Before explaining economic rent, it is better to explain the different uses of the term rent in different time phases. It will be more helpful to fully understand the meaning of land as used in the economic profession. So, let’s first know what the term land refers to in economics.
What is Land?
Different Usages of Rent in Economics
What is Land Rent?
What is Economic Rent?
Concept of Quasi-Rent
What is Contract Rent?
Economic Rent Vs Contract Rent
Classical Vs Modern Rent
What is Land?
The ordinary meaning of land is the surface of the earth. However, in an economic sense, the term’s usage is slightly different. It refers to all the gifts of nature whose existence on the earth is without human efforts. So, the term land, as used in economics, implies the planet’s surface and natural resources.
Land is one of the significant factors of production, and it has passive characteristics because it alone cannot produce unless we combine other factors of production, especially labor.
One may be puzzled and question why somebody has to pay a large sum of money to buy an acre of land in an urban area if it is a gift of nature.
Of course, one has to pay, but that payment is for transferring land ownership or sacrificing current usage. This is because land is freely available in limited supply or is a freely available scarce resource. So, one pays for land, but in essence, the payment is only for its scarcity, not for naturally gifted land.
Now, I think it’s time to cover the main focus of this article.
Different Usages of Rent in Economics
There are three uses of the term rent in an economic sense: land rent, economic rent, and quasi-rent. Because of the concept of classical economists that rent is the price for the use of land and land alone, the term rent is usually attributed to land. Classical economists consider rent the price paid to the fixed factor of production – land. It is the concept of land rent.
However, the modern view also incorporates the other factors of production to earn the rent, and this view relates to economic rent. Others argue that rent is the earnings of fixed factors in the short run, and this view belongs to the quasi-rent category.
So, the different usages of the term rent depend on how it is ascribed to.
What is Land Rent?
The classical economists used the term to argue that land can earn rent. Land is freely available without any human efforts but in fixed supply. No other factors can earn rent because their supplies are not fixed like land. This is the concept of land rent: Land alone earns rent.
The land supply is inelastic even in the long run, so it does not have alternative uses, and the entire payment is land rent. In the long run, the earning of the fixed factor is the land rent. This view considers the supply of land from the perspective of society as a whole (macro perspective). Rent does not enter into the cost of production in this perspective: it is not price-determining but price-determined.
Of course, land is improved with drains, hedges, wells, irrigation, and the like. These improvements increase land productivity. They are man-made and constitute a capital investment. We obtain the pure land rent when we deduct the return on these improvement costs as capital expenditure from the total price.
That is, rent is the entire amount of land earned, excluding the improvement costs, to increase productivity. To the classicists, rent is a surplus, superfluous, unnecessary, and functionless payment because it is not necessary to bring the land into existence or to make it available in society.
What is Economic Rent?
It is the modern use of the term rent which recognizes the alternative uses of the factors. Unlike the classical concept of land rent, it posits that all the aspects of production can earn economic rent. The economic rent is defined as the surplus or excess of the payment over and above the minimum required amount to keep the factors in its current use. In other terms, economic rent is the excess of payment over the transfer earnings of factor or opportunity cost.
The transfer earning is the price of the next best use of the factor that results from the alternative uses. It is transfer earnings because it would transfer elsewhere from the present use if the necessary payments are not made. So, the transfer earnings are the minimum necessary amount to keep the factor in its present use or occupation. It is also known as transfer cost.
The implicit assumption here is that the factors are always in the best manner. Unlike the classical view, this modern view considers the supply of land, for example, from the perspective of use, industry, or individual producer, i.e., the micro perspective. From society’s viewpoint, fixed factors (such as land) may be the variable factor for a particular use, industry, or individual use.
That is, the supply of the fixed factor from the viewpoint of a nation or society may be elastic for a particular use, industry, or individual. So, for the individual producer, the transfer earnings are similar to any other cost of production. Hence, in the modern view, at least that portion of the payment transferred to earnings enters the production cost.
When does economic rent appear?
When there is perfect competition among the bidders of the factor, the supply curve of the factor for an individual will be perfectly elastic, implying that a slight change in price results in the entire movement of the factor from one use or occupation to another. So, a whole payment that is transfer-earning is the cost of the production for the individual producer, resulting in nil economic rent.
Economic rent arises when the supply of factors is less than perfectly elastic. Given the perfectly inelastic supply of factor, the entire payment for factor is economic rent (also known as pure economic rent). This is because there is nil transfer cost due to a lack of opportunity cost factors. Given the perfectly elastic supply, the entire payment is the transfer earnings because every factor has the exact transfer costs, and no more surplus prevails. Finally, given the relatively elastic supply of factors, some parts of the payment are transfer costs, while the rest is economic rent.
This analysis conveys that factor units having smaller opportunity costs or transfer costs gain an enormous surplus while the factors having higher transfer costs have a smaller surplus. But, the marginal unit earns no surplus at all. Note that the term rent as a price for land use and rent as the surplus earning of land is quite different. They are equivalent only when the supply of the factor is perfectly inelastic. Also, I’d like to point out that the economic rent has emerged based on factors such as the ability to earn transfer costs.
Concept of Quasi-Rent
This concept of quasi-rent is an extended form of the classical concept of land rent, applied to the short-run earnings of fixed factors (like machinery, buildings, etc.). Marshall coined this view. Like land, a change in the price of machinery, buildings, or the like does not alter their supply.
Once they are produced and used, it isn’t easy to move these factors elsewhere to earn the transfer earnings in the short run. These factors have specific uses and lack alternative uses, which means that such factors possess nil transfer earnings in the short run. Hence, the entire payment to the fixed factors (including land and others) over and above the nil transfer earnings is quasi-rent.
It is quasi-rent because it is characterized as the rent from short-run fixed factors. However, in the long run, these short-run fixed factors are moveable elsewhere to earn the transfer earnings, and their supplies are changeable because they are man-made. Accordingly, the quasi-rent is temporary and vanishes in the long run.
Logically, keeping the machinery in the running order must have some costs. Therefore, the more precise definition of quasi-rent is the excess of the short-run earnings over the cost of keeping machinery in the running order. Alternatively, quasi-rent is the total income earned minus total variable cost.
Both variable and fixed factors jointly operate in short-run production. To get the price of the fixed factors, it is reasonable to deduct the total variable cost from the total revenue. The total variable cost includes the short-run costs of keeping the machinery in running order.
What is Contract Rent?
We usually practice contract rent in our day-to-day lives. Sometimes, it is referred to as the gross rent. The actual payment is made to the owner of the factors. It is just like the periodical payment to the owner of the house, the owner of machinery and equipment, the owner of the land, or the like.
The contract rent is determined by the mutual agreement between the parties involved – owner and renter – and includes the economic rent, transfer earnings, and other improvements to the factors. These improvements, undertaken by the owner of the factors, take the form of capital expenditures. The rewards for these improvements in the form of interests for the capital expenditures undertaken by the owner of factors are, thus, included in the contract rent. As to land, such improvements could be the expenditures incurred by the landlord in hedges, drains, wells, and the like.
Economic Rent Vs Contract Rent
In modern economic literature, all factors of production, such as land, labor, capital, and entrepreneurs, earn rent. This concept of rent is economic rent, the excess amount over the transfer earnings paid to the owner of the factors. In the practical sense, contract rent refers to the gross payment to the owner of the factors in exchange for their use.
Thus, the most significant difference between economic rent and contract rent is that economic rent concerns the financial meaning of rent, whereas contract rent concerns the practical meaning of rent.
Classical Vs Modern Rent
The comparison between classical and modern views of rent proceeds by identifying similarities and differences between these views.
Similarities
- Both views accept the concept of scarcity rent.
- Classical and modern Views use a concept of derived demand concept (read Recardian theory of rent here)
- Both Views use the concept of economic rent despite the classical view limiting the idea of rent to pure economic rent.
- Rent is the price determined in both concepts.
- Both views use the demand-for-and-supply approach to determining rent, despite the classical view being implicit.
Differences
- The classical view postulates that only land earns rent: land rent/pure economic rent whereas the modern view argues that all factors of production earn rent.
- While rent is a surplus, superfluous, and unnecessary reward for using land for classical economists, it is an excess amount over transfer earnings for modern economists.
- The classical view does not identify the alternative uses of land, but the modern view does identify the alternative uses of factors.
- The classical view is related to the long run whereas the modern view is related to both the long- and short run.
- Rent does not enter into the cost of production in the classical view, whereas transfer earning, which looks like rent in the classical view, enters into the cost of production in the modern view.
- While the classical view uses a society’s viewpoint regarding the supply of land i.e., macro perspective; the modern view uses a viewpoint of industries, uses, or individuals regarding the supply of factors i.e., micro perspective.
- Rent is not price-determining in the classical view, while in the modern view, it is to the extent that transfer earnings are interrelated to the cost of production.
- The classical view concerns pure economic rent, whereas the modern view regards pure economic rent as a special case of economic rent.