FBM 1101 PRINCIPLES OF ECONOMICS

LEC 5 FACTORS OF PRODUCTION

The primary purpose of economic activity is to produce utility for individuals. The
business firms as an important component (units) of the economic system, takes up
production activities with this view of creating utility for individuals in future. They are
artificial entities created by individuals for the purpose of organising and facilitating
production. The essential characteristics of the business firm is that it purchases factors of
production such as land, labour, capital, intermediate goods, and raw material from
households and other business firms and transforms those resources into different goods or
services which it sells to its customers, other business firms and various units of the
government as also to foreign countries.

MEANING OF PRODUCTION
Production is the organised activity of transforming resources into finished products
in the form of goods and services; the objective of production is to satisfy the demand of
individuals for such transformed resources.
Through production, utility of goods/services increases. Thus, production is any
activity directed to the satisfaction of other peoples’ wants through exchange.

Three Types of Production:

1. Primary Production:
Primary production is carried out by ‘extractive’ industries like agriculture, forestry,
fishing, mining and oil extraction. These industries are engaged in such activities as
extracting the gifts of Nature from the earth’s surface, from beneath the earth’s surface and
from the oceans.
2. Secondary Production:
This includes production in manufacturing industry, viz., turning out semi-finished
and finished goods from raw materials and intermediate goods— conversion of flour into
bread or iron ore into finished steel. They are generally described as manufacturing and
construction industries, such as the manufacture of cars, furnishing, clothing and chemicals,
as also engineering and building.

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3. Tertiary Production:
Industries in the tertiary sector produce all those services which enable the finished
goods to be put in the hands of consumers. In fact, these services are supplied to the firms
in all types of industry and directly to consumers. Examples cover distributive traders,
banking, insurance, transport and communications. Government services, such as law,
administration, education, health and defence, are also included.

BASIC CONCEPTS OF PRODUCTION

 Factors of Production/ Input: A factor of production/ input is defined as any good or

service that goes into the production process.
Depending on how readily the usage of input can be changed according to the
increase or decrease in the output, there are two types of inputs- fixed and variable input.
• Fixed input – An input for which the level of usage cannot readily be changed. Eg-
Land, building, machinery etc.
• Variable input - Variable inputs are those whose level of usage could be changed with
changes in output. Example- labour, raw materials.

 Output- is any good or service that comes out of a production process.

 Depending on time horizon needed for a producer to have flexibility over all relevant
production decisions, we have short run production and long run production.
• Short run production
– At least one input is fixed
– All changes in output achieved by changing usage of variable inputs
Y= f (X1, X2 / X3…..Xn)
where Y is output, X1, X2 are variable inputs and X3…..Xn are fixed inputs.

• Long run production

– All inputs are variable
– Output changed by varying usage of all inputs
 Y=f (X1, X2,…..Xn)
where X1, X2 ,…..Xn are variable inputs.

The Short Run Versus The Long Run in Production Decisions

The short and long run is not defined as a specific period of time, but is instead
defined as the time horizon needed for a producer to have flexibility over all relevant
production decisions.
For example, Let's say that you own a bakery and have been contracted by local
restaurants to supply them with a given number of cakes every week. This is your short-run
production. As the order for number of cakes increases, you try to increase the production
through a proportionate increase in the quantities of raw materials, no of ovens for baking,
no of cooks, utensils etc within the same bakery unit.
As the business flourishes, you will come up with the idea of expanding your business
on long run. You wanted to open a new store to sell directly to customers. Or you decide to
expand your business from cakes to chocolates and candies. You are now flexible enough to
make more changes on long run.

Production Function
A systematic and mathematical expression of the relationship among various
quantities of inputs used in the production of a commodity and the corresponding quantities
of output is called a production function.
Or simple sense, a production function shows Input-output relationship. It describes
the rate at which resources are transformed into products.
Y=f (X1, X2,…..Xn)
where Y is the output and X1, X2, …. Xn are inputs.

Factors of Production
Production of a commodity or service requires the use of certain resources or factors
of production. A factor of production/input is defined as any good or service that goes into
the production process. As economists refer to it, an input is simply anything which a firm
buys for use in its production process. These may be raw materials or services or capital.
Since most of the resources necessary to carry on production are scarce relative to
demand for them they are called economic resources.
There are four factors of production employed in a production process- Land, labour,
capital and entrepreneur/ enterprise. For a production to run, land, labour and capital need
to be combined together and should be coordinated by an entrepreneur/ enterprise.

Each factor gets a reward on the basis of its contribution to the production process

Characteristics of factors of production

The four characteristics of factors of production are:
i) Substitutability
A factor can be a substitute for another factor in the production process without
affecting the output i.e. Machine can replace human labour in harvesting of paddy. Machine
can replace bullock pairs and human labour in land preparation.
ii) Complementarity
The factors are said to be complementary if increase in use of one factor leads to
increase in use of another factor. Machine needs human labour for operating the machine.
Here machine and labour are complementary factors. Human labour and capital have both
supplementary and complementary character.
iii) Specificity
A factor is said to be specific when it is used for only one purpose. E.g. spare parts of
a particular machine.
iv) Versatility
A factor is said to be versatile when it can be put to any or every use. Eg: Electricity
used for different purposes.

LAND
According to Marshall, land means “all natural resources which are free gifts of
nature.
Land, therefore, includes all gifts of nature available to mankind—both on the
surface and under the surface, e.g., soil, rivers, waters, forests, mountains, mines, deserts,
seas, climate, rains, air, sun, etc.

Characteristics/peculiarities of land:
1. Land is free gift of nature and not man-made- i.e. land has no cost of production of
the society.
2. The quantity/ extent is finite or given i.e. limited in supply- Its supply can be neither
increased not decreased by human effort and is a permanent resource.
3. Land is a Primary Factor of Production- In any kind of production process; we have to
start with land. For example, in industries, it helps to provide raw materials, and in
agriculture, crops are produced on land.
4. Land is heterogeneous (Ex: Fertility status, productivity etc.,)
5. Land has multiple uses (Ex: Cultivation, dairy farming, sheep rearing, building
construction, playground and so on.
6. Land is permanent- Land is indestructible. Thus it cannot go out of existence.
7. Immovable- It cannot be transported from one place to another.
8. Land is a Passive Factor of Production- This is because it cannot produce anything by
itself. For example, wheat cannot grow on a piece of land automatically. To grow
 wheat, man has to cultivate land. Labour is an active factor but land is a passive
factor of production.

Factors affecting land productivity:

1. Natural factors: Like climate, slope of land, chemical and biological properties of soil,
rainfall etc.,
2. Irrigation potentials: The land with more irrigation potential will be more productive.
Artificial means of irrigation viz., wells, tube wells, tanks, canals etc. helps in supply of
water.
3. Organization: An efficient and capable organizer will judiciously use the land resulting in
increasing productivity.
4. Location: Ex: Nearness to irrigation source, market access etc.,
5. Ownership: Owners always take much interest in increasing the productivity but it is
reverse with the temporary settlers.
6. Availability of capital: The productivity can be increasing with the availability of seed,
fertilizers, machines etc., Intensive cultivation gives more productivity, which is
possible with availability of capital.
7. Proper use: Suitability for a particular use need to be known in prior. Ex: Land use for
paddy, if used for pulses, gives decreased productivity.
8. Availability of labour: If labour is efficient, trained and capable to employ techniques,
the land productivity can be increased.
9. Government policy: Ex: Adoption of proper agricultural policy, providing require
assistance to farmers, etc.,
10. Agricultural research: Adoption of improved package of practices results in increase
productivity.

LABOUR
The term, labour has wide and diversified meaning in economics. It can be physical
work or mental work that is done by a person with an aim of earning money. It includes the
work done by farmers, workers, the service of teachers, doctors, actors, etc.
 In the words of Marshall, labour is defined as “any exertion of mind or body
undergone partly or wholly with a view to earn some good other than the pleasure derived
directly from the work”. Any work that is done for pleasure does not come under labour.

Characteristics of Labour
1. Labour is Inseperable from Labourer: The worker has to sell his labour in person and he
has to be physically present, while delivering the work. He cannot deliver the work in
absentia. It varies from labourer to labourer depending on races, climate, physical and
mental alertness of labourer.
2. Labour is Perishable: Labour cannot be preserved which means that labourer has no
reserve price. He has to sell the work without really minding the wages, fork, a day’s
work lost is a loss forever. In other words, it is a flow resource.
3. Labour has Very Weak Bargaining Power: Perishability of labour is a prime factor for the
labourer, which rather forces him to accept whatever the wage that is offered. The
weak bargaining power of the labourer is taken as an advantage by the employer.
4. Lack of Free Mobility: Compared to capital, labour is less mobile. No doubt labourers
move from one place ot another and from one occupation to another, but it is not a
common feature. Thus, labour lacks horizontal and geographical mobility. This leads to
a variation in wages among the occupations as well as spatially.
5. Supply of Labour is Independent of Demand: Supply of labour depends on the
population in a country. Population is one factor which can neither be increased nor
decreased overnight. The increase or decrease is a slow process and supply of labour is
independent of demand.
6. Supply of Labour Peculiarly Changes with the Wages: Normally the seller of a good sells
more when the price per unit of commodity is higher and vice versa. But regarding
labour a fall in wages leads to an increased supply of labour. A fall in wages leads to a
reduction of their incomes. So to make good this fall in income, family members who
were not working earlier also work to supplement the family income.

Aspects of Labour:
There are two aspects viz.,
 i) Qualitative aspects / Efficiency of labour and
ii) Quantitative aspects / Number of labours (or) size of the working population.

Efficiency of Labour:
It refers to the amount of work that a labour can do within a given time. According to
economists efficiency of labour means “the ability of labour by virture of which it is
productive”. E.g. A person can weed 10 cents per day and another person can weed 8 cents
per day. The first person is more efficient than the second person. It indicates the
qualitative and quantitative performance of the labourer. All individuals are not equally
efficient, because of several factors affecting their efficiency.

Efficiency of labour depends on:

1. Racial and Hereditary Characters: Some races are known for their physical and some are
for their intellectual qualities. This emerges out of climate and natural environment.
Pattans are well built and physically very strong. The Punjabies and Rajpupts are
hardworking compared to other Indians.
2. Literacy and Training: Education brightens the outlook of labourers and builds up
character. Training imparted to the labourers makes them more efficient to do
specialized works.
3. Environment: The working environment must be congenial for the labourers to put up an
impressive performance. Environment refers to conditions in the work place in which the
labourers have to work and the equipment and machinery which they handle. Better
physical facilities, modern machinery and equipment encourage to get best out of them.
4. Working Hours: Long working hours retard the performance and the efficiency of
labourers. The working hours should facilitate them to relax. Short working hours keep
them fresh and help to rejuvenate their energies.
5. Fair and Prompt Payment: Wages influence the performance of labour. Fair and prompt
payments of wages encourage them to put their heart and soul into the job.
6. Capability of Organization: Organization has to plan to allocate the right people at right
places for the right work. Assignment of work as per the capabilities of labour leads to
expected output and maximum profits.
7. Social and Political Factors: Social securities for the labourers and concern of State
towards their conditions will be quite encouraging to improve their efficiency.
8. Personal Qualities: Personal qualities like intelligence, alertness, honesty, health etc.,
improve the efficiency of labourers.
9. Incentives: Incentives like extra payment, and some perquisites for a good performance
encourage them to be more devoted to the work.

Division of Labour
In modern production activity, the production of a good is divided into several sub-
processes, and each sub-process is entrusted to a group of workers. This is what division of
labour implies. Division of labour is meant to improve the efficieny of labourers.
There are three different types of division of labour; Simple division of labour,
Complex division of labour and Territorial division of labour.

1. Simple Division of Labour

It is also known as occupational specialization. This means that people in a society
undertake various occupations to make their livelihood. The choice of an occupation
depends on the suitability of an individual in serving the society. That is how we have in a
community, some are doctors, others are lawyers, some others are teachers and we have
blacksmiths, goldsmiths and others craftsmen. They execute duties regularly and help the
society to develop by helping themselves through their professions.
2. Complex Division of Labour
It is assigning the work by task. The task here is a sub-process that is found in
producing a commodity. Each group of people is given a task in which it is considered as
specialists. For example, in making silk cloth, many sub-processes such as reeling, weaving,
dyeing, etc., are involved and for all these sub-processes such as reeling, weaving, dyeing,
etc., are involved and for all these sub processes we require sophisticated technology and
trained people to run the silk industry. Similarly, in the manufacturing of tractors, electric
motors, TVs, etc., many sub processes are involved.
3. Territorial Division of Labour
It refers to localization of industries. Certain areas or regions specialize in production
of a commodity. The examples are textile mills in Bombay and Ahmedabad, silk sarees in
Kanchi, jute mills in Kolkata, leather in Kanpur, etc.

Merits of Division of labour

1. Increase productivity.
In Pin Making industry, there are 18 distinct operations. 10 men made 48000 pins/ day
and 1 worker makes 4800 pins. In absence of division of labour and Machinery, one
could hardly have made 20 pins.
2. Increase Skill – Practice makes a man perfect – He becomes expert.
3. Enhances large scale production – It also facilitates inventions and large scale
production is possible by saving of time, machine tools and implements
4. Right man into right place. Workers are so distributed that each worker is put
according to his ability.

Demerits of Division of Labour

1. Monotony– workers lack interest in the work.
2. Retards Human Development
3. Lack of General Responsibility
CAPITAL
According to Marshall, “Capital consists of all kinds of wealth, other than free gifts of
nature, which yield income.” Therefore, every type of wealth other than land which yields an
income or helps in further production of wealth is called capital.
According to Karl Marx, capital is ‘crystallized labour’. This is indicated in his book,
‘Das Kapital’.
All capital is necessarily wealth but all wealth is not necessarily capital. Money when
used for the purchase of capital goods, then only it becomes capital. For instance, residential
buildings are the wealth of the individuals, but these are not considered as capital.
Capital is regarded as the man-made instrument of production. Machines, tools and
instruments, factories, canals, dams, transport equipment, stocks of raw materials, etc., are
some of the examples of capital.

Money Vs Capital
Money Capital
• Used to buy goods & services Includes all those wealth’s such as machines,
• Includes currency notes & coins tools, buildings, etc.
• All money is not capital ( only that Helps to yield further income or aid in further
part which helps in further generation production of wealth.
of income)

Characteristics of Capital
1. Capital is not a free gift of nature. It is the result of man-made efforts. Machinery,
implements, etc., are considered as capital goods.
2. Capital is productive, as it helps in enhancing the overall productivity of all the resources
employed in the production process. Invested capital also fetches interest for its
productive capacity. Farm machinery when used with skilled labourers enhances the
productivity of land. Irrigation dam is considered as the capital good and with its water;
we can bring out complementary effect on the productivity of other resources such as
fertilizers, seeds, etc.
3. It is also prospective as its accumulation rewards income in future. Savings and
investment in the economy leads to growth and development of the economy due to
accumulation of capital over time.
4. Capital is highly mobile as it possesses the characteristic of territorial mobility. For
example, capital goods like tractor.
5. Capital is supply elastic as its supply can be altered according to the need. Based on
demand, supply of the capital goods can be changed.

Classification of Capital
Capital is classified based on several criteria the details of which are given below:
1. Based on Nature of Ownership
a) Individual Capital or Private Capital: These are the assets which are owned by the
individuals in the business.
b) National Capital: It is the capital that is owned by the community. Examples: Airways,
Railways, etc.
2. Based on Durability
a) Fixed Capital: It is the capital which is used time and again in the production of other
goods. Examples: Machinery, tools, etc.
b) Circulating Capital or Working Capital: It is the capital that is used once and exhausts
after a single use. Examples: Fertilizers, seeds, feeds, etc.
3. Based on the Scope of Alternative Uses
a) Sunk Capital or Specific Capital: These are the capital goods, the use of which is
confined to a specific purpose. Examples: Plough, seed drill, harvester, transplanter,
winnower, etc.
b) Floating capital: It is the capital good that can be used for different purposes at any
time. Examples: Electricity, coal, etc.
4. Based on Incentives
a) Remunerative Capital: The capital when used for the payment of wages in the
production process is called remunerative capital. Examples: Liquid money or case,
Foodgrains, etc.
 b) Auxiliary Capital: It represents the various capital goods that help the labourers in the
production process. Examples: Machinery, tools, etc.
5. Based on Usage
a) Production Capital: These are the capital goods which help the labourers directly in the
production activity. Examples: Food grain, cloth, money used for consumption, etc.
b) Consumption capital: these are the goods which are consumed by the labourers. These
indirectly assist in the process of production, Examples: Food grains cloth money used
for consumption etc.
6. Based on Place
a) Internal Capital: The capital that is generated from the domestic savings of the public in
a nation. Ex: Public roads, etc.
b) External Capital: This is the capital generated from the external source. Examples:
Funds received from World Bank, aid from UNO, etc.

Capital formation
Murray and Nelson say that capital formation is the investment. Capital formation
means increasing the stock of real capital in a country. In other words capital formation
involves making of more capital goods such as Machines, tools, factories, transport
equipment, materials, electricity etc, which are all used for future production of goods. For
making additions to the stock of capital, savings and investment are essential.
The amount which a community adds to its stock of capital during a year is called
capital formation in that year. Savings is equal to total output – consumption during the
year. It represents surplus of production over consumption.
S = Y- C
where S = Savings
Y= Total output
C = Consumption
In any form of Economy where socialist like Russia or capitalists like America, capital
formation is a must for economic development.
Stages of Capital formation
In order to accumulate capital goods, some current consumption has to be sacrificed,
so that it can be diverted to new capital formation savings and investment are so
consolidated to have capital formation.

Capital formation takes place in stages.

1. Creation of savings
2. Mobilisation of savings
3. Investment of savings

1. Creation of savings:
Savings are done by:
i) Individual/household/voluntary organizations
ii) Business enterprises
iii) Government on compulsory basis
The level of saving in particular country depends up on
1) Power to save
2) Will to save
Power to save depends up on
1) Average level of Income of the people
2) Distribution of National Income
Apart from the power to save, the total amount of savings depends up on the will to
save various personal, family and national/ considerations induce the people to save people
save in order to provide against old age, unforeseen emergencies. Some people desire to
save a large amount to start new business or to expand the existing business. Moreover
people want to make provision for education, Marriage and to give a good start in business
for their children.
Savings are of two types:
1. Forced savings: Tax imposed by Government represents forced savings.
2. Voluntary savings: The savings which people do of their own free will.
 Business people save by retaining a part of their profits in the form of undistributed
profits. They use these profits for investment in real capital. Government increases savings
by collecting taxes and profits from public undertaking to build up new capital goods like
factories.
Mobilisation of savings
The amount that was saved by individuals, business man and Government should be
transferred to businessmen (or) entrepreneurs who require them for investment. In the
capital market funds are supplied by the individuals investors, banks, investment trusts,
insurance companies, finance corporations, Governments etc., If the rate of capital
formation is to be stepped up the development of capital market is very necessary a well-
developed capital market will ensure that the savings of the society will be mobilized and
transferred to the businessmen for investment.

Investment of savings:
For savings to results in capital formation, they must be invested by business men
who are honest and dynamic in the country, who are able to take risk and bear uncertainty
of production.

Factors affecting Capital formation:

The following factors will influence the capital formation:
1) Per capita income will influence the capital formation
2) Technology
3) Productivity
4) Government policies
5) Tradition/ customs of Society
6) Desire for saving the amount for old age Needs.
7) Desire for saving the amount for meeting children education, Marriages etc.
8) Good infrastructural facilities (Roads, Railways, etc.)

Causes for low capital formation

1. Low Income of Individual
2. Poor technology is being existed
 3. Low productivity
4. Domestic savings are very small
5. Inducement to investment is very weak.
Why capital formation is essential:
1. For higher production & productivity
2. For higher level of Income
3. For better employment
4. For high standard of living
5. For better Economic condition
6. For high infrastructural facilities

Suggestions for improvement of Capital formation

1. Production should be increased by developing Agriculture, trade, Industry, transport,
banking, insurance etc.
2. Compulsory insurance scheme should be implemented
3. Provident fund scheme should be extended
4. Tax reliefs should be given to industries which are producing capital goods.
5. Safety of life and property Guaranteed
6. Capital market should be well established
7. Population should be controlled
8. The working of stock exchanges should be improved
9. Small saving drive should be intensified

Steps should be taken to improve the distribution of wealth in the Country.