Factors of Production

Efficient Economic Allocation of Labor, Natural Resources and Capital

An Article in the Compendium of Market-Based Social-Ecological Economics

Key issues in view of the neoliberal crisis:
How can we guarantee employment and fair income?
How can we protect the environment effectively?
How should we shape the economic globalization?
What should the economic sciences contribute?
What must be the vital tasks of economic policy?
How can we legitimize economic policy democratically?

Click here for the list of all articles: Compendium
Click here for the German-language version: Produktionsfaktoren

Table of Contents

  1. Abstract
  2. The Historical Development of the Concept
  3. Productive Factors and Productivity
  4. The Macroeconomic Impact in Detail
  5. Competition between Productive Factors
  6. Neoliberal Factor Competition
  7. Future-Proof Factor Competition

1. Abstract

ProduktionsFaktorenJPG03There is broad consensus as to the substantial scope of productive factors. However, their economic function is distorted by the current (neoliberal) economic system due to the interests of powerful capital owners, especially with respect to the efficiency of factor allocation and the associated sustainability. The deregulation of national economies, which is promoted by these interests, is aimed solely at the efficiency of capital – at the expense of labor and natural resources – and ends up in overall economic inefficiency, that is: in economic destruction. For more details see the article Economic Globalization.

2. The Historical Development of the Concept

The synonymous terms “factors of production” and “productive factors” both refer to material (physical) and immaterial goods and services which are used to produce other goods and services. The productive factors (as input) are combined in a production process to achieve a desired production result (output). Classical economics introduced labor, land and capital as productive factors and assigned wages, rent and profit as the corresponding income types, thereby laying the foundation for national and business cost accounting. Later, Marxism fell back into conceptions of bartering and regarded human labor as the only value-creating factor. Consequently, it described land and capital as subordinate means of production, thus letting the chance slip to develop a coherent cost allocation for capital-intensive productions.

ProductiveFactorsPNG01Modern economics extends the substantial scope of productive factors and distinguishes between the groups of labor, natural resources and capital. The factor labor not only includes paid labor, but also all means and measures of education and training as well as managerial and entrepreneurial tasks. The corresponding potential of the labor force is called human capital. The factor natural resources, also referred to as natural capital, comprises land, raw materials (non-renewable and renewable resources such as minerals and wood respectively), energy carriers and energy, including the labor and capital costs for their exploitation; also included are the soft locational factors such as taxation, standards and legal requirements. The factor capital (more precisely: non monetary, physical or real capital) comprises all material goods produced in previous periods, such as buildings, roads, industrial plants, machinery and tools, as well as all intangible assets such as processes, patents and stored knowledge. Accordingly, real capital includes production technologies and thus substantiates progress.

Monetary or financial capital is not regarded as a productive factor in the strict sense, but can be exchanged for labor (by paying wages), for natural resources and real capital (by paying prices), thereby bringing fresh impetus for new economic value creation. This effect is intensified when the private savings volume is made available to business enterprises through commercial banks as loans, and when the enterprises pay interest for the borrowed money that flows to the involved banks and private savers in due proportion. For further support of economic value creation, banks can provide fresh money to enterprises as loans within the limits of the so-called creation of credits controlled by central banks (for more detail see the article Money Creation and Destruction).

Labor and natural resources are both called original factors of production since they are naturally present, whilst capital is termed derivative factor, because it is derived from the two original factors.

For practical considerations business administration (industrial economics) does not follow the general economic distinction between productive factors as described above. According to E. Gutenberg (1951), the managerial or entrepreneurial task, as the dispositive factor, includes auxiliary functions such as planing, organizing and controlling. On this basis, the dispositive factor combines, manages and controls the subordinate elementary factors for the business success. The elementary factors include the object-related human labor; operating resources such as buildings, machinery, tools and equipment; materials, which are subdivided into raw materials, semi-finished products and indirect material; and finally energy. Gutenberg’s structure has a crucial disadvantage in that the distinction of scarce natural resources and increasable real capital is neglected although it is indispensable for ecological orientation and balance. Under the current neoliberal economic system this distinction is not only neglected at the business level, but also at the macroeconomic level. In addition, the substantial losses of natural resources are not recorded by national accounting systems and hence cannot be fought (see next paragraph).

3. Productive Factors and Productivity

Macroeconomic productivity results from the aggregated efficiency of production processes and the efficiency of the macroeconomic distribution and allocation of productive factors to the production processes. When determining a particular business productivity, the macroeconomic distribution and allocation of productive factors is obviously not the primary focus. However, to ensure that the aggregate of all recorded business productivities matches the recorded macroeconomic productivity, a uniform and mandatory basis for the calculation of both the business and macroeconomic balancing is required. The starting point, apart from the usual commercial criteria, must be the social and environmental criteria of macroeconomic efficiency – for example regarding the distribution of income and the access to clean water – to be applied to both business and macroeconomic accounting.

In the first stage these criteria are qualitatively defined and subsequently have to be transformed into numerical quantities which can be expressed in local currency. On this basis, the relevant numerical quantities are individually derived for each economic process to the best of the present social and ecological knowledge and entered into the business and national accounting systems. That way, the external costs imposed on society and environment by economic activities are recorded to the largest possible extent and charged to the causers for avoidance. In economic terms that means: the external costs are internalized.

With such a downright accounting, the high external costs generated in the current (neoliberal) economic system would shed light on the actually negative business and macroeconomic productivities. However, to counteract this development there is no way but to start disclosing the external costs and their causes.

For a better understanding of the impact of the present neoliberal doctrine I recommend the articles Neoliberal Vicious Circle, Neoliberal Economic Doctrine and Excesses of Capitalism.

If we fail however to establish social and ecological criteria for the regulation and control of economic activities, enterprises will be furthermore tempted to operate short-sightedly, to hold back external costs on their balance sheets and to show falsely inflated productivities. The same applies for national accounting systems, which will furthermore show equally false and excessive macroeconomic productivities. All in all, there will still be no base for economic and political countermeasures and the social and ecological decline will still be veiled.

4. The Macroeconomic Impact in Detail

With regard to the productive factors, sustainable overall economic efficiency essentially means that labor demand matches labor supply regarding both quantity and quality, that natural resources are used sustainably, and that the productive capital is subordinate to the efficient allocation of labor and natural resources, in other words: returns on capital investments must be attained without exception on the basis of efficient allocation of labor and natural resources, that is, on the basis of full employment and sustainable resource use.

Factor »Labor«: The maximum efficiency of human labor is achieved when the entire workforce can productively use its skills and make a living from its work, that is, when the workforce can participate in economic life under conditions of full employment and without requiring state transfer payments, and finally, when the factor labor is not burdened with work related illnesses and accidents. Full employment and existence-securing earned income can best be achieved through decentralized, subsidiary economic structures (for more details see the article Economic Subsidiarity).

Subsidiary structures guarantee

  • that the efficiency of capital, being synonymous with the returns on investment, is placed at the service of the efficiency of labor (and natural resources, see below), and
  • that concentrations of productive capital are prevented.

This means in particular that productivity gains through economies of scale and economies of scope may only be realized within the social and ecological limits set by subsidiary structures, and that these structures have to be decentralized uncompromisingly to the extent allowed by the technological options and requirements of production. Conversely this means, the economic structures must not be guided by the technologically achievable maximum of economies of scale and scope. Moreover, the efficiency of labor, and thus the productivity of economic processes, can indefinitely be increased by acquisition of knowledge. See in addition the article Scale Economies and Productivity.

In a market economy the allocation of labor takes place in dependence of labor market conditions, when jobs and wages are negotiated under the conflicting influence of supply and demand.

Factor »Natural Resources«: The maximum efficiency of natural resources is achieved when the non-renewable, scarce resources such as land and minerals are permanently re-used (recycled) or replaced (substituted) by renewable resources insofar as possible, and when the latter are only used within the limits of their natural regenerative capability. The re-use of non-renewable resources like minerals can and should be ensured through downstream reprocessing (technological recycling). The re-use of renewable resources such as wood should be ensured through downstream composting (biological recycling) if an immediate re-use is not possible.

Incentives for an efficient allocation, meaning minimal damage and contamination of resources and efficient re-use, can be created through fiscal measures (taxes) and legal requirements. As with labor, subsidiary economic structures to assign the responsibility for efficiency directly to the local players and to prevent externalization, are an essential prerequisite for effective incentives.

In a market economy the allocation of natural resources takes place in the land and raw materials markets, where prices are as well negotiated between the conflicting poles of supply and demand.

Factor »Capital«: The maximum efficiency of real (physical) capital can only be achieved when its use is aimed at the highest possible efficiency of labor and natural resources. For an isolated capital efficiency (returns on investment), independent from the other factors, is not sustainable and therefore inefficient and destructive. The most important prerequisite for sustainably high capital efficiency are the above-mentioned subsidiary economic structures, which prevent concentrations of capital and formation of monopolies, including the inevitable detachment of arbitrarily high economies of scale and scope from the efficiency of labor and natural resources. This means that the macroeconomic efficiency of factor allocation arises from the structure of production and from the output level produced within the structure. In addition, the efficiency of real capital can be increased indefinitely by further developing its quality. In its intangible form, as knowledge, real capital can even be multiplied indefinitely and thereby contribute indefinitely to capital efficiency. For the productivity of production processes that means: their productivity can also be increased indefinitely. Finally we can conclude that there is no limit for qualitative economic growth, whereas quantitative economic growth is limited by the finiteness of the amount of natural resources that can be used without causing irreversible damage.

In a market economy the allocation of real capital takes place in the markets for capital goods, where prices are also negotiated under the conflicting influence of supply and demand.

The allocation of monetary capital, provided as debt or equity for investments in real capital, takes place in financial and stock markets, where interest rates or emission rates and current rates respectively are negotiated by market participants or fixed by market makers, again under the conflicting influence of supply and demand.

5. Competition between Productive Factors

In a market economy, the factor providers are competing with one another within each productive factor as well as between different factors. Workers, for example, compete with one another, but just as well with natural resources and especially with real capital, because all three factors are mutually exchangeable to a degree depending on their level of development. The progress induced by competition in and between factor markets in terms of efficient factor allocation and social welfare depends on the degree of social and environmental orientation of the economic policy framework and its regulations.

6. Neoliberal Factor Competition

The deregulation, as practiced in the course of the current neoliberal globalization, creates cross-border factor competition starting with a convergence of factor prices and ending up in a worldwide downward spiral of factor prices (for more details, see the article Factor Price Equalization).

Concerning labor that means: In developed countries wages are decoupled from productivity growth and fall due to direct cross-border competition disrupting the balance between productivity, wages and purchasing power, and damaging economic cycles, whilst in developing countries, wages rise in globally competitive industries. In newly industrializing countries such as China, being in a state of transition, both phenomena can occur simultaneously.

Concerning natural resources that means: Price levels fall as low – relative to the U.S. dollar or the euro functioning as quasi-reserve currencies – as the global interplay between supply and demand and the knowledge and fear of resource scarcity and exploitation allow at the time, without creating incentives for sustainable allocation and use of resources. With respect to natural resources and their intermediate and final products, both open markets and uniform dollar and euro prices are responsible for unidirectional trade flows from capital-poor, underdeveloped to capital-rich, highly developed countries.

Concerning capital that means: Real and monetary capital strive to where they can combine the lowest possible wages with the lowest possible resource prices to achieve the highest possible capital returns (returns on investment).

In open (deregulated) markets, factor competition and converging or falling factor prices, combined with the expectation of worldwide welfare gains, prove to be extremely inefficient under neoliberal conditions, meaning they are destructive.

7. Future-Proof Factor Competition

Figure 2: In a market economy with social-ecological orientation, the direct factor competition based on absolute advantages of wages, prices and interest rates takes place exclusively within the boundaries of autonomous economic areas, national and supranational alike. By contrast, cross-border factor competition must be agreed upon, regulated and controlled between autonomous economic areas: Concerning workers, cross-border movements and exchanges have to be bilaterally regulated and controlled. Concerning natural resources and real capital, trade and competition have to be based on bilaterally agreed exchange rates, which have to be recalculated in regular intervals to neutralize the difference of average price levels (and hence productivity levels) between trading partners. This way, foreign trade and its competition can take place, by contrast to domestic transactions, on the basis of relative prices (and relative price advantages) and generate mutual gains in prosperity and welfare. As a complement see the articles Comparative Advantage – upgraded, Future-Proof Foreign Trade and Sustainable Social Welfare.

Quite different from material capital, a direct cross-border competition between immaterial capital (patents, stored knowledge, etc.) can take place on the basis of absolute prices completely independent from bilateral material trade and under the framework of multilateral agreements. This immaterial free trade is, as a compliment of controlled material trade, an absolute necessity for global progress.

Click here for the German-language version: Produktionsfaktoren

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