Under present conditions, it is usual to find the three factors of production combined with one another in every type of production. What is of especial significance in this connection is the fact that it is possible, in considerable degree, to substitute one factor of production for another (substitution of the factors of production). Agriculture, for example, can be carried on by combining a given area of land with little labor and capital (extensive agriculture) or with much labor and capital (intensive agriculture). Labor and capital, in turn, may be substituted for one another; there are many tasks which we may choose to entrust either to manual labor or to the machine. Every housewife who buys a washing machine substitutes capital for labor. Careful reflection on her part is required before deciding whether she should or should not make such a purchase. Two motives can influence her decision, one of which has already engaged our attention. We found that the purchase of a machine is warranted only insofar as there exist sufficient opportunities for its use. In calculating whether her laundry is regularly of a sufficient quantity to require the full use of a washing machine, the housewife is unconsciously employing a general principle of great significance designated commonly as the law of mass production. Using our household laundry as example we may explain this law as follows. The costs of using a washing machine fall into two large groups: the costs which increase or diminish with the amount of laundry (electricity, water, attention required, soap) and those which are given once for all as a fixed amount (interest and amortization on the washing machine). The more clothes there are to wash (the mass or amount of production) the smaller will be the costs of laundering per piece of laundry since the fixed costs are distributed over a greater number of production units.12 The last piece of laundry is thus the cheapest to do as the last passenger to board a train is, from the point of view of the railroad, the cheapest to transport. Hence the dominant consideration in purchasing a washing machine is that the household regularly furnish a sufficient amount of soiled laundry. To artificially soil the laundry for this purpose, as a kind of harmless family sport, would hardly be the ideal of good housekeeping. It would be well if this point could be driven home to those numerous individuals who strive by equally artificial means to extend the system of mass production throughout the economy.
In deciding whether to buy a washing machine, our housewife will be guided by still another consideration—the relation between the prices of the two factors of production. Where labor is less costly as compared to capital (i.e., where wages are low and interest rates high), the washing machine would prove uneconomical. Where these conditions are reversed, it will pay to use such a machine. This explains why in America many more machines are used—in the home as well as in industry and everywhere else—than in Europe, and why in Europe more machines are used than in Asia. It is for the same reason that in American agriculture, labor is much more sparingly used in relation to land and capital than is the case in Europe. In most Asian countries, labor is the cheapest of the factors while land and capital are the dearest; in the United States, labor is the dearest of the factors and land and capital the cheapest. In China, human labor is so cheap that it figures as an important source of motive power in the public transportation system (ricksha coolies). No further explanation is needed to show that in all these cases the price relationships existing among the several factors of production reflect the supply relationships of these factors in the national economy: that factor of production which is at a given moment the “scarcest” is also the dearest, and since it is the dearest it is used, perforce, sparingly. A socialist economy must be guided by similar considerations if it wishes to dispose economically of the several factors of production. A principle of primordial importance is herewith revealed, one which not only enables us to understand how the prices of the factors of production are formed (the wages of labor, the rent of land, and interest) but which also shows that the optimum combination of the factors in a given country is determined by the individual economic structure of that country. Once again we observe that what may be technically impressive is by no means always what is best economically.
It is now clear that one of the chief tasks of the organizer of production—the one who in industry is called the entrepreneur—consists in a continual search for the most advantageous combination of the factors of production. Since all producers tend to aim at this objective, they all collaborate in the formation of the prices of the factors of production. The optimum combination at any given moment is decisively influenced by the fact that the quantity of one of the factors cannot be continually increased without ultimately causing a fall in the yield due to such increase. It is this process which is meant when in agriculture we speak of a “law of diminishing returns.” This means that if to a given area of land we apply ever greater amounts of labor and capital, there occurs a fall in the rate of yield following an initially over-proportionate increase of yield. Here is a truth which everyone can verify experimentally by subjecting some hapless tomato plant to ever heavier doses of artificial fertilizer. This law applies generally to the whole of production in the sense just illustrated, viz., that the continual addition of new increments of one of the factors of production to fixed quantities of the others produces an increased yield which is at first over-proportional and then under-proportional. This is such a commonplace and undisputed principle that cooks make use of it daily. The first dose of salt that is put into a given quantity of potatoes greatly enhances their taste while the utility of succeeding doses becomes increasingly doubtful. The cook knows that there is an optimum combination of potatoes and salt. Thus we arrive at the momentous principle that for every type of production the factors must stand in a harmonious relationship to one another, since otherwise the yield of the one will develop disproportionately to the yields of the others. The average office can certainly benefit by the employment of at least one stenographer, but if the manager of that office hires a second he soon becomes aware that she is by no means as indispensable as the first, that a third stenographer would be even less valuable, etc. Their productivity declines and it is clear that the productivity of the last stenographer hired—the “marginal productivity” of this species of productive factor called labor—can hardly be higher but also hardly lower than her wage.