Factor Pricing

The theory of factor pricing, also called the theory of distribution, explains how the reward of each factor of production is determined. The four factors of production are land, labour, capital and entrepreneurship, and their respective rewards are rent, wages, interest and profit. Just as the price of a commodity is determined by the demand for and supply of that commodity, the price of a factor is determined by the demand for and the supply of that factor. This chapter explains each of the four factor prices.

Rent

Rent is the reward paid for the use of land. In ordinary language rent means the periodic payment made by a tenant to a landlord for the use of land or a building, but in economics rent has a special meaning. According to David Ricardo, rent is the payment made for the use of the original and indestructible powers of the soil. Ricardo held that rent arises because land differs in fertility and situation. The most fertile land is cultivated first, and as demand grows less fertile land is brought under cultivation. The surplus that the more fertile land yields over the least fertile or marginal land, which itself pays no rent, is economic rent.

Modern economists broaden the idea. Economic rent is the surplus earned by any factor of production over and above its supply price, that is, the minimum payment necessary to keep it in its present use. Rent arises whenever the supply of a factor is limited or inelastic.