This section is from the "Elementary Principles of Economics" book, by Richard T. Ely and George Ray Wicker. Also available from Amazon: Elementary Principles Of Economics: Together With A Short Sketch Of Economic History
The Three Factors.Three things contribute to production as it is carried on to-day. They are therefore called the factors of production. Of these, two are called original or primary factors, because they exist in the very earliest forms of production, and because it is from them that the third factor is derived. These two factors are land, or nature, and labor. Of these, in turn, we may notice that one is passive, while the other is active. In other words, it is primarily labor, acting upon nature, that produces wealth. From this action of labor upon nature, followed by postponement of the enjoyment of the result of the labor, comes capital, which we therefore call a secondary or derived factor. That is, it is secondary to nature and labor, and is derived from them.
Meaning of the Term.Under the term " nature" we here include all the material things furnished directly by her hand, together with all the natural forces used in production, the power of the wind, the movement of water, gravitation, cohesion, etc. Some of these materials and forces are furnished in unlimited quantities, and are therefore free goods. It is common in economics to use the word " land " instead of " nature," because of all the gifts of nature it is land with which we have chiefly to do in our science. But it must be remembered that the word " land " in this use has the very broad meaning which we have here given it. To avoid any possibility of confusion some economists have used the term "natural agents," when the broader meaning is intended.
What Land does for Production. By analysis we learn that the service of land to production is not a single or a simple thing, but that it usually renders three distinct services. In the first place (1) it furnishes standing room, or situs. It gives men something upon which they may rest and move about while conducting productive processes. Moreover, it enables them to utilize the natural forces which go with the land itself. Mere space is often a source of great value, as can be seen in the case of city real estate. As a continually increasing proportion of a growing population dwells in cities, this first service rendered by land is becoming more important. In the second place, (2) land contains those elements needed by plant life, and thus renders a service to agriculture. We call this property of the land its " fertility." Finally, (3) land contains natural products below its surface, such as coal, gas, petroleum, iron, silver, and gold. Man does not create these natural treasures nor give direction to nature in their formation. Some nations have deemed it unfair that they should become the property of individuals, and have therefore treated them as a common heritage, exacting a rent or royalty for the opportunity to exploit them. This is perhaps generally the case to-day on the continent of Europe; but English law, with its inclination to the exaggeration of private rights, has long established the principle that he who owns the surface owns downward to the centre of the earth and upward to the sky.
The Law of Diminishing Returns from Natural Agents. One of the most fundamental and far-reaching laws in economics is that which describes the result of investing labor and capital upon land or other natural agents. This law, known as the law of diminishing returns, will repay careful thought and study.
Every farmer is naturally desirous of reaping the largest possible return from his expenditure of labor and capital upon his land. Yet this very statement implies that there is a limit beyond which further expenditure will be unprofitable. Let us see why this limit exists, and how it is determined. Suppose the case of an acre of land which a fanner intends to "put into" potatoes. The field would yield some crop even if it were hurriedly and poorly ploughed, if no fertilizer were used, and no care were taken to prevent the growing vines from destruction. Yet the farmer knows that further expenditure of labor and capital will result in a much larger crop, and that, if prices are good, the increased crop will fully repay the increased outlay. If we were to inquire more particularly from the farmer as to his opinion regarding the possibilities, we should get from him something like the following estimate :
An investment of would give a total return of or an average per dollar invested of and so on. Now an examination of these figures will show that a doubling of the expenditure from $5 to $10 results in more than a doubling of the product, and that similarly the increase in the product is more than proportionate to the increase in expenditure in the case following. So, too, there is an increase in the product in each of the other cases given; but notice that when the expenditure is increased from $15 to $20, an increase of one-third, the increase in the product is only from 165 bushels to 200 bushels, an increase of only a little more than one-fifth, and that in the same way in the following case, increasing the expenditure by one-fourth results in an increase of product of only one-eighth, and so on. In other words, up to a certain point an increase of expenditure results in a proportionate or more than proportionate increase in return, while after that point has been reached, further increase in expenditure results in less than a proportionate increase in the return. If it were not for this fact, there would be no limit to the amount of labor and capital which the farmer could profitably employ in the cultivation of the acre of land. And the fact that farmers are everywhere strictly limited as to the amount of such profitable expenditure is complete proof that such a point of diminishing returns exists in the application of labor and capital to natural agents.
It will appear on reflection that the farmer will not necessarily discontinue his expenditure upon the land at the point at which the product begins relatively to diminish. The limit of profitable expenditure will depend upon the price of the product, which of course cannot be exactly known at the time of planting. Thus at a price of ten cents a bushel, the farmer would lose absolutely in all except the second, third, and fourth cases in our illustration, and he would make a surplus only in the third case. At a price of nine cents a bushel, be could not afford to raise the crop at all. On the other hand, at a price of fifty cents a bushel, he could afford to expend $30 upon the acre, since the last $5 of expenditure would yield a return of fifteen bushels, worth $7.50, or $2.50 more than the amount expended in labor and capital. At a still higher price he could afford possibly to expend more labor and capital in the cultivation, the amount depending upon the rapidity with which the proportionate return of the product decreased beyond the point covered by our illustration. Indeed, in the cases assumed there are only four prices, ten to twelve cents, inclusive, at which the point of diminishing returns would correspond with the point at which profitable expenditure would cease. We may, therefore, say that there are two ways in which returns diminish as expenditure increases: there is a diminishing return from the point of view of the product, and there is a diminishing return also from the point of view of the value of the product. The second is of course decisive with the farmer, but this itself is due to the diminishing return measured in terms of the product.
A further point remains to be particularly noted. An imperfect understanding of the nature of the law has led at times to the conclusion that as population increases it becomes increasingly harder to secure the means of subsistence from the soil. But this conclusion is at variance not only with the known facts of the history of society, but also with the law itself when the law is properly stated. It would be a valid conclusion if the point of diminishing returns remained everywhere at the same point from year to year and from generation to generation. But we all know how far from the truth this last assumption is. The art of agriculture is constantly improving as a result of invention and the discovery of better methods and processes, and every improvement makes it possible to secure a greater crop without a greater expenditure; in other words, every such improvement pushes forward the point of diminishing returns. The law of diminishing returns still holds true. There is still a point beyond which further investment of labor and capital upon an acre of land will yield a less than proportionate return, but that point is not now reached so soon as before.
We are now ready for a formal statement of the law which we have been discussing. At any given time, there is a point in the investment of labor and capital upon natural agents beyond which further investment yields a less than proportionate return.
We have taken for our illustration the case of labor and capital expended in agriculture. But the law is equally true of the expenditure of labor and capital upon land or other natural agents in the case of mining, manufacturing, and commerce. The only difference is that in these industries greater amounts of labor and capital may be expended upon a given unit of land, say an acre, before the point of diminishing is reached, than is the case in agriculture.
It is possible to look upon the law of diminishing returns from other points of view than the one here taken. For example, instead of taking an acre of land as a unit and supposing successive amounts of labor and capital to be added to it, we might have considered the farmer himself as the unit, giving him successive amounts of land, labor, and capital to manage. In this case we should also have found at first an increasing and then a diminishing return. As still other points of view are possible, it is important to adhere to one standpoint in comparing different lines of industry.