1 Factors of Production – Overview (Cambridge 9708)
Economics distinguishes four classic factors of production. Each factor supplies a distinct input to the production process and receives a specific reward (factor‑price). The syllabus also requires students to understand opportunity costs, mobility constraints and any externalities associated with each factor.
| Syllabus code |
Factor |
Typical reward (factor‑price) |
Key features (incl. opportunity cost) |
| 1.3.1 |
Land (natural resources) |
Rent |
- Fixed supply in the short‑run – the quantity of land cannot be increased quickly.
- Includes minerals, forests, agricultural land and location advantages (e.g., city‑centre sites).
- Opportunity cost: the foregone return from the next best alternative use of the land (e.g., using a plot for housing instead of a factory).
- Immobile – cannot be moved; relocation would require huge costs.
- Possible externalities: environmental damage from extraction, congestion from urban land use.
|
| 1.3.2 |
Labour |
Wages |
- Human effort measured in hours worked.
- Quality depends on skills, health, motivation and experience.
- Opportunity cost: the income that could be earned in the next best employment or leisure activity.
- Highly mobile – workers can move between firms, regions or countries (subject to migration costs).
|
| 1.3.3 |
Capital – Physical & Human |
Physical → Interest / rent / profit
Human → Higher wages (reflecting a higher marginal product of labour) |
- Physical capital: tangible man‑made goods used to produce other goods (machines, buildings, infrastructure).
- Human capital: intangible stock of knowledge, skills, health and abilities acquired by individuals.
- Opportunity cost: the foregone return from using funds for alternative investment or from time spent acquiring skills.
|
| 1.3.4 |
Entrepreneurship |
Profit (return to risk‑bearing) & Entrepreneurial rent (excess profit above normal returns) |
- Risk‑taking, innovation and coordination of the other three factors.
- Decides on the optimal combination of inputs and bears the uncertainty of outcomes.
- Opportunity cost: the return that could be earned by investing resources in the next best activity (e.g., a salaried job).
- Mobility constraints: entry barriers, licensing requirements and capital requirements can limit movement into entrepreneurship.
|
1.5 Division of Labour & Specialisation (1.3.5)
- Division of labour – breaking a production process into separate tasks.
- Specialisation – workers (or firms) concentrate on the tasks where they have a comparative advantage.
- Both increase the marginal productivity of labour and capital, shifting the production possibilities curve (PPC) outward.
- Illustrated by Adam Smith’s pin‑factory example and modern assembly‑line production.
2 Capital – Two Distinct Forms
Within the capital factor, the syllabus requires a clear distinction between human capital and physical capital. Both raise productivity, but they differ in nature, acquisition, measurement and economic effects.
2.1 Human Capital
- Definition (1.3.3): The stock of knowledge, skills, health and abilities that individuals acquire through education, training, experience and medical care.
- Form: Intangible; resides in people.
- Acquisition: Schooling, vocational training, apprenticeships, on‑the‑job learning, health services and continuous professional development.
- Depreciation: Skill obsolescence, health decline, or migration of skilled workers; requires ongoing investment to maintain or upgrade.
- Mobility: Highly mobile – workers can move between firms, regions or countries (subject to migration costs).
- Measurement: Average years of schooling, literacy rates, health indicators, or proxy measures such as wage differentials and productivity gaps.
- Reward: Higher wages (or higher marginal product of labour) and, where relevant, profit‑sharing that reflects the contribution of enhanced labour.
- Effect on the production function: Shifts the labour‑productivity curve upward; for a given amount of labour, output increases.
2.2 Physical Capital
- Definition (1.3.3): Tangible, man‑made goods used in the production of other goods and services (machinery, equipment, factories, infrastructure, ICT).
- Form: Concrete; can be seen, touched, bought, sold or rented.
- Acquisition: Investment spending by firms or the state on machinery, buildings, transport networks, research labs, etc.
- Depreciation: Physical wear and tear, technological obsolescence; recorded through straight‑line or reducing‑balance depreciation schedules.
- Mobility: Relatively immobile – relocation entails high transport, installation and downtime costs.
- Measurement: Monetary value of the capital stock (net capital stock in national accounts) obtained from capital‑stock surveys and other statistical sources.
- Reward: Interest on borrowed funds, rental income, or profit derived from the marginal product of the capital asset.
- Effect on the production function: Increases the amount of output that can be produced per unit of labour; shifts the aggregate production curve outward.
2.3 Key Differences at a Glance
| Aspect |
Human Capital |
Physical Capital |
Relevant Syllabus Terminology |
| Nature |
Intangible; resides in people |
Tangible; man‑made assets |
Human capital – intangible factor of production; Physical capital – tangible factor of production |
| Acquisition cost |
Education, training, health expenditure |
Investment in machinery, buildings, infrastructure |
Both are “investment” – human capital via spending on education/health, physical capital via capital formation |
| Depreciation |
Skill obsolescence, health decline, migration of skilled workers |
Wear‑and‑tear, technological replacement |
Human capital – “skill loss”; Physical capital – “depreciation” |
| Mobility |
Highly mobile (labour market) |
Low mobility – costly to relocate |
Human capital – mobile factor; Physical capital – relatively immobile factor |
| Measurement |
Years of schooling, health indices, wage differentials |
Monetary value of assets; net capital stock; capital‑stock surveys |
Human capital – measured by “human‑capital stock”; Physical capital – measured by “physical‑capital stock” |
| Reward |
Higher wages (reflecting higher marginal product of labour) |
Interest, rent, profit |
Human capital – “wage reward”; Physical capital – “interest/rent/profit reward” |
| Effect on production function |
Shifts the labour‑productivity curve upward |
Increases output per unit of labour (shifts aggregate production outward) |
Both raise total factor productivity (A) in the Cobb‑Douglas function |
3 Illustrative Production Function
A Cobb‑Douglas function that recognises both forms of capital is:
\[
Y = A \cdot K^{\alpha} \cdot H^{\beta} \cdot L^{\gamma}
\]
- \(Y\) – total output (real GDP).
- \(A\) – total factor productivity (technology, institutions, efficiency).
- \(K\) – physical‑capital stock.
- \(H\) – human‑capital stock (e.g., average years of schooling or a composite skill index).
- \(L\) – labour input (hours worked).
- \(\alpha, \beta, \gamma\) – output elasticities (positive constants; usually \(\alpha+\beta+\gamma = 1\) for constant returns to scale).
Holding other inputs constant, an increase in either \(K\) or \(H\) raises \(Y\), demonstrating why both forms of capital are essential for long‑run economic growth.
4 Economic Methodology (AO1 – Knowledge)
Positive vs. normative statements
• Positive: “An increase in human‑capital investment raises the marginal product of labour.”
• Normative: “The government should increase spending on vocational training.”
Ceteris paribus – All other relevant factors are held constant when analysing the effect of a single change (e.g., the impact of a rise in physical‑capital stock on output, assuming labour, human capital and technology are unchanged).
Time‑period considerations – Distinguish between short‑run (some inputs fixed) and long‑run (all inputs variable) analysis; capital accumulation is a long‑run process, whereas labour‑hours can be adjusted in the short run.
5 Why the Distinction Matters (Policy & Growth)
- Policy implications – Governments may allocate resources to:
- Education, health and skills programmes (human capital).
- Infrastructure, research labs, subsidies for machinery (physical capital).
- Growth strategies:
- High‑human‑capital economies tend to innovate, adapt to technological change and achieve sustained growth.
- Physical‑capital‑rich economies can industrialise rapidly but may face diminishing returns without complementary skill upgrades.
- Income distribution – Returns to human capital appear as higher wages; returns to physical capital appear as interest, rent or profit. Understanding the split helps explain patterns of inequality.
- Externalities & opportunity costs – Over‑exploitation of land creates environmental externalities; under‑investment in human capital can generate a “skill gap” externality that reduces overall productivity.
6 Examples
- Human capital: A civil engineer who holds a university degree, has completed a chartered‑engineer programme and regularly attends CPD (continuing professional development) courses.
- Physical capital: The design software, high‑strength steel, construction cranes and the bridge site that the engineer uses to deliver a new highway.
- Land: The river valley where the bridge is built; the owner receives rent for its use.
- Entrepreneurship: The construction firm’s managing director who decides the mix of labour, machinery and subcontractors, bears the risk of cost overruns and earns profit; any profit above the normal return is termed “entrepreneurial rent”.
7 Suggested Diagram (PPC & AD/AS Context)
To illustrate the effect of each type of capital on the economy, draw a Production Possibilities Curve (PPC) and an Aggregate Demand/Aggregate Supply (AD/AS) diagram.
- PPC:
- Vertical axis – output of good A (e.g., manufactured goods); horizontal axis – output of good B (e.g., services).
- Show two outward shifts: one labelled “↑ K (physical capital)” and another “↑ H (human capital)”. Explain that both increase the economy’s productive capacity, but the shape of the shift may differ (physical capital often expands the manufacturing side, human capital expands both sides).
- AD/AS:
- Vertical axis – price level; horizontal axis – real GDP.
- Long‑run aggregate supply (LRAS) is vertical at potential output.
- Illustrate a rightward shift of LRAS when physical capital accumulates (↑ K) and a separate rightward shift when human capital improves (↑ H). Both shifts represent higher potential output.
Label the shifts clearly (“Increase in physical capital” vs. “Increase in human capital”) and add brief captions linking the diagram to the factor‑price theory (higher factor rewards arise because the marginal product of the expanded factor rises).