In economics the word ‘rent’ originally related only to the income received from the ownership of land. In the language of Ricardo: “rent is that portion of the produce of the earth which is paid to the landlord for the use of original and indestructible powers of the soil.” Rent was, therefore, paid for unimproved value of land, for its physical characteristics.
When all factors are employed on land, they are paid the value of their marginal product. But we know that the supply of land is fixed. So it does not have a marginal product. Rent is what is left over after all factors are paid their due reward. Rent is basically a producer’s surplus. It is the price paid for the use of land and other resources whose supply is completely fixed.
And we shall note, in the context of Ricardian theory, that it is determined by the price of the product it produces, say, corn, after paying each factor the value of its marginal product. In this sense, rent is price-determined and not price-determining.
Ricardo offered a two-fold reason for the emergence of rent:
1. Scarcity Rent:
Land is limited in quantity and thus with the growth of population it becomes scarce in relation to the demand for it. Thus rent arises due to scarcity of land as a factor.
2. Differential Rent:
Different pieces of land are not uniform in quality. Hence, with the progress of society, successively worse qualities are brought under cultivation. In the process, rent immediately arises on the better quality lands. The amount of rent certainly depends on the difference of productive powers of these various grades of land. The owner of the marginal quality land gets no rent at all.
The Ricardian theory is thus called the differential theory of rent. Rent is maximum on the best quality land, the amount of rent decreasing as successively worse grades of land are taken in simply due to a rise in cost of production. The marginal land is one where the cost of production eats up the whole surplus after wage payment.
1. Scarcity Rent:
From our study of price mechanism we know that whenever the supply of good or factor is perfectly inelastic, its price is determined by the demand for in Fig. 27.1 the inelastic supply of land is represented by the vertical line S. The equilibrium price here depends on the position of the demand curve D alone.
The greater is demand, the higher the price (OR0) of land (i.e., rent) will be. If demand shifts, the price will change accordingly, but the stock of land will remain unchanged. Since land is a gift of nature and has no cost of production, the entire return to land is a surplus income at least from society’s point of view.
An interesting feature of the equilibrium is that, given the fixed nature of the supply of land, demand plays an active role in determining the equilibrium land rent. We see in Fig. 27.1 that an increase in the demand for land leads to an increase in the size of the pure economic rent from OR0EL0 to OR1FL0. The equilibrium level of rent is entirely determined by the demand side of the market.
Since the demand for land is a derived demand, we see that an increase in the price of the product that is produced on the land, and an increase in marginal physical product of land together shift the demand curve to the right, leading to higher rents. An increase in land rent corresponds to an unchanged quality of land. Thus the rent of land is entirely demand determined.
2. Differential Rent:
The concept of economic rent can be used as an alternative measure of natural resources scarcity. Let re and Ce represent the market equilibrium price and quantity of coal, respectively. In Fig. 27.2 the area 0CeM (an area under a supply curve) represents the total cost of production or extraction.
This cost represents the opportunity costs of all production (labour, capital and other resources, such as the capitalized value of land, etc.) that are used to extract the equilibrium level of coal, Ce. On the other hand, area 0reMCe represents the total receipt (income) to the owners of the coal mines.
The difference between what the owners receive as income and the cost of extraction is a rent which is represented by the area of triangle 0reM. It represents the total payment to owners of a factor of production in excess of the minimum price necessary to bring the resources into the market. In other words, it is the payment above a resource owner’s minimum acceptable price.
In this case rent is a payment (value) to resource as it exists in its natural state (with zero value-added). In other words, rent is received by owners purely for owning the resource under consideration. Owners play no part in the creation of this resource. Hence, rent is intimately related to the value of natural resources in a particular area.
The implication of this is that rent can be used as a measure of physical scarcity. This point is illustrated in Fig. 27.3 using the concept of differential rent. We will see that all scarcity rent is differential rent. Similarly, all differential rent is scarcity rent.
For most extractive resources, such as coal, gold, aluminium and even agricultural land, the normal pattern tends to be to utilise or mine these resources in step-by-step fashion in accordance with quality and accessibility. Mines containing higher quality ores or agricultural land with high natural fertility are put to use first. In Fig. 27.3 the supply of coal has three segments.
The first segment is the horizontal line P0-A. This supply curve relates to the amount of coal arriving on the market from the highest quality and most easily accessible coal mines. Since the quality of this resource is assumed to be uniform, the horizontal supply curve, P0 – A, represents the constant unit production cost (extraction and transportation costs) of coal from such mines.
The second segment of the supply curve is represented by another horizontal line, B – C. This parallel upward shift of the supply curve from P0 – A to B – C reflects the change in the quality of the coal mines, from mines containing high-grade ore to those whose ore is of lower grade. Thus, for the coal arising from this second tier of mines, the unit cost is assumed to be uniform and higher than from the first tier of mines.
The supply curve for the coal arriving from the third and last tier of the coal mines, line E – F, can be interpreted in a similar way. Thus it is clear that the unit cost of production (in terms of extraction, refinement, transportation, etc.) of coal increases as mining is extended towards a fringe area containing poorer quality of ore.
Let us now include the demand factor in our analysis. In Fig. 27.3, D0, D1 and D2 represent three different levels of demand condition for coal. For a demand curve at or below D0, the market price for coal will be P0.
Since the supply curve P0 – A, is horizontal, in this case rent will be zero. This is because P0 represents both the market price and the unit cost of coal. Thus, owners of coal mines are not receiving anything in excess of their actual cost of production.
However, suppose the demand for coal increases to D1. Now the market price for coal will increase to P1. Thus, as a result of this development, owners of the coal mines from the first tier will start to earn rent since their production cost is still P0, while the market price for coal is now P1.
On the other hand, owners of coal mines from the second tier will realise no rent — since there is no difference between the market price they receive and their unit cost of production, in this case P1. Thus it is clear that the total rent received by the owners of coal mines from the first tier, area P0P1BA (or the area of the rectangle I), is attributable to difference in the quality (grade) of coal — hence the term differential rent.
Differential rent increases with an increase in demand. In Fig. 27.3, if the demand further rises to D2, the rent obtained by owners from the first tier of mines also increases from area P0P1BA to area P0P2GA (or the combined areas of rectangles I and II).
In addition, the owners of mines from the second tier are now able to realise rent which is shown by area BCEF (or area of rectangle III). Thus, as a result of shift in demand from D1 to D2, the total rent has increased from area P0P1BA (the area of rectangle I) to area P0P2ECBA (or the area of rectangles I + II + III).
Another example that could have been used to illustrate the concept of differential rent is agricultural land. Agricultural land varies in its natural productive capacity — fertility. In Fig. 27.3, then horizontal line P0 – A represents the supply curve of available farming land that is of high and uniform quality (in terms of fertility).
The rent accruing from this farmland will be negligible provided the demand for farmland remains at or below D0. This is because, over this range, the market price of a unit of farmland (P0) is the same as the cost per unit of making the farmland available for cultivation.
We know that this type of land is called by Ricardo marginal (no-rent) land. Any land which is inferior to this is called below-marginal land. Similarly any land superior to this in fertility is above-marginal land. Rent arises only on such land because the market value of output exceeds the cost of production. However, as we know, owners of this type of land start to earn rent as soon as the demand for farmland exceeds D0.
Similarly, the lines B – C and E – F represent the supply curves for marginal and sub-marginal farmland, respectively. Fig. 27.3 shows that rent increases as demand for farmland grows and progressively inferior land is brought slowly into cultivation. In this case rent increases not due to the existence of absolute scarcity of farmland. Rather, it is the rise in the cost of harvesting resulting from the progressive decline in the quality of farmland. This phenomenon was first discussed and presented by David Ricardo.
One important implication of our analysis is that an increase in rent is intimately associated with a growing scarcity of natural resources. Since the increase in rent is closely related to the physical condition (decline in quantity and/or quality) of the resource under consideration, it could in some way be taken as a measure of physical scarcity. This is indeed the case both for coal mines and for farmland. This is why rent is used as a true measure of natural resource scarcity.
Rent could also be largely affected by technological changes, which diminish the effectiveness of rent as a measure of physical scarcity. In the absence of technological change, rent falls if the physical condition of a natural resource (in terms of quality and/or quantity) is diminishing.
Rent also depends on demand and supply conditions, and for that reason it is not a purely physical measure of resources scarcity. Furthermore, due to the lack of easily observable and consistent market information concerning rent, its practical value — as measure of natural resource scarcity — is rather limited.
Rent and Cost (Price):
Another interesting question is whether rent is price-determined or price is rent- determined. Land is a free gift of nature and, therefore, its cost of production is zero. To Ricardo, price can never be rent-determined; rather the converse is true, because rent is viewed as a pure surplus.
The higher the price, the larger will be the rent. So rent depends on price but price is not determined by rent. Therefore price is high not because rent is paid but rent is paid because price is high. Rent is thus price-determined, not price-determining.
Paul Samuelson generalizes this viewpoint when he says:
“Whether rent is or is not a price-determining cost depends upon the viewpoint.” If we take a broad view and consider the economy as a whole, rent will be price-determined. But if we take a narrow view and consider the case of a single farmer from a micro-angle we can say that rent is a price- determining cost. This means that if rent of land increases, the cost of production of any individual farmer is bound to increase.
Criticisms of the Ricardian Theory of Rent:
Ricardo’s theory of rent has been criticised on the following grounds:
(a) It is absurd to treat land as a homogeneous factor of production, except for differences in grades and fertility. The only test or measure of land quality is rent per hectare and quality of land cannot be used to explain rent.
(b) Ricardo assumed that the supply of land is fixed for the society as a whole and the supply curve of land is perfectly inelastic. But supply is not fixed if we consider alternative uses of land.
Land, in actual fact, has alternative uses. For example, the same plot of land used for growing wheat could be used to set up a chemical factory. Thus, from the point of view of any particular use, part of the payment for land would necessarily have to be made to keep it in that use.
The minimum payment that is required to induce landowners to keep land for a particular use is called transfer earning. Economic rent is the extra payment land receives over and above its transfer earning required to induce the landowner to keep it in that particular use.
In Fig. 27.4, CS is the supply curve of land for a particular use and D is the demand curve for land in that use. Higher rent is required to induce landowners to shift to other purposes, say, growing wheat (or any other crop such as jute). In reality land has alternative uses. So it has transfer cost (earning) or opportunity cost.
The supply curve CS shows the transfer earnings that land used for growing wheat earns to induce it to be used for that purpose. At the equilibrium point E, the last unit of land used for growing wheat has transfer earning EA since E lies on the supply curve CS.
And it is worth using their last unit of land for growing wheat since its marginal revenue product is also EA, that is, E also lies on the demand curves. However, all previous units of land for growing wheat are also paid EA. The earlier units of land whose transfer earnings are less than EA are enjoying economic rent. It is a pure surplus. It arises because EA is needed to induce the last unit of land to be used for growing wheat.
Thus, in Fig. 27.4, the wheat farmers make total rent payments equal to OBEA. However, their payments can be divided into the total transfer earnings OCEA and the economic rent CBE. It is against this background that we study the modern theory of rent.