Factors of Production and the Production Function

Every good or service that reaches a consumer is the result of production — the process of combining resources to create goods and services that satisfy human wants. Understanding how firms combine resources, and at what cost, is the starting point of producer behaviour in Economics, and it is a recurring theme in the Andhra Pradesh Intermediate Economics syllabus for BIEAP first-year commerce students.

Factors of Production

Economists classify the resources used in production into four broad factors:

1. Land — all natural resources given by nature (soil, water, minerals, forests, climate). Its reward is rent. Land is fixed in supply and has no cost of production of its own.
2. Labour — the physical and mental effort of human beings applied to production. Its reward is wages. Labour is inseparable from the labourer and perishable (a day's labour lost cannot be stored).
3. Capital — man-made resources used to produce further goods (machinery, tools, buildings, working capital). Its reward is interest. Capital is itself a produced factor, unlike land.
4. Organisation / Entrepreneurship — the factor that combines land, labour and capital, takes business decisions and bears the risk of the enterprise. Its reward is profit, which is residual and can be negative (a loss) unlike the other three rewards.

The Production Function

The production function expresses the technical relationship between the quantity of inputs used and the maximum quantity of output that can be obtained from them, given the existing state of technology. Symbolically,

where $Q$ is the output, $L$ is the quantity of labour and $K$ is the quantity of capital used (other inputs held constant or included as needed).

Economists distinguish two time-period versions of the production function:

• Short-run production function — at least one factor (usually capital, land or the size of plant) is fixed, and output can be varied only by changing the variable factor (usually labour or raw material). This is the setting for the Law of Variable Proportions.
• Long-run production function — all factors are variable; a firm can change its scale of operation itself. This is the setting for Returns to Scale.

This distinction — which factors are fixed and which are variable — is the single most important idea to carry forward into the next two sections, since it decides which 'law' applies.