Land market
Land is not a homogenous resource, and that important complication cannot be skipped over. It is the basis of the theory of rent, first proposed by English economist David Ricardo, and still considered the correct theory of rent by just about all economists.
Some land is more fertile than other kinds of land, or more profitable because it is closer to markets; and some land is more suitable to one kind of crop than another. These differences in fertility will be reflected in the marginal productivities and therefore in the demands for the different kinds of land. Let us think of a very small economy with just three kinds of land: good, fair, and bad. There are just 10,000 acres of each kind of land. The supply and demand for each kind of land is shown in Figure 4 below:
Figure 4: Marginal Productivity of Land with Different Fertilities
The demand for good land is pMPA, for fair land pMPB, and for bad land pMPC. The supply of land of a particular quality is always a vertical line, because "they're not making any more of it" – the supply of land cannot be increased no matter how high the price. Since there are 10,000 acres of each sort of land, the three kinds of land have identical supply curves, all shown by the vertical line at S.
In a supply-and-demand equilibrium, then, the rent per acre of good land will be RA. For fair land it will be RB, and for bad land zero. The bad land in this example is what Ricardo called "marginal" land – good enough to be cultivated, but only if it can be had free of rent.
Thus, the rent on fair land is just enough to offset its greater productivity relative to the marginal land. Similarly, the rent on good land is just enough to offset its productivity advantage over marginal land. If the rent of good land were any lower than that, no-one would want to use fair or marginal land, but all would compete for the limited supply of good land – forcing the rent on the good land up until it is large enough to offset the productivity advantage of that good land. Similarly, the difference in rent between the good and fair land is just enough to offset the productivity differential between them. This is called the "differential" theory of rent – that the rent of any land is just large enough to offset its differential productivity relative to marginal land. To stress the basis of land rent, it is often called differential rent.
Capital market
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.
Of course, capital includes many kinds of producers' goods, from tractors and other machines through grapevines and orchards and many intangible assets. What they all have in common is the opportunity cost corresponding to the interest rate. With that in mind, we identify the price of capital as the interest rate. The demand for capital is the marginal productivity of capital (net of wear and tear) times the price of output.
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.
Here is a diagram the demand for capital by an individual firm as it is sketched in the previous page. We assume that the firm uses a given quantity of labor and land and that the quantity of capital used varies. The quantity of capital used (measured in dollars' worth) is marked off on the horizontal axis. On the vertical axis is the rate of interest, which we understand as the price of capital.
In the diagram, the horizontal red line, corresponding to the market interest rate, is the supply curve of capital to the firm. The green line is the demand for capital, that is, the marginal productivity of capital (net of the cost of wear and tear of specific capital goods) times the price of the output – the value of the marginal product of capital. The profit-maximizing demand for capital for the firm is shown by K. That is, it will be profitable to expand the capital stock of the company until diminishing returns reduces the value of the marginal product to r, the market rate of interest, at K.
Some economists criticize this approach to the supply and demand for capital on the grounds that "capital" really consists of many different kinds of capital goods and cannot be expressed as a single amount of "capital." If we accept that argument, we would have to think of a marginal productivity curve and demand for each respective capital good, measure the capital goods in natural units (number of machines, number of grapevines, and so on), and treat the price in a little more complicated way. But, for microeconomics, the results would be pretty much the same: the demand for a capital good, like the demand for any input, depends on marginal productivity.