exertion in production is called labor. Everything that people do, to convert natural opportunities into human satisfactions -- whether it involves the exertion of brawn, or brains, or both -- is labor, to the economist.

When the stuff of nature is worked up by labor into tangible goods, which satisfy human desires and have exchange value, we call those goods Wealth. (When labor satisfy desires directly, without providing a material good, we call that "Services"; thus, economists say that labor provides the economy with "goods and services".) When some of the wealth is used to produce more wealth, economists refer to it as Capital. A hammer, a screwdriver, and a saw are used by a carpenter to make a table. The table has exchange value. The truck which delivers the table to a retail store, the hammer and other tools -- and even the cash register -- are all forms of capital.

Capital increases labor's ability to produce wealth (and services too). Therefore, there is always a demand for capital goods, and some labor will be devoted to supplying those goods, rather than supplying the consumer goods that directly satisfy desires.

How do we figure out how much of society's labor to devote to capital goods vs. consumer goods? In a market economy, we don't! The returns, or payments, to capital and labor move naturally toward an equilibrium, or balance, in which neither factor has an advantage over the other. If a shortage of capital goods develops, people will be willing to pay higher prices for those goods, and more workers will work on making them. In time, this will create a shortage of consumer goods, and workers will be drawn back toward making them.

Likewise, when there's more demand for land, the land factories gear up and crank out more land -- or, well, er, they can't do that, can they? That is why land must be defined as a distinct factor of production. Since land is needed for all production, any time overall production is increasing, land will be in greater demand. When capital goods are in greater demand, labor will eagerly produce more of them. But, the supply of land cannot be increased, because land is not produced by human labor.

Definition of the three distinct, interdependent factors of production is another important analytical tool that helps economists make sense of the processes of production and distribution in a complex society. Each is clearly different from the other.. The mutually exclusive nature of these categories is what makes them so useful.

In other contexts, these terms are sometimes used differently, or oddly combined, such as "human capital". It is important to remember that different schemes of definitions and terms can be used for different purposes. Land, for example, is often referred to as "capital", in the sense that one can buy land and use it as a "capital investment". The use of a term like "real estate" -- which is a combination of land and capital as we have defined them here -- can further cloud the issue. This shows us that when economic terms are used, it is very helpful to clearly understand how they are being defined!

Background Questions

  1. Briefly define each factor of production.
  2. Why are the factors interdependent? Explain.
  3. What is wealth? Give an example.
  4. Why is land considered a passive factor of production?
  5. How do capital and labor differ from land?
  6. Why is it important to understand how terms are used in different contexts?