We have now addressed the basic requirements of production—acquiring land, labor, physical and human capital, and finding financial capital to pay for it. Is that all that is required to operate a business? Not quite. Recall that the four factors of production are land, labor, capital, and entrepreneurship.

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What is entrepreneurship? Entrepreneurship is the willingness to take risks and to use ideas to convert physical inputs into final products that are appealing to consumers. Entrepreneurship is an essential factor of production—without a great idea on how to use resources, the final products will likely be of little value or may not even be produced.

Profits are the rewards entrepreneurs receive for (1) combining land, labor, and capital to produce goods and services, and (2) assuming the risks associated with producing these goods and services. Entrepreneurs must combine and manage all the inputs of production; make day-to-day production, finance, and marketing decisions; innovate constantly if they hope to remain in business over the long run; and simultaneously bear the risks of failure and bankruptcy.

As we have seen over the past decade, large firms that have become household names can implode quickly. Circuit City, Blockbuster, and Borders are a few companies that have closed after filing for bankruptcy.

Even for large firms, business is risky. Bankruptcy or business failure, meanwhile, can be exceedingly painful for business owners, stockholders, employees, and communities. Still, a free economy requires such failures. If firms were guaranteed never to fail, perhaps through government subsidies, they would have little incentive to be efficient or to innovate, or to worry about what consumers want from them.

When a firm earns economic profits—profits exceeding normal profits—this is a signal to other firms and entrepreneurs that consumers want more of the good or service the profitable firm provides, and that they are willing to pay for it. Profit signals shift resources from areas of lower demand to the products and services consumers desire more highly.

Innovation describes both entrepreneurship, when individuals and firms develop something new, and the constant retooling of existing products. Innovation arguably is the most productive input in the production process. Many countries, such as those in sub-Saharan Africa, have abundant natural resources and labor, yet have not been able to convert those inputs into substantial outputs. Meanwhile, countries such as Japan, Germany, and Sweden, have compensated for their more limited natural resources by generating high levels of human capital and innovation, and consequently generate a very high standard of living for their citizens.

An important issue is that to encourage innovation, those who innovate must be provided with incentives to make the money and effort invested worthwhile. For example, an individual’s or a firm’s innovations can be protected using intellectual property rights, including patents, copyrights, trademarks, and industrial designs, allowing innovators an exclusive right to earn profits from their investments for a fixed amount of time.

The importance of innovation as a driver of economic growth will continue to increase as the economy becomes more globalized. Specifically, deficiencies in physical capital can easily be resolved through trade and foreign direct investment. But deficiencies in human capital and innovation are a much more difficult obstacle to overcome.

Therefore, the future of a country’s economic growth will depend on its ability to generate new ideas and find more productive uses of its limited resources. At the start of this chapter, we discussed the aerospace industry and its goals of developing planes that provide more comfort to passengers, and reduce operating costs. Both objectives increase the productive use of limited resources, which will allow the industry to grow as people demand more travel.

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But advances in innovative technology cannot be limited to just a few industries. All industries must avoid falling behind the trend of increasing productivity throughout the world. Emerging countries have begun to invest significant sums to improve physical infrastructure and human capital. This had led to innovations in all industries and an improvement in the standards of living in these countries. In order for rich nations to continue increasing their standard of living, they must continue to innovate; otherwise, emerging countries such as China or India will be quick to catch up.