Here is an elaborated discussion on the modern theories of rent.
The Modern Theory of Rent:
According to the modern theory the equilibrium earnings of a resource has two elements:
(1) Transfer (necessary) earnings and
(2) Economic (surplus) earnings.
In the context of modern theory of rent, we use the term economic rent instead of economic earnings. Transfer earnings are the part of the earnings of a resource that are equal to the earnings that this resource could derive in the next best use to which it can be put. For example, the earnings of a piece of land (measuring, say, 3 acres) that is currently being used as a site for a factory complex might be Rs. 1 lakh per year. Its next-best use might be as a wheat farm in which it could earn only Rs. 10,000 per year.
This sum is the transfer earning of this piece of land. Modern economists also define transfer earnings as that part of the earnings of resource which it must earn to keep it from being transferred to its next-best use. In our example, if for some reason the earning of the land as a factory site were to fall below Rs. 10,000 per year, the land would be used for wheat farming instead.
The second part of the earnings of a resource is called economic earnings. Economic (surplus) earnings refer to that part of the earnings of a resource which is not needed to keep that resource at its present use. Thus it is a surplus in one sense. It is the difference between the total earnings of a resources and its transfer earnings.
Alternatively stated, it is that part of the earnings of a resource which is over and above what it would earn in its next-best use. In our example, where the earnings of a piece of land were Rs. 1 lakh per year and the transfer earnings were Rs, 10,000, economic earnings (rent) would be Rs. 90,000 per year.
Case 1. All Economic Earnings (Rent):
When one resource has only a single use, its transfer earnings are zero and the price of the resource is made up entirely of economic earnings. Such a case is illustrated in Fig. 27.5(a). Here we show the supply and demand curves for land on a certain mountain in Shillong (Meghalaya).The land is used as a golf ground and cannot be economically used for any other purpose. The size of the land is 80 acres and the whole of it is needed for playing golf, so its supply is completely (perfectly) inelastic.
The demand for golfing on that mountain will determine its price, Rs. 100 an acre per annum in this case. Since transfer earnings are zero the whole payment for the 80 acres — Rs. 8,000, represented by the shaded area is surplus area — is surplus income or economic rent.
If the derived demand curve for this land shifted to the left, its price would fall, but no land would be transferred to another use. If the demand curve shifted to the right, its price would be raised, but there would be no increase in supply of this land.
Case 2. All Transfer Earnings:
According to the modern theory of rent, when a factor of production is put to use for which it commands a price slightly higher than what it can command for its next-best use, its economic earnings are almost zero. Fig. 27.5(b) illustrates such a case. This case is the exact opposite of the previous one. Whereas in Fig. 27.5(b) the supply curve is a vertical straight line, in Fig. 27.5(b) it is horizontal. This might be a case of farmland used to produce carrots.
At Rs. 100 an acre per annum, almost unlimited amounts of land are available to grow carrots. Thus, although the total supply of land in an area is fixed, the supply to a particular use (viz., carrot production) is completely elastic. If the price were lowered by even Re. 1 per acre, all 80 acres would be diverted by the land-owners to their next-best use, say, growing of tomato. Thus almost the whole payment for the 80 acres (Rs. 8,000 per annum) is transfer earning. Economic rent is zero.
Case 3. Mix of Transfer Earnings and Economic Rent:
Finally, when a factor has more than one use, and when a slightly lower price will not cause all of it to move to its next-best use, its earnings are a mix of transfer earnings and economic rent. If the market price of such a resource rises all units of the resources already employed will derive extra income (above their transfer cost) in the form of economic rent.
It is because the owner of these units were willing to supply their services at a lower price. This type of situation is illustrated in Fig. 27.5(c). Here the supply curve of a factor for a particular use is neither fixed (i.e., completely inelastic) nor completely elastic (i.e., infinitely responsive to price changes).
This is likely to be the case of a farmland used to produce wheat. As in Fig. 27.5(a) and Fig. 27.5(b) the payment for the 80 acres is Rs. 8,000 but now it has two parts transfer earnings (shown by the Shaded area) and economic rent (or surplus). If the demand curve shifts slightly to the left, so that the price of (the service of) the resource falls marginally, one acre (the 80th one) would be transferred to another use such as growing soya beans.
At successively lower and lower prices, more and more of this land would be diverted from crop production to other uses. However, some acreage will remain in wheat until the price falls below Rs. 40 per acre. At prices b low Rs 40, all 80 acres will have been transferred out of corn into other uses [such a change took place at a price below Rs. 100 in case 2, as shown in Fig. 27.5(b)].
In the normal case of upward sloping supply curve of a resource, we can make the following prediction:
If the market demand for a resource in any of its uses rises relative to the supply available to that use, its market price will rise in that use. This, in its turn, will serve to allocate additional units into that use. It will also increase the economic rent to all units of the factors already in that use, since their transfer costs have already been covered.
Determinants of the Division:
We have noted that according to modern theory the total return to a factor has two parts: transfer earnings and economic rent. There are two determinants of the division of total income into transfer cost and economic rent, viz, mobility of the resource and time allowed for the move. The mobility of resource depends largely on the alternatives open to it. The second determinant is time. In general, a factor is more mobile in the long run than in the short. Thus the rent element in the income of a factor is usually higher in the short run than in the long.
These two factors may now be discussed one by one:
1. Types of Transfer:
The mobility of a factor largely depends on the view point that we adopt. If we focus on the narrowly defined use of a factor, say labour, by a firm then it will be highly mobile. A worker in a tea garden of North Bengal can easily move to another tea garden. Thus within the same industry there are a number of alternatives open to him. Therefore, from the view point of the view of the firm the bulk of the wage payment is transfer earning.
If, however, we take a broad view of the situation and we consider the use of the factor in a industry, then its mobility will be restricted. It is because the worker, in our example, will find it difficult to find out employment in another industry (say, jute industry) quickly. Thus from the view point of the particular industry (rather than the specific firm within the industry), the bulk of the factor payment is economic rent and a small proportion is transfer earning.
Finally, from a more wider view point of a particular occupation, such as manufacturing, mobility is even less. It is because a worker from a tea garden can somehow manage to work in a jute mill after a brief period of training. But he may never be in a position to operate as a computer mechanic or to fly an aircraft. So from the general perspective of a particular occupation, a small portion of actual earning is transfer earning and the major portion is economic rent.
In the words of R. G. Lipsey:
“As the perspective moves from a narrowly defined use of a factor to a broadly defined use, the mobility of the factor decreases; as mobility decreases, the share of the factor payment that is economic rent increases.”
2. Time Allowed to Move:
As a general rule factors are more mobile in the long run than in the short run. Thus a major portion of the actual income of a factor is rent in the short run than in the long run. It is to this issue that we turn now.
As a general rule factors are more mobile in the long run than in the short run. Thus a major portion of the actual income of a factor is rent in the short run than in the long run. It is in this context that Alfred Marshall introduced a new concept, viz., quasi-rent. Let us illustrate the concept. Suppose a business firm installs a specialised machine in its factory.
It has only one use. It is expected to yield an annual return of Rs. 20,000. Will it be really worthwhile to keep the machine in operation? Once it has been installed any return from it in the short run above its operating (variable) cost is economic rent. In the short run a firm just seeks to cover variable cost.
Thus the difference between P and AVC (in Fig. 27.6) or TR and TVC measures economic rent or surplus. Thus if the machine yields an annual income of 100 above its operating costs it will remain allocated in its present use. In short, in the short run any net income is economic rent.
However in the long run the firm will seek to cover all costs. Thus not only variable cost but fixed cost as well will be a part of its transfer earning. In other words, what is surplus income in the short run becomes a necessary income in the long run. It is, therefore, quite obvious that if the total revenue of the firm is not sufficient to cover its total cost the machine will not continue to be allocated in its present use in the long run.
Thus in the short run the major part of the income from a man-made asset like a machine is economic rent. But in the long run the bulk of the earning of a resource is transfer earning. According to Marshall, factor income — which – is economic rent in the short run and transfer income in the long run — is called quasi-rent.
Quasi-rent is different from economic rent because it disappears almost completely in the long run (when supply conditions become favourable, i.e., when the supply curve of a resource becomes more and more elastic).
In short, the additional reward to a factor of production which is in fixed supply in the short run over and above variable costs, is called quasi-rent. In the long run the revenue to the factor of production will be equal to its transfer earning. The concept of quasi-rent is illustrated in Fig. 27.6.
Suppose the short-run demand curve of resources is DD and its supply curve is QS. The initial price of the resource is P and quantity is Q0. Suppose now the demand curve shifts to the right to D1D1. In the short run it is not possible to increase the supply of the resource.
Therefore, the price of the service of the resource (say, a machine) rises to P1. Since the machine will be kept operational as long as variable cost is covered, i.e., 0 > 0, as long as P > AVC the entire surplus revenue from the machine above the variable cost, i.e., P2P1KH, is economic rent or surplus income.
In fact, the term quasi-rent, coined by Alfred Marshall, refers to the earnings of a factor of production like machinery, equipment, etc., whose supply is inelastic in the short run, but not in the long run. Land is assumed to be in limited supply both in the short run and in the long run. Hence its remuneration is called economic rent.
The term quasi-rent implies a remuneration similar to rent but not rent in the true sense. House rent, however, is a peculiar borderline case which may be regarded both as rent and quasi-rent, depending on whether it is a rent for the building or ground rent.
We can also offer another formal definition of quasi-rent. Quasi-rent of a machine is nothing but its total short-run receipt, minus the costs of hiring the variable factors used with it as also the costs of keeping the machine in running condition in the short run.
Thus there are two components of quasi-rent:
(i) Total net profit and
(ii) Total fixed cost In other words, quasi-rent = TR – TVC = TNP + TFC.
There are two further points about quasi-rent that are important. It can be earned by inanimate objects like machinery and appliances, equipment, etc., and also by persons who are efficient in every special sense of the term. Now, this sort of earning always refers to the short run, because in the long run the supply of durable goods can be increased.
Moreover it is not possible to monopolise the gain of specialised ability and so quasi-rent is competed away in the long run. Also, the question of transfer earnings may arise here, as in the case of rent, as also the question of maintenance cost, i.e., the problem of keeping the machine in order.
Some part of the short-run earning of a machine must be set aside for the purpose of maintenance. Thus, to conclude, there is no need for treating rent as a separate category of factor remuneration because, like land, there are many other factors whose supplies cannot be increased as their prices rise.
Rent Element in Other Factor Incomes:
According to Ricardo, economic rent was payment for the original and indestructible powers of the soil. Although, Ricardo outlined his theory of rent in relation to land we may now examine in detail how rent may arise in the return to all four factors. We may start with land.
The modern economists have extended the Ricardian theory to include elements of economic rent in the earnings of all factors of production. Workers who receive differential payments based on their abilities (which are scarce in relation to demand) receive a rent of ability. This is true of professional people.
The best-known lawyer or doctor in the city earns much more than the ordinary lawyer. Likewise, there is rent element in profits. In perfect competition all firms have to accept the same price. But all firms or entrepreneurs are not equally efficient.
So their cost of production is not the same. Thus, an efficient entrepreneur who can produce the same commodity at lower cost (per unit) will make more profit than an inefficient entrepreneur whose cost is high.
As L. B. Curzon puts it:
“Where an entrepreneur’s profit is determined partly by the extent to which his abilities surpass those of the marginal entrepreneur, these supra-marginal earnings may be considered as a rent accruing to him.”
1. Economic Rent and Land:
In the case of land which is completely specific, i.e., what has only one use, the whole of its income is economic rent. Since it has no alternative use it cannot be transferred to another use. In other words, it will remain in that use for an indefinite period even when its earnings are zero.
In reality, however, we observe that most land has several alternative uses. Suppose a plot of land has one alternative uses. It will be earning economic rent if – and only if – its income in its present use exceeds what it could earn in its next best use.
A simple example will make the point clear. Suppose a small plot of land is being used for growing wheat and the farmer is paying a rent of Rs. 90 per acre for it. Its next best (or most profitable) use would be growing jute. But another farmer who is willing to use the land for jute cultivation is just ready to pay Rs. 75 per acre.
Thus, according to modern theory payment for the land in its present use (i.e., wheat cultivation) contains a rent element of Rs 15 per acre. Now, it is quite obvious that any price greater than Rs. 75 per acre will cause this plot of land being transferred from jute to wheat. It is just a matter of relative demand and relative supply. If it is really profitable to produce wheat, farmers will bid against each other for suitable and available land and this very fact could cause the rent per acre to rise well above the transfer earnings of the plot of land.
2. Economic Rent and Labour:
Economic rent is a payment to a factor of production which is in excess of supply price of that factor. Take the example of a person in Civil Service job earning Rs. 260,000 a year. If he had not joined the Civil Service he would have gone to teach in college where he would have been earning Rs. 220,000 a year.
Thus this sum Rs. 220,000 represents the person’s transfer earnings. If the Civil Service cut his earnings to below Rs. 220,000 he would leave and go to work in a college instead, but provided that he receives Rs. 220,000 he will stay in the Civil Service.
Therefore he would be prepared to work in his present job for Rs. 220,000, yet he is being paid Rs. 260,000, The extra amount (Rs. 40,000) is economic rent — a payment in excess of his supply price or transfer cost. One may consider the phenomenal amounts being earned by some of the top singers today.
If they had not taken up singing, they would most probably be in jobs where their earnings would be much less. There is, therefore, a high element of economic rent in the earning which they now receive. They are given these high payments because of the particular skills which they possess and such rent is known as the ‘rent of ability’.
Further examples are found in other sports, films, etc. The high earnings in such cases contain a large element of economic rent and this occurs because the supply of such talent is limited in relation to the demand for it. Once the demand for a particular star, whether in sports or music, falls, the earnings also fall drastically and quickly.
The amount of rent in wages obviously depends upon the elasticity of supply and the level of demand. Elasticity of supply, in turn, depends largely on mobility. The higher the mobility of labour, the more elastic will be the supply of labour and the smaller will be the element of economic rent.
Economic rent in wages of the different unskilled labourers is shown in Table 27.1:
Highly specialised labour is in very inelastic supply. This is true of film stars, cricketers and singers. A superstar has, it seems, some unique characteristics and supply of his (her) particular talent is perfectly inelastic (because it cannot be duplicated overnight). The earning of such a person probably contains a huge amount of economic rent.
His relatively high rewards are due to the fact that his service is in much higher demand relative to its supply. His transfer earnings will be very much less than his current remuneration because his market values outside his own specialised profession is probably very low. One wonders whether Sachin Tendulkar could earn more than Rs. 5,000 per month outside cricket!
It may be added that earnings of superstars can reach very high figures in a very short time period and transfer earnings constitute a very small proportion of their incomes. But we often observe that the popularity of many superstars does not last for long. So their earnings fall as quickly as they rise.
3. Economic Rent and Capital:
Economic rent can also be found in relation to capital Consider a machine which has only one use. Once it is installed in a factory, it cannot be transferred to any other use. So any revenue it makes above its operating costs is surplus income or economic rent, because the only alternative is to keep the machine idle, in which case revenue would be zero.
However, this is true only in the short run. In the long run the machine will wear out and a decision will have to be made as to whether or not to replace it. Therefore, in the long run some of the revenue of the machine will be transfer earning, because if a certain level of revenue has not been achieved, no such machine will be purchased.
Much of a nation’s capital stock consists of highly specialised equipment. Each machine is designed for a particular purpose and cannot be transferred to another use easily and quickly. Once an equipment (such as a blast furnace) is installed, it cannot be transferred to any other use except steel production. So it will be used so long as the operating cost (i.e., variable cost) is fully covered.
Therefore, any return from the equipment which is greater than variable cost is to be treated as surplus income or economic rent. In other words, the transfer cost of the equipment is its current operating cost. If this cannot be covered the machine will not be used. It will be kept idle. So one is going to lose more than its fixed cost.
However, in the long run the machine will replaced if the revenue derived from it is sufficient to cover both variable cost and depreciation. This two together constitute its transfer cost (earning). Unless this transfer cost is covered the supply of this equipment to the iron and steel industry will gradually cease.
4. Economic Rent and Organisation (Entrepreneurship):
Economists make use of the concept of normal profit to the refer to the maximum rate of return which is necessary to keep an entrepreneur in his existing line of business. Thus, normal profits might well be regarded as the entrepreneur’s transfer earnings. And any super-normal or excess profit (excess of IR over TC) has to be treated as surplus income or economic rent. It is to be noted that normal profit varies from industry to industry depending on the degree of risk involved.
The minimum expected rate of profit required to induce a firm to go for oil exploration will obviously be much greater than that needed to keep a firm in the transport business. Since even (abnormal) profits can only be maintained in the long run only where there is a monopoly situation, such abnormal profits go by the name monopoly rent. Thus, we see that there is rent element in the return to all factors. This is why Marshall commented that rent is the leading species of a large genus.
Rent of Ability: The Economics of Superstars:
In general people with superior ability are able to earn more than other people belonging to any profession. A superstar like Amitabh Bachchan (AB) was paid an astronomical amount when he was in his prime. The reason is that when the producers and directors plug in his name, the numbers go way up.
The numbers are box office revenue about half of which goes to the film makers and distributors. In large part because of his endowments of talent and looks a superstar earns more revenue for producers and distributors.
AB and Shah Rukh Khan are examples of superstars – individuals who are almost universally regarded as the best, or among the top few, in their professions. Whatever our own feelings about any of these people, the market – where people vote with their rupees – considers them at the top of their professions.
The question here is does outstanding ability fully explain the extremely earnings of these superstars?
AB is substantially better than the average actor, maybe even among the best. But is he better enough to justify a compensation hundreds of time greater than the average?
The explanation in this case is based on ability and also by exaggerated rewards the market bestows on those deemed the best or one of the best in the field. In all cases, where those at the top can sell their services to the millions of people simultaneously, the reward of being the best can be astronomical. Even, in the film industry, small differences in perceived abilities lead to huge differences in earnings.
However, it is not always true that people with rare abilities or talents will earn more than others. Few people can act in silent movies or in art films yet the silent movie or art film actors earn substantially less than action movie actors.
The reason is that very few people see silent movies or art films and that in the market, the derived demand for silent movie actor is very low relative to their supply. On the other hand, large numbers of people see action movies. Compared to the market for silent movie actors, the derived demand for action movie actors is considerable higher relative to the supply.
After all the equilibrium wage (in this case, the price of talent) is determined by both sides of the market – supply and demand – rather than just one or the other. Thus although AB acting talent may not be a thousand times better than average, he earns more than thousand times the average actor’s salary because he is at the top of his profession.