Economic rent

This article is about Economic rent pertaining to economic theory. For other uses, see Rent.

In classical economics, three factors of production were recognized: labor, capital and land. Wages were defined as the portion of production that went to the workers for their contributions of labor to production; interest was the portion that went to the owners of tools, buildings, etc. for their contributions of capital to production; and rent was the portion that went to landowners for not blocking production on the land they controlled. David Ricardo is credited with the first clear and comprehensive analysis of land rent and the associated economic relationships (Law of Rent), and his conclusions have long been accepted by all competent economists.

Economic rent is distinct from economic profit, which is the difference between a firm's revenues and the opportunity cost of its inputs. The term "economic profit" does not seek to clarify income from Wages, interest and rent. Real business enterprises typically own some of the factors of production, which they use to produce goods and services for sale, meaning that the business enterprise receives the income due to those factors of production. While payments for and income from owned or controlled factors could be imputed in calculating profit, the common-sense idea of a highly profitable firm is typically a firm which realizes a high rent in the use of those factors it owns or controls: a farm that owns highly productive farmland or a merchant who owns a highly productive retail location might be thought "profitable" in the common sense of the term "profit," because the firm is receiving a large rent on the factor of production it owns.

In the latter part of the 19th century, as neoclassical economics was being formulated, it was realized that the classical definition of rent made the non-contributory nature of the landowner's participation in economic activities rather too obtrusive, leading to calls for recovery of publicly created land rents for the purposes and benefit of the public that created them (most famously by the American Henry George), and even for nationalization of land and other natural resources as demonstrably more economically efficient than their private ownership (most notably by Karl Marx).

In addition, it had long been known that certain kinds of rent-like income flows were obtained through other means than ownership of land, such as the royal patent monopolies on trade in salt, spices, silk, etc., or the privileges of exacting tolls from travellers on publicly created roads. More modern parallels to these sorts of government-issued privileges had also begun to be established by the late 19th and early 20th century in the form of utility monopolies; production, import and export quotas; drug regulation and alcohol prohibition; intellectual property monopolies; labor union certification; and legal barriers to entry in law, medicine and other professions. The common characteristic of the income derived from such privileges with land rent income, and what distinguishes possession of such privileges and owning land from the provision of labor or capital to production, is that the economic rent incomes obtained thereby are obtained not by contributing anything to the production process, but by controlling others' access to otherwise accessible production opportunities.

A new basis for consideration of economic rent had therefore to be devised, which would permit a logical and moral defense of both long-standing and emerging institutional arrangements that many in leadership positions found highly congenial, and that (then as now) few people considered it conceivable (or at any rate convenient) to do without.

Consequently, in modern neoclassical economic theory economic rent income is defined not by how it is obtained, but by whether it is greater than some other (typically unknown, or even unknowable) sum: i.e., it is defined as either the difference between the income realized by the owner of a factor of production in some particular use of that factor and the cost of bringing that factor into that use (Classical Factor Rent), or the difference between the income realized in the current use of the factor and the income that would be realized in its next most profitable use (Paretian Factor Rent). Unfortunately, while these definitions of economic rent usefully encompass the kinds of privilege-based incomes enumerated above in addition to ordinary land rent, they also have the effect of encompassing large amounts of wage and interest income, and introducing substantial uncertainty as to what portions of production can accurately be accounted wages, interest and rent.

Classical Factor Rent

Classical Factor rent is the return to a factor of production above the amount necessary to place that factor in productive use; income in excess of cost of the factor. Without politically contrived barriers to entry the cost of land is zero. And therefore any amount paid to own, use, or consume land is economic rent. The proper beneficiary of this rent is very much at issue. The private ownership of land forms the barrier to entry necessary to the privatization of the land rent. While the Physiocrats were inclined to recognize the implications of this privatization in regard to taxation and production, classical economists as well as the neoclassical and Austrian schools have spent a good deal of effort ignoring or obfuscating the issue. Henry George first publicized and popularized the economic implications of land based taxation; Mason Gaffney has described the attempt at forced or feigned ignorance on the part of neoclassicals.

In classical economics, analysis focused on three factors of production -- land, labour and capital -- each of which earned a distinct type of income -- rent, wages and interest, respectively. These three categories or types were used to explore what determined the distribution of income. It was observed that higher privatised wages and interest would draw additional labor or capital into production, but higher rents did not increase the supply of land; the owners of land would rent or make useful all the land they had, regardless of the going rent. Land rent is thus somewhat akin to a lump sum transfer. Still, users were willing to pay higher rents for particular sites because those sites offered some beneficial opportunity for production or commerce. But no rent whatsoever is needed to "bring" land into production, and all of the fees paid to insure exclusive use of the land over some period of time must be attributed to allocation of land by market forces. It was/is assumed that the user that can/will pay the most for the use of the land will be the most productive user of that particular section of land. This is described as "allocating the land to best use".

Virtually all of the land rent could be assigned to the allocative function of market prices, while only a small portion of wages (the income earned by labor) or interest (the income earned by capital) could be attributed to allocation, since wages and interest also serve to draw these factors into productive use. Johann Heinrich von Thünen was especially influential in developing the spatial analysis of rents, which highlighted the importance of centrality and transport. Simply put, it was density of population increasing the profitability of commerce and providing for the division and specialization of labor that commanded higher rents. And the high rents determined that land in a central city would not be allocated to farming, but would be allocated instead to more profitable residential or commercial uses.

Special attributes of a particular piece of land that make it especially productive in a particular use will always determine the rent. Highly productive agricultural land might be highly productive because of its fertility, or special suitability to a particular crop, as well as being well-situated in relation to transportation and access to markets. Rent attributable to special variations in resource quality is sometimes called Ricardian rent.

One implication of the classical analysis is that while a tax on wages or interest income would affect the quantity of labor or capital offered to productive use, almost the whole of land rent could be taxed away without affecting the quantity or quality of available land. Henry George, seeing that a properly designed tax on land rent would have none of the efficiency-reducing deadweight losses of other taxes, advocated a single tax on land as a way of financing government.

Karl Marx agreed with Henry George and with the classical economists that land rent was a form of exploitation. Landowners were able to get "something for nothing" just because they controlled such important natural resources. To Marx, the landowners received a part of capitalist society's surplus-value that was redistributed from the industrial sector, where workers produced it. However, unlike other economists, Marx also saw industrial capitalists as rentiers who simply extracted economic surplus from labor, while otherwise contributing nothing to the economy. Henry George was adament that land and capital are two different factors of production not to be aggregated under the umbrella of "means of production." George saw that political privilege (primarily land ownership) was the primary drag on production and the proper place to levy direct taxes while leaving wages and interest untaxed.

Paretian Factor Rent

Modern neoclassical economics has generalized the concept of rent to suggest that the owner of any kind of production factor can receive income from that factor in excess of what is necessary to "bring" the factor into a particular productive use and/or to keep the factor in that particular use. The rent, in this conception, is the difference between what is realized in the "rent subsidized" use and the opportunity cost, represented by the income available in the next best alternative use of the factor. This generalization does not extend to classic land rent and there are some such as Mason Gaffney who believe that this is an attempt by neoclassical economists to hide the true nature of economic rent.

The generalization of the concept of rent to include returns above opportunity cost has served to highlight the role of political barriers to competition in determining and creating rents. A person seeking to become a medical doctor makes a huge sunk cost investment in medical training and education, which has limited potential application outside of medical practice. In a competitive market for medical services, a doctor's wages would be bid down until the expected net return on the sunk cost investment in training would be just enough to justify making the investment. In a sense, the required investment is a natural barrier to entry, discouraging some would-be doctors from making the necessary investment in training to enter the competitive market for medical services. This is a natural "free market" self-limiting control on the number of physicians and/or the cost of training necessitated by certification. Some of those who would have opted for a medical career may well decide to be lawyers or business majors or technologists. However, arbitrary or self-indulgent restrictions on the numbers of people entering into the competitive market for medical services has the effect of raising the return on investments in medical training by creating a politically contrived scarcity of physicians. Associations of doctors have been known to lobby government to limit, in various ways, the number of medical schools training medical doctors and the number of medical students at those institutions. This kind of political activity is sometimes termed rent-seeking. To the extent that a constraint on entrants to the medical profession actually increases the returns to physicians as opposed to insuring competence, then to that extent the practice of limitiing entrants to the field is a rent seeking activity, and the excess return realized by the physicians is a Paretian factor rent.

See also

• list of economics topics
• Quasi-rent
• Rent-seeking
• Hotelling rent
• Ricardian rent
• von Thünen rent