Is there a Margin of Production?
|February 16, 2014||Posted by Fred Foldvary under Editorials|
One of the key concepts in classical economics, which was lost when it changed into the neoclassical school of thought, was the extensive margin of production. I have written previously on the margin of production at <http://www.progress.org/fold97.htm>, but because in recent discussions the existence of the margin has been questioned, it is time to revisit the topic.
Imagine a agricultural territory with one crop, corn, and areas of various productivity because of the natural fertility, the climate, and the rainfall. We can number the output in bushels in a range from zero to ten. If the land is not populated or claimed, the first settlers will go to the most productive land, where the output per period of production is ten bushels. When the ten-bushel land is filled, the next settlers go to the nine land, and then the eight-bushel land.
The least productive land in use is called the “margin of cultivation,” or more generally, the extensive margin of production. If land cannot be claimed unless used, the margin is also the best land available for free, hence without rent. The margin is called “extensive” because people keep extending or moving it out to lands of ever lesser quality as the better lands get claimed.
The significance of the margin of production was its role in the determination of rent and wages. The classical law of rent is that the rent of a plot of land equals its output minus what the same quality of labor and capital goods will yield at the margin of production. The law of wages is that the wage level for the economy is set by the wage at the margin of production. The margin of production itself is determined by the supply of labor and the amount of super-marginal land that is unproductively being held by speculators waiting for land values to rise further.
When workers are completely mobile, and not emotionally attached to any location, they will move to the land that provides the highest wage. Competition among equally skilled workers will result in a common wage, because if one area pays more, workers move there, and drive the wage down. The law of wages applies to unskilled labor, and workers with more human capital obtain a premium above that to compensate them for their greater productivity.
There is another margin of production, the intensive margin. In the best lands, another worker can contribute more to output than he earns in wages, and so labor will be hired so long as the extra output (marginal product) of the next worker is greater than the wage. Hiring stops when the marginal product of labor at the intensive margin equals the marginal product at the extensive margin where the wage level is set.
In the early 1800s, the classical economist David Ricardo developed this model of the relationship between land and labor, the original and ultimate factors or inputs of production. In the latter 1800s, Henry George, the last of the classical economists, added land speculation to the model. If land at the margin can be claimed even if not used, it will get fully claimed, and new settlers will have to go to less productive land, which, by the law of wages, drives down the wage for all workers.
In the prevailing mainstream neoclassical school of economic thought, land disappears, and theory only uses labor and capital goods. The margin of production also vanishes from theory – you will not find it in any economics textbook other than my Science of Economics. The wage level in neoclassical economics comes from a simple economy-wide supply and demand model. What today’s economists do not realize is that the area in the graph between the demand for labor curve and the wage line is land rent. You can see this illustrated in the lower left graph at <http://www.foldvary.net/ec2/four-graph/morris.doc>, where the rent is the area between the demand curve labeled D and the horizontal real wage line labeled R. The rent in that neoclassical model is the same as the rent in the classical model, illustrated at <http://www.foldvary.net/images/RentWages.jpg>.
But some followers of Henry George now question whether the margin of production exists in today’s economy. All solid surface land today has been claimed either by private title or by governments. There is bare land that is not being used, but is it possible to have any production there at all?
If the margin of production is no longer relevant, then the classical economic theory of wage determination no longer applies. Then how is the wage level determined? The output is produced by a combination of land, labor, and capital goods, and the distribution of the wealth depends on how much is going to rent. A ten-bushel plot of land will yield a wage of ten if it is rent-free, while it will yield a wage only of four if the margin is at four, with the same amount and skill of labor. Therefore it is not just the exertion and skill of a worker alone that determines his wage, and it is not the intensive margin of extra workers in the same place that determines the wage, because the typical firm is a wage taker, paying the wage that the market has determined.
The margin of production has to be lurking somewhere in the shadows. The margin is not visible and not obvious and not self-evident. It is the task of economic theory to enable people to understand the implicit reality beneath superficial appearances. The margin of production has no superficial appearance today, as it had in more primitive economies.
The ocean provides one rent-free margin. Another rent-free margin is the edge of cultivation, grazing, or residential land, beyond which is land that is not being used. Today, such land will be claimed, and may have a positive price, such as from speculation that this plot will be developed later, but if such land is submarginal, not being used, with no expectation that it will soon be used, then that implies that there is some marginal border, even if the rent and price are not zero. The essence of the margin is not that the land is unclaimed, or that the land is free, or that the worker is self-employed, but that it is the least productive land in use, beyond which lies submarginal land.
All cities have a margin of production in the top stories of buildings, because another story on top of the existing ones would use the same site surface. Building one more story will not increase the ground rent, so the extra use of that space is rent free, free of extra rent.
The extensive margin of production lurks unrecognized in the neoclassical model. The supply of labor is the least that workers will accept, and that would be close to zero if not for some margin where they can get a subsistence wage. The demand for labor is based on the marginal product of labor at various quantities of labor, and the share of output going to labor depends on the share going to rent due to the productivity of land at the least productive land in use. Of course the wage also depends on the productivity of complementary capital goods.
The margin of production is an implicit reality. We cannot observe the law of wages directly, because the wage of unskilled labor has become distorted by taxes, minimum wage laws, restrictions on employment and self-employment, and mandates such as required medical insurance. We cannot also observe the law of rent directly because of interventions. We need to understand economic theory to mentally envision the hidden economic reality.
The margin of production can no more disappear from the economy than can gravity disappear just because an iron bar is being held up by a magnet. The fact that government interventions alter prices, profits, and output does not imply that supply and demand have stopped working. If theory says there is a margin of production, it must be there, and our task is to uncover its implicit reality.