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Understanding Factors of Production
Understanding Factors of Production
For anything to be produced (made) by a firm (business), they require one or a combination of the Factors of Production. There are 4 factors of production and they are as follows:
Land - This is the natural land or resources of the land, such as raw materials. This is sometimes referred to as Natural Capital.
Labour - This is the workers or people who work for a firm. This is sometimes referred to as Human Capital
Capital - This refers to the machinery or technology that is used in the production process. This is sometimes referred to as Physical Capital.
Enterprise - This refers to the ideas or ownership of firms and produce profits.
In order for a firm to make anything, the firm must use one or more of the above. For example, a coffee producer requires Land - to grow the coffee on, Labour - to maintain and pick the coffee, Capital - the machinery to process the coffee berries into coffee beans to be sold and finally, the Entrepreneurship - this is the farm owner who runs the business.
Understanding these factors of production in economics is important. Not only are they used in the production process, but they are also help us understand how people in an economy receive an income. Income is the money received for providing one of the factors of production. For example, a person working on the coffee farm (who isn't the owner of the farm) will receive a salary or wages for providing their labour. This is what we call a Factor Payment and helps us understand how money flows around an economy. We will look at this in more detail in the section on the Circular Flow of Income.
Scarcity, Choice and Opportunity Cost
Scarcity, Choice and Opportunity Cost
Scarcity is the concept of something being limited. In the case of economics, an economies Factors of Production or resources is limited to a certain amount. At a moment in time, a country has a fixed amount of people able to work (labour), a fixed amount of machinery, a fixed amount of natural resources and land. As a result, in that period of time, that particular economy can produce a maximum amount of goods. This is because of Scarcity.
Understanding the Basic Economic Problem
Understanding the Basic Economic Problem
In Economics we use Economic Models to help us understand what will happen if there is a change in a situation or event and what could happen as a result. We will discuss more of this in the Methodologies part of the introduction. For now, we will look at one such model to help us illustrate the ideas above and the basic economic problem. Below is an example of a Production Possibility Curve.
Imagine the following scenario. You have set aside 5 hours to study for upcoming exams. For simplicity, let's take 2 subjects. Maths and Economics. You can study Maths for 5 hours or study Economics for 5 hours or a combination of the two (3 hours economics and 2 hours maths). In this case time if the finite resource, you have a scarce (limited) amount of time. As a result you are presented with a choice. If we were to plot the possible combinations of study, we would have a diagram that looks like the above.
We can see from the above all of the possible combinations of study within the given time. For example, if you were to study for 4 hours of Econ, you can study only for 1 hour of Maths. Similarly if you want to study more maths, you must forego one hour of economics (-1 hour) to study an additional hour of maths (+1 hour). The finite hours of study (5) means that you can't study 4 hours of Economics and 4 hours of Maths. This therefore forces you to make choices.
This concept of choice due to scarcity (limited amount) of time, presents you with what we call in economics opportunity cost. That is, if you forgo one hour of economics to study one additional hour of maths, what is the cost of the lost hour of studying economics.
Economics is therefore, the study of how we can best allocate scarce finite resources to produce infinite wants.
In economics, due to scarcity, we will always face opportunity costs, but our aim is to minimise the opportunity costs and therefore make decisions which bring the most benefit, whilst limiting the costs. This situation presents us with Trade Off's. In this situation, if we want to study 1 more hour of economics in our fixed time, we must give up studying 1 hour of Maths. We aren't able to increase studying Economics and Maths by 1 hour each.
The Production Possibility Curve
The Production Possibility Curve
To the right, we can see the Economic Model called a Production Possibility Curve (PPC). The PPC is a model that is used to show the combination of two goods we can produce with our given limited resources, represented by the purple curve.
For example, if an economy produced at point A, it could produce 15 units of guns and 0 units of Butter. In order to produce more units of butter, it must forego units of guns. In this case, in order to produce at point B, which is 100 units of butter and 10 units of Guns, the opportunity cost is 5 units of guns to produce 100 units of butter.
If the economy wishes to produce 200 units of butter (point C), then it must forego a further 2 units of guns in order to do so.
It is only when the economy is producing at a combination of the two goods within the PPC that it will not face a trade off. For example, if the economy is operating at point D, producing 8 units of guns and 100 units of butter, it is able to produce both more guns and more butter without the trade off. This is because at point D, the economy is producing below its maximum potential.
However, as with all economics models, the above is based on a number of assumptions that limit the models analysis. These assumptions include:
The resources are given and remain constant.
The technology used in the production process remains constant.
The resources and technology are fully and efficiently utilized.
The technique of production remains constant.
Producing more of both Goods
Producing more of both Goods
In the PPC model to the left, we can see that we are able to produce a greater quantity of both goods. This is caused by an increase in the available factors of production. For example, if the economy was producing at point A and produced 10 capital and 8 Merit goods, with an increase in FOPs, we could produce at point B, C or D (which producers greater quantities of both goods) without foregoing any of either good and therefore avoiding the opportunity costs.
This is only true until we produce anywhere along the PPC, at points B,C,D the above assumptions made hold true once again and so to produce more of one good, we will need to forego the production of another.
Calculating the opportunity cost
Calculating the opportunity cost
Opportunity cost is the value of the next best alternative that must be sacrificed when a choice is made. Because resources are scarce, producing more of one good inevitably means producing less of another. The PPC allows us to measure this trade-off visually and numerically.
On the PPC, moving from one point to another represents reallocating resources between two goods. The opportunity cost of gaining more of one good is shown by how much of the other good must be given up.
Step-by-Step: Calculating Opportunity Cost
Step-by-Step: Calculating Opportunity Cost
Identify the two points on the PPC
Choose two points that represent different production choices.Note the output levels
Record the quantities of each good at both points.Calculate the change in one good
Find how much production of Good A increases (or decreases).Calculate the change in the other good
Find how much production of Good B must be reduced.Calculate the opportunity cost
The opportunity cost of the increase in Good A is the reduction in Good B.
The above table shows the combinations of two goods that can be produced, if all of our resources were fully used. If we plotted this data, we would get the PPC/PPF below:
The above represents the Production Possibilities for food and clothing.
Moving from Point B (10 food, 27 clothing) to Point C (20 food, 21 clothing):
Gain = 10 units of food
Loss = 6 units of clothing
Opportunity cost of 10 units of food = 6 units of clothing
Therefore, opportunity cost of 1 unit of food = 0.6 units of clothing
The opportunity cost above of 1:0.6 shows the marginal analysis. In economics, when we analyse anything Marginal, this means for 1 additional unit. In this case, to produce 1 more unit of food, we must give up 0.6 units of clothing. It is important to note however, that this analysis is solely the marginal analysis between points B and C.
In the example, the opportunity cost of food rises as we move from left to right. This is because the relationship between the production of the two goods is not proportional. Most PPCs are concave to the origin (bowed outwards). This reflects the law of increasing opportunity cost: as more resources are devoted to one good, resources less well-suited to its production are used, so the opportunity cost of producing additional units rises.
From A → B: 3 clothing lost for 10 food = 0.3 clothing per food
From B → C: 6 clothing lost for 10 food = 0.6 clothing per food
From C → D: 9 clothing lost for 10 food = 0.9 clothing per food
Understanding Free Goods and Economic Goods
Understanding Free Goods and Economic Goods
The above situation is true for goods that require scarce resources in their production. For example, cars require metals and other materials in the production process. Therefore, when one person consumes that goods that has been produced, this will impact the ability by another to consume. If we chose to produce only a certain amount of cars, this will impact someones ability to consume. These goods are referred to as Economic Goods, goods which use scarce resources in the production and therefore provide an opportunity cost.
On the other hand, there are some goods that provide zero opportunity cost to produce and consume. They require no scarce resources to produce or consume. A simple example is air. Everyone has the ability to consume air, without that consumption limiting someone else's ability to consume (and therefore providing an opportunity cost). We refer to these goods as free goods.
Understanding the Basic Economic Problem
Understanding the Basic Economic Problem
How does the above problem look like on a wider scale for an economy. Well, as we have mentioned, we have a limited amount of resources, how do we best use these scarce resources to produce Economic goods? Who decides how to use these resources? How do we deal with the opportunity cost?
These questions help form the Basic Economic Problems (or Questions)
How to Produce?
What to Produce?
For whom to Produce for?
These questions have been the key questions governments have been trying to answer for centuries. We will look more into these ideologies in the Economic Thinkers part. In part we will look at whether a Free Market (the interaction between consumers and producers) best answers these questions or whether the government best decides in a Planned Economy. Or is there a balance between free markets and intervention needed to best address these questions in the form of a Mixed Economy.
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