Economic rent

Economic rent is the difference between what a factor of production is paid and how much it would need to be paid to remain in its current use.There are multiple mechanisms that can create economic rent: political contrivance, network effect, monopoly power, star power, etc.

In neoclassical parlance, an economic rent is the difference between the income from a factor of production in a particular use, and either the cost of bringing the factor into economic use (Classical factor rent), or the opportunity cost of using the factor, where opportunity cost is defined as the current income minus the income available in the next best use (Paretian factor rent). In other words, economic rent is generally defined as the difference between the income in the current use of the factor and the absolute minimum required to draw a factor into a particular use (from no use at all, or from the next best use). But this neoclassical treatment does not tell us whether the income is earned by virtue of a contribution to the society, or simply created by natural happenstance or government sanction and taken by virtue of unearned privilege. And it is that distinction which is essential to any proper understanding of the term.

Land rent

In political economy including Physiocracy and Classical economics and other schools of economic thought excepting neoclassical economics, land (generic) is recognized as a separate factor of production. Classical economics recognizes three factors of production: labor, capital and land (generic). Within this school of thought, wages are defined as the portion of production that goes to workers for contributing labor toward production; profit is the portion that goes to owners of capital for "allowing" their capital to be used in production; and rent is the portion that goes to freeholders for "allowing" production on the land they control. 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 municipal 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. David Ricardo is credited with the first clear and comprehensive analysis of land rent and the associated economic relationships (Law of Rent).

Classical factor rent

Classical Factor rent is the return to a factor of production above the amount necessary to keep that factor in productive use; income in excess of cost of the factor. The cost of land (generic) is only the cost of enforcing an entitlement to exclusive use of the resource. Any income realized in excess of the cost of enforcing exclusive use is economic rent , and is Classical Factor Rent. The distinction of profits from rent is very important here. Any improvement to the land (drain a swamp, cut down some trees, till the soil) or on the land (a home, a factory, a barn) is considered fixed capital and the income or benefit received from such capital is profit as distinct from rent. It is considered to be earned income just as wages would be earned income.

Paretian factor rent

Modern neoclassical economics has attempted to generalize the concept of rent to suggest that the owner of any kind of production factor can receive "economic rent". This is done by asserting that opportunity costs approximate economic rents. The rent, in this conception, is the difference between what is realized by the provider/owner of a factor in the current "rent subsidized" use and what would be realized in the next best alternative use of the factor. This generalization does not extend to classic land rent and in many instances income from, so called, opportunity costs are not rent at all.

Example and controversy

The generalization of the concept of rent to include opportunity cost has served to highlight the role of political barriers in creating and privatizing 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 set at where 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, 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 especially for those already practicing by creating a politically contrived scarcity of physicians. This kind of political activity to the extent that it exists is 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 limiting entrants to the field is a rent seeking activity, and the excess return realized by the physicians is economic rent as herein defined.

However,

The purveyors of Paretian rent are constantly asserting the “celebrity” as an example of rent. It makes no difference whether the celebrity is a singer or a baseball player or whatever. If the only other job the celebrity could qualify for is to wash dishes then the Paretian subscribers claim that the difference in wages paid a celebrity and a washer of dishes is rent. The problem with that claim is that there is no political force involved here. People pay to watch or hear the celebrity and absolutely nothing compels them to do so. And there is no political restriction to entry into the celebrity world. While it may be that the “certification” is being done by a baseball league or the officials on “American Idol”, there is absolutely no restriction on who can attend baseball school or audition for a shot at the big time. No political contrivance, therefore, not economic rent. The celebrity is fortunate to receive very high wages for the work performed, but no person is coerced or deprived and the performance of the work has added to the public welfare.Dubious|date=March 2008

Brief summary of historical avoidance of the matter

The private freehold 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 did not seem eager to take it up. Smith mentions it in passing and then it is on to other things. In the 1800s Henry George publicized and popularized the economic implications of land based taxation, exposing the flow of rent into the hands of the classical nobles as a tax on the producing sector of the economy that was simply consumed by the nobility. The Austrian and neoclassical schools have spent a good deal of effort ignoring or obfuscating this inequality issue. Mason Gaffney has described this attempt at forced or feigned ignorance on the part of neoclassicals.

Detailed historical terminology

In the 1700s it was observed that higher wages and interest will draw additional labor or capital into production. As wages and returns to capital development increased then people came to the cities to work for wages and to help in the construction of capital. The early “capitalists” sought the interest that flowed from industrialization. People who would have died in the countryside were alive because they were able to find employment in the city. But attempting to increase rents merely resulted in unused land. The freeholders of land historically rented or made useful all the land they had at whatever the market would bear. Still, users were willing to pay higher rents for particular sites because these sites offered some beneficial opportunity for production or commerce. But no rent whatsoever was needed to "bring" land into production. In a free market all of the fees paid to insure exclusive use of land over some period of time can 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 using 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. This was so, as discussed above, because 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 municipal 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.

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. Later in the 1800s Henry George, seeing that a properly designed tax on land rent would have none of the efficiency-reducing adverse effects 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 George, Marx also saw industrial capitalists as rentiers who simply extracted economic surplus from labor, while otherwise contributing nothing to the economy. Henry George was adamant that land and capital are two different factors of production not to be aggregated under the umbrella of "means of production." George saw that economic rent derived from political privilege (primarily land ownership) was the proper place to levy direct taxes while leaving wages and interest untaxed.

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 apparent, 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). A new basis for consideration of economic rent had therefore to be devised, which would permit a logical and moral defense of long-standing institutional arrangements that many in positions of authority found highly congenial, and that (then as now) few people considered it conceivable (or at any rate convenient) to do without. [Harvard reference | Surname=Gaffney | Given=Mason | Year=1994 | Chapter=Neo-Classical Economics as a Stratagem Against Henry George | Editor=M. Gaffney and F. Harrison | Title=The Corruption of Economics | Publisher=Shepheard-Walwyn | Place=London | URL=http://homepage.ntlworld.com/janusg/coe/cofe00.htm | accessdate=September 16, 2006.] [cite book | last = Blaug | first = Mark | title = Economic Theory in Retrospect, 4th ed | publisher = Cambridge University Press | location = Cambridge |date= 1985 | pages = 308 Cited by: cite web | url = http://www.eco.utexas.edu/~hmcleave/chipprop.html | title = The Political Origins of Neoclassical Economics ]

In addition, certain kinds of rent-like income flows have long been 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 travelers on public roads. [cite web | url = http://www.friesian.com/rent.htm | title = Rent-Seeking, Public Choice, and The Prisoner's Dilemma ] 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 additional income derived from such privileges with land rent income, and what distinguishes possession of such privileges and ownership of land from contribution 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. Since publication of the seminal paper, "The Welfare Costs of Tariffs, Monopolies, and Theft," by Gordon Tullock in 1967, a substantial economic literature has been developed around the concept of rent-seeking behavior and its social and economic consequences.

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.Fact|date=February 2007

ee also

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

External links

* [http://www.economist.com/research/Economics/alphabetic.cfm?LETTER=R#rent Definition of economic rent at Economist.com]
* [http://www.generation-online.org/other/artofrent.htm The Art of Rent] , a series of seminars at Queen Mary University of London.
* [http://www.Rent-seeking.net "Rent-Seeking Network"] Rent-Seeking papers by Behrooz Hassani

References