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SSC CGL Tier 1 Economic Study Material – Rent in Economy

SSC CGL Tier 1 Economic Study Material – Rent in Economy

SSC CGL Tier 1 Economic Study Material – Rent in Economy

Introduction

In economics, economic rent is any payment to a factor of production in excess of the cost needed to bring that factor into production. In classical economics, economic rent is any payment made (including imputed value) or benefit received for non-produced inputs such as location (land) and for assets formed by creating official privilege over natural opportunities (e.g., patents). In neoclassical economics, economic rent also includes income gained by beneficiaries of other contrived exclusivity, such as labor guilds and unofficial corruption.

Economic rent should not be confused with producer surplus, or normal profit, both of which involve productive human action. Economic rent is also independent of opportunity cost, unlike economic profit, where opportunity cost is an essential component. Economic rent should be viewed as unearned revenue, whereas economic profit is a narrower term describing surplus income greater than the next best risk-adjusted alternative. Unlike economic profit, economic rent cannot be eliminated by competition, since all value from natural resources and locations yields economic rent.

In regard to labor, economic rent can be created by the existence of guilds or labor unions (e.g., higher pay for workers, where political action creates a scarcity of such workers). For a produced commodity, economic rent may also be due to the legal ownership of a patent (a politically enforced right to the use of a process or ingredient). For occupational licensing, it is the cost of permits and licenses that are politically controlled as to their number, regardless of the competence and willingness of those who wish to compete in the area being licensed. For most other production, including agriculture and extraction, economic rent is due to a scarcity of natural resources (e.g., land, oil, or minerals). When economic rent is privatized, the recipient of economic rent is referred to as a rentier.

By contrast, in production theory, if there is no exclusivity and there is perfect competition, there are no economic rents, as competition drives prices down to their floor.

Economic rent is different from other unearned and passive income, including contract rent. This distinction has important implications for public revenue and tax policy. As long as there is sufficient accounting profit, governments can collect a portion of economic rent for the purpose of public finance. For example, economic rent can be collected by a government as royalties or extraction fees in the case of resources such as minerals and oil and gas.

Definition of Rent

The term ‘rent’ is an unfortunate one. Its meanings in Economics differ from the ordinary usage. In the every day speech, the term, rent is applied to the periodic payments made regularly for the hire of a particular asset.

For example, the payments made by a tenant to the owner of a house, or factory or land on weekly, monthly, or yearly basis is a rent in the popular sense.

In Economics:

“The concept of rent or to be more precise ‘economic rent’ is used in a special sense. According to the classical economists, rent is a price of land. It is a payment made by a tenant farmer to the landlord for the use of original and Indestructible powers of the soil”.

Economic rent is an excess payment made to or for a factor of production over the amount required by the property owner to proceed with the deal. This often occurs when a buyer, working to attain a good or service that is considered exclusive, makes an offer prior to hearing what a seller considers an acceptable price. Market imperfections lead to the rise of economic rent; it would not exist if markets were perfect, since competitive pressures would drive down prices.

Example of Economic Rent – Labour.

Suppose a football player would be willing to work for £200 a week. If the football player got paid £1,000 a week. His economic rent is £800 a week.

Economic rent is the area between the supply curve and the wage rate. The supply curve indicates the minimum wage people are prepared to work at.

Example of Economic Rent – Property

Suppose a landlord has a property and he would be willing to rent it out for a minimum of £400 a month. If the landlord was able to rent the property for £950 a month, then his economic rent is £550.

Modern Concept of Rent:

The modem economists do not use the concept of economic rent in the restricted some. They apply rent to all the factors of production which do not have a perfect elastic supply. According to them:

“Economic rent is a surplus or excess over the transfer earnings”.

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Terminology relating to rent

  1. Gross rent – Gross rent refers to the rent paid for the services of land and the capital invested on it. It consists of economic rent, interest on capital invested for improvement of land, and reward for the risk taken by the landlord in investing his or her capital.
  2. Scarcity rent – Scarcity rent refers to the price paid for the use of homogeneous land when its supply is limited in relation to demand. If all units of land are homogeneous but demand exceeds supply, all land will earn economic rent by virtue of its scarcity.
  3. Differential rent- Differential rent refers to the rent that arises owing to differences in fertility of land. The surplus that arises due to difference between the marginal and intra-marginal land is the differential rent. It is generally accrued under conditions of extensive land cultivation. The term was first proposed by David Ricardo.
  4. Contract rent – Contract rent refers to rent that is mutually agreed upon between the landowner and the user. It may be equal to the economic rent of the factor.
  5. Information rent- Information rent is rent an agent derives from having information not provided to the principal.
  6. Quasi-rent -Quasi rent differs from pure economic rent in that it is a temporary phenomenon. It can arise from the barriers to entry that potential competitors face in the short run, such as the granting of patents or other legal protections for intellectual property by governments.

 

Theories of rent

The theories of rent are-

image

 1. Ricardian Theory of rent-

Definition:

The theory of economic rent was first propounded by the English Classical Economist David Ricardo (1773 -1823). David Ricardo in his book. “Principles of Political Economy and Taxation”, defined rent as that:

“Portion of the produce of the earth which is paid to a landlord on account of the original and indestructible powers of the soil, Ricardo in his theory of rent has emphasized that rent is a reward for the services of land which is fixed in supply. Secondly, it arises due to original qualities of land which are indestructible”. (The original indestructible powers of the soil include natural soil, fertility, mineral deposits, climatic conditions etc., etc.).

Assumptions:

(i) Rent Under Extensive Cultivation.

(ii) Rent Under Intensive Cultivation.

Explanation and Example of Ricardian Theory of Rent:

Rent Under Extensive Cultivation:

According to Ricardo:

“All the units of land are not of the same grade. They differ in fertility and location. The application of the same amount of labor, capital and other cooperating resources give rise to difference in productivity. This difference in productivity or the surplus which arises on the superior units of land over the inferior units is an economic rent”.

The Ricardian theory of rent is explained by taking an example:

Schedule:

Grades of Land Yield in Quintals per Acre Price per Quintal ($) Total Return ($)
A 50 50 2500
B 35 60 2100
C 20 70 1400
D 15 80 1200

 

In the above schedule, we assume that there are four grades of land A, B, C and D in an uninhabited country. A grade land is more fertile than B grade land. B grade land is superior to C grade and so is C grade to D grade land.

Following Ricardo let us assume, a batch of settlers migrate to this island. They begin cultivating A grade land which yield 50 quintals of wheat per acre. Let us suppose now that the population of that country increases and A grade land is not sufficient to meet the food requirements of the growing population. The inhabitants of that country shall then have to bring under cultivation B grade land. With the identical amounts of labor and capital. B grade land yields 35 quintals of wheat per acre. A surplus of 15 quintal of wheat {50 – 35 = 15) which arises with the same outlay on A grade land is an economic rent. B grade land being a marginal land gives no rent. When owing to the pressure of growing population and a rise in demand for food, C grade land is brought under cultivation, it yields only 20 quintals of wheat with the identical amount of labor and capital. With the cultivation of C grade land, the economic rent of A grade land is now raised to 30 quintals per acre: (50 – 20 = 30) and that of B grade land 15 quintals of wheat per acre. C grade land is a no rent land as it is cultivated at the margin.

If the expenses of production on A grade of land yielding 50 quintals of wheat are $2500 and the market price of total yield on A grade land is also $2500, then A grade land only will be brought under cultivation. A grade land here is the marginal land. If the price of agricultural produce increases ($60 per quintal) and the expenses of producing wheat on B grade land are equal to the market price of the produce i.e.. $2100, then B grade of land which was hitherto neglected would be brought under cultivation. B grade land then becomes the marginal land. Similarly, D grade land will be the marginal land when it compensates the cultivator by giving a yield of $1200, and enjoys no surplus over cost. Marginal land is thus not fixed. It varies with the changes in the price of agricultural produce. If population increase still further and the demand for food increases, then D grade land will be brought under plough. The surplus or economic rent of A grade land will go up to 35 quintals (50 – 15 = 35), of B grade 20 quintals, of C grade 5 quintals. D grade.  land being the marginal land yields no rent.

Diagram: 

diagram-1

The Ricardian model is now explained with the help of a diagram:

In the figure , the various grades of land in the descending order of fertility are plotted on OX axis and yield per acre is shown on OY axis. The cultivated area due to pressure of population and the rising demand for food is pushed to D grade of land which is a marginal land. The owner of A grade of land gets a surplus, or economic rent of 35 quintals of wheat, of B, 20 quintals and on C grade, the rent is 5 quintals of wheat.

Rent Under Intensive Cultivation:

The theory of rent which has been discussed above applies to Intensive margin of cultivation. The surplus or economic rent also arises to the land cultivated intensively. This occurs due to the operation of the famous law of diminishing returns.

When the land is cultivated intensively, the application of additional doses of labor and capital brings in less and less of yield. The dose whose cost just equates the value of marginal return is regarded marginal or no rent dose. The rent arises on all the infra-marginal doses.

For example, the application of first unit of labor and capital to a plot of land yields 25 quintals of wheat, the 2nd dose gives 15 quintals of wheat and with third it drops down to 10 quintals only, the farmer applies only 3 doses of labor and capital as the total outlay on the third does equals its return. The rent when measured from the third or marginal dose is 15 quintal       (25 – 10 = 15) on first dose and 5 quintal on second dose (15 -10 = 5). The third dose is a no rent dose.

Criticism on Ricardian Theory of Rent:

(i) No Original and Indestructible Power: Ricardo is of the opinion that rent is paid due to the original and indestructible powers of the soil. It is pointed out that there are no powers of the soil which are indestructible. As we go on cultivating a piece of land time and again, its fertility gradually diminishes. To this criticism, it is replied that there are properties of the soil, such as climate situation, sunshine, humidity, soil composition, etc., which are infect original and indestructible.

(ii) Wrong Assumption of ‘No Rent Land’: Ricardo assumes the existence of no-rent land. A land which just meets the cost of cultivation. The modern economists are of the opinion that if a plot of land can be put to several uses, then it does yield rent.

(iii) Rent Enters Into Price: According to Ricardo, rent does not enter into price. The modern economists are of the opinion that it does eater into price.

(iv) Wrong Assumption of Perfect Competition: Ricardo is of the opinion that perfect competition prevails between the landlord and the tenant, but in the actual world, it is imperfect competition which is the order of the day.

(v) All Lands are Equally Fertile: Ricardo assumes that rent arises due to difference in the fertility of the soil. But the modern economists assert that if all lands are equally fertile, even then the rent will arise. The rent can arise: (a) if the produce is not sufficient to meet the requirements of the people, and (b) due the operation of the law of diminishing returns.

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  1. Modern Theory of Rent:

Definition and Explanation:

The modern economists like Pareto, Mrs. Joan Robinson, Boulding, Sligler, Shepherd, have tried to simplify and generalize the ricardian theory of rent. According to them, the Ricardian theory of rent is too closely related to land. This creates on impression that rent is a peculiar earning of land only. The fact, however, is that other factors of production i.e., labor, capital and entrepreneurship may also be earning economic rent. The determination of rent, the modem economists say, can be explained in the same manner as the reward of other factors, that is by demand and supply forces.

Demand and Supply Analysis:

(A) Demand For a Factor:

The demand for a factor which may be land, labor or capital is a derived demand. Land, say for instance, is demanded for its produce. The higher the produce, the greater is the demand for land. A firm will pay rent equal to the marginal revenue productively of land. The rent diminishes as more land is used due to the operation of law of diminishing returns. The demand curve of a factor is, therefore, negatively sloped which means more land will be used only at lower rents, other things of course remaining the same.

Supply of a factor. The supply of land to a particular use (say industry) is quite elastic. It can be shifted to other uses by offering higher rent than that being earned by it now. The supply of a factor (to an industry) is, therefore, rent elastic. If higher rent is paid, the supply of a factor can be increased by withdrawing it from other uses. The supply curve of a factor (industry) slopes upward to the right.

Diagram:

diagram-2

Determination of rent. The economic rent is determined by the intersection of demand and supply curves for a factor. In this figure (19.2), the demand curve for a factor say labor in a particular industry is DD/ and the supply curve of workers is SS/. The wage rate or factor price of labor as determined by the market forces is OW. The total workers employed in a particular industry at OW wage rate is OL. The total earning of the workers employed is equal to the area OWEL. At wage rate OW, there are workers who would work, at lower pay but they are also paid at OW wage rate. Those workers whose transfer earnings are less than this wage rate will be getting economic rent. The total economic rent earned by all the intra marginal workers is equal in the area WES. The marginal worker i.e., Lth worker is not obtaining any rent or surplus.

(B) Rent is a Surplus Return:

The modern economists are also of the view that rent as a surplus can be earned by other factors also. It is not peculiar to land alone as explained by Ricardo. The modern theory of rent is that it is the difference between the actual earning of a factor unit over its transfer earnings. The transfer earnings of a factor of production is the minimum payment required for preventing that factor for transferring it to some other use. It is called the factor supply price in its present occupation.

For example, a worker earns $6000 per month in a factory. In the next best employment, he can get $5000 only per month. The surplus or excess of $1000 which a worker is earning over and above the minimum payment necessary for inducting him to work in the present occupation is the economic rent.

 

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