The Nature of Economics

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Definition of Economics
Economics is the social science that studies how consumers, firms and
the governments make choices on allocating scarce resources to satisfy the
unlimited wants of society. Economics is divided into two broad categories which
are microeconomics and macroeconomics. Microeconomics deals with individual
agents such as consumers, firms and state-owned companies. Macroeconomics deals
with the aggregate or the entire economy and focuses on issues such as aggregate
demand and aggregate supply, inflation, unemployment, the exchange rate,
international trade and foreign reserves.

The Three Basic Economic Questions

The three fundamental questions in economics are:

1. What to produce?

In economics, what to produce is usually determined by the demand for goods

and services by consumers. Therefore, what consumers demand is what is
usually produced. The decision as to what to produce is also influenced by the
type of economy; whether the economy is a planned or command economy, a
free economy or whether the economy is a mixed economy. In a planned or
command economy, what to produce is determined by a central economic
authority established by the government. In a true free market, what to produce is
determined by choices of consumers. However, most nations fall somewhere
between a true command economy and a true free market system and
production is determined by both the demand by buyers and by some level of
government intervention.

2. How to produce?

Many different ways and methods are available to firms in determining how
goods and services can be produced. A firm can employ a few skilled or a great
deal of unskilled workers. The firm can also be more capital intensive with high
technological methods of production. The firm can also produce locally or
overseas. In addition, firms can use new or recycled raw materials to make their
products. These are some of the issues that can confront firms in the
economy regarding how to produce society’s goods and services.
 3. For whom to produce?

If a good or service is produced, a decision must be made as to who will

consume it. Decisions to have one person or group receive a good or service
usually means it will not be available to others or less will be available to others.
Usually those persons or groups in society who and which have access to
financial capital will usually have quicker access to the goods and
services produced by society. Therefore, the question as to whom to produce for
is usually geared to those persons in society who have the financial capacity and
can afford to purchase these goods and services that are produced.

Land As a Factor
Land has a broad definition as a factor of production and can take on various
forms, from agricultural land to commercial real estate to the resources
available from a particular piece of land. Natural resources, such as oil and
gold, can be extracted and refined for human consumption from the land.

Cultivation of crops on land by farmers increases its value and utility. For a

group of early French economists called “the physiocrats,” who predated
the classical political economists, land was responsible for generating
economic value.
While land is an essential component of most ventures, its importance can
diminish or increase based on industry. For example, a technology company
can easily begin operations with zero investment in land. On the other hand,
land is the most significant investment for a real estate venture.

Labor As a Factor
Labor refers to the effort expended by an individual to bring a product or
service to the market. Again, it can take on various forms. For example, the
construction worker at a hotel site is part of labor, as is the waiter who serves
guests or the receptionist who enrolls them into the hotel.

Within the software industry, labor refers to the work done by project

managers and developers in building the final product. Even an artist involved
in making art, whether it is a painting or a symphony, is considered labor. For
the early political economists, labor was the primary driver of economic value.
Production workers are paid for their time and effort in wages that depend on
their skill and training. Labor by an uneducated and untrained worker is
typically paid at low prices. Skilled and trained workers are called “human
capital” and are paid higher wages because they bring more than their
physical capacity to the task.
For example, an accountant’s job requires the analysis of financial data for a
company. Countries that are rich in human capital experience increased
productivity and efficiency. The difference in skill levels and terminology also
helps companies and entrepreneurs create corresponding disparities in pay
scales. This can result in a transformation of factors of production for entire
industries. An example of this is the change in production processes in the
information technology (IT) industry after jobs were outsourced to countries
with lower salaries.
Capital As a Factor
In economics, capital typically refers to money. However, money is not a
factor of production because it is not directly involved in producing a good or
service. Instead, it facilitates the processes used in production by enabling
entrepreneurs and company owners to purchase capital goods or land or to
pay wages. For modern mainstream (neoclassical) economists, capital is the
primary driver of value.

It is important to distinguish personal and private capital in factors of

production. A personal vehicle used to transport family is not considered a
capital good, but a commercial vehicle used expressly for official purposes is.
During an economic contraction or when they suffer losses, companies cut
back on capital expenditure to ensure profits. However, during periods of
economic expansion, they invest in new machinery and equipment to bring
new products to market.

An illustration of the above is the difference in markets for robots in China

compared to the United States after the 2008 financial crisis. After the crisis,
China experienced a multi-year growth cycle, and its manufacturers invested
in robots to improve productivity at their facilities and meet growing market
demands.12 As a result, the country became the biggest market for
robots.3 Manufacturers within the United States, which had been in the
throes of an economic recession after the financial crisis, cut back on their
investments related to production due to tepid demand.4

Association for Advancing Automation. "North American Robot Orders Fall 21% in 2008 ."
   

 
As a factor of production, capital refers to the purchase of goods made with
money in production. For example, a tractor purchased for farming is capital.
Along the same lines, desks and chairs used in an office are also capital.
Entrepreneurship As a Factor
Entrepreneurship is the secret sauce that combines all the other factors of
production into a product or service for the consumer market. An example of
entrepreneurship is the evolution of the social media behemoth Meta (META),
formerly Facebook.

Mark Zuckerberg assumed the risk for the success or failure of his social
media network when he began allocating time from his daily schedule toward
that activity. When he coded the minimum viable product himself,
Zuckerberg’s labor was the only factor of production. After Facebook, the
social media site, became popular and spread across campuses, it realized it
needed to recruit additional employees. He hired two people, an engineer
(Dustin Moskovitz) and a spokesperson (Chris Hughes), who both allocated
hours to the project, meaning that their invested time became a factor of
production.5

The continued popularity of the product meant that Zuckerberg also had to
scale technology and operations. He raised venture capital money to rent
office space, hire more employees, and purchase additional server space for
development. At first, there was no need for land. However, as business
continued to grow, Meta built its own office space and data centers.6 Each of
these requires significant real estate and capital investments.

Connecting the Factors

Another example of entrepreneurship is Starbucks Corporation (SBUX). The
retail coffee chain needs land (prime real estate in big cities for its coffee
chain), capital (large machinery to produce and dispense coffee), and labor
(employees at its retail outposts for service). Entrepreneur Howard Schultz,
the company’s founder, provided the fourth factor of production by being the
first person to realize that a market for such a chain existed and figuring out
the connections among the other three factors of production.7

While large companies make for excellent examples, a majority of companies

within the United States are small businesses started by entrepreneurs.
Because entrepreneurs are vital for economic growth, countries are creating
the necessary framework and policies to make it easier for them to start
companies.

Ownership of Factors of Production

The definition of factors of production in economic systems presumes that
ownership lies with households, who lend or lease them to entrepreneurs and
organizations. But that is a theoretical construct and rarely the case in
practice. Except for labor, ownership for factors of production varies based on
industry and economic system.

For example, a firm operating in the real estate industry typically owns
significant parcels of land, while retail corporations and shops lease land for
extended periods of time. Capital also follows a similar model in that it can be
owned or leased from another party. Under no circumstances, however, is
labor owned by firms. Labor’s transaction with firms is based on wages.

Ownership of the factors of production also differs based on the economic

system. For example, private enterprises and individuals own most of the
factors of production in capitalism. However, collective good is the
predominating principle in socialism. As such, factors of production, such as
land and capital, are owned and regulated by the community as a whole
under socialism.

What Are Examples of the Factors of Production?

Land refers to physical lands, such as the acres used for a farm or the city
block on which a building is constructed. Labor refers to all wage-earning
activities, such as the work of professionals, retail workers, and so on.
Entrepreneurship refers to the initiatives taken by entrepreneurs, who
typically begin as the first workers in their firms and then gradually employ
other factors of production to grow their businesses. Finally, capital refers to
the cash, equipment, and other assets needed to start or grow a business.