Capital

The third of the classical "factors of production" is capital. The earliest generation of economists did not think of capital as being an independent factor. But as the nineteenth century wore on, it was increasingly clear that capital (and specifically, mechanization) is a key factor in modern production. It was Nassau Senior who pointed out that capital investment in and of itself would increase productivity. Senior wrote "That the powers of Labor, and of the other instruments that produce wealth, may be indefinitely increased by using their Products as the means of further production."

As we know, capital is more than just machinery, but it may be helpful to think in terms of a specific kind of machine. We may think of a tractor to be used on the potato farm. As we increase the number of machines in use, with the same amount of land and labor, output will increase, but at a decreasing rate. Capital, like the other inputs, is subject to diminishing returns. Once again, we will focus on the "marginal productivity" of the machines. On the other hand, the costs of using the machinery will also increase as the number of machines increases.

The machines will gradually wear out and will have to be replaced.

It is customary to deduct wear and tear from the output, so that the total and marginal productivity are net of wear and tear. But, for practical applications, we should remember that wear and tear is a real cost and must be taken into account.

The resources "tied up" in the machine have an opportunity cost.

The money laid out to buy the machines pays for the resources used in producing the machines. The money (and resources) will be recovered only gradually, using the machines to produce goods and services. However the money (and the resources) could be used for other purposes. For example, the investor might instead have bought a vineyard, which would produce a crop of wine grapes every year. It will not make sense to invest in the machine unless the net revenue from using the machine to produce goods and services is worth at least as much as the wine grapes. Similarly, the investor might instead have leant his money to someone else, to finance either production or consumption expenditures. It will not make sense to invest in the machine unless the net revenue from using the machine to produce goods and services is worth at least as much as the interest the investor could get on the loan.

As for the supply of capital, that will depend on the decisions made by savers. Many economists believe that an increase in interest rates will result in an increase in saving and so in the quantity of capital supplied, giving an upward sloping supply curve of capital. However, for capital as for labor, it is logically possible that the supply curve (in the economy as a whole) could be backward sloping. For an individual industry, however, the supply of capital will probably be horizontal and correspond to the opportunity cost of capital in other industries.

In the next page, we see a picture of the supply and demand for capital as many economists understand them.