Returns to A Fixed Factor

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Returns to A Fixed Factor

A factor of production is any input that contributes in a positive way to a production process. For example, to grow wheat a farmer requires inputs such as seed, farm machinery, land, and labor. Economists aggregate factors into three categories: (1) land or natural capital (such as soil, the air individuals breathe, or the fish in the sea); (2) labor (the skills people have and their education, the hours they work and how they cooperate and interact with each other); and (3) capital (machinery and tools that can be used to produce other goods).

An input that can only be changed in a production process in the long run is called a fixed factor. A factor may be fixed because: (1) the input might take a long time to build or replace; (2) it has few substitutes and is required in fixed proportion to other inputs; or (3) more cannot be purchased because its supply is fixed in the short run.

The return to a fixed factor is the payment to owners of fixed inputs. This return is related to the concept of economic rent, described by the English economist David Ricardo (1772–1823) in Principles of Political Economy and Taxation (1817) and defined as the payment in excess of the minimum required to elicit the supply of an input in the long run. Rent is like a windfall gain and can arise because of a factor’s overall scarcity, but may also be due to differential quality, location, or other desirable characteristics of particular units of the input, as shown by R. Quentin Grafton et al. in The Economics of the Environment and Natural Resources (2004, pp. 215–216).

If demand exceeds current supply at the existing price, an input’s price will be bid up, thereby attracting a greater supply in the future. The larger the excess demand and the slower the supply response to a price increase, the greater will be the amount a firm has to pay for an input. Thus a factor fixed in supply, all else equal, will accrue greater returns per unit than if its supply were highly responsive to price changes. Similarly, if a factor is fixed because of inflexibilities in the production process, then any price increase imposes a greater cost burden than if the short-run use of the input could be varied.

Returns to fixed factors have a major influence on the world economy. For example, due to excess demand, the price of crude oil more than doubled over the period 2002 to 2005, despite an increase in supply. Because oil is an essential input into many production processes, firms have, in the short run, little choice but to pay the higher prices in order to maintain their production. The beneficiaries of these price hikes are oil producers. By providing a factor that has few substitutes in many production processes and is also, more or less, globally fixed in supply in the short run, petroleum suppliers receive a windfall gain. These surpluses are worth hundreds of billions of dollars each year and affect the standards of living of millions of people. High oil prices, in turn, encourage oil exploration that should increase supply in the future and also provide incentives for firms to modify their input mix and become less reliant on oil.

SEE ALSO Rent; Returns; Returns to Scale; Returns to Scale, Asymmetric; Returns, Diminishing; Returns, Increasing