"Rent" usually conjures up payments to landlords or prices charged for temporary use of a videotape, or a truck at the local "Rent-All." As seems too often true, economists have taken a perfectly good word, "rent," and attached their own special meaning to it.
Economic rent is realized whenever the owner of a resource is paid more than the minimum necessary to elicit the quantity supplied of that resource.
Thus, economic rent broadly applies to parts of many payments to resource owners.
Economic rents may have little to do with apartment leases or similar "rental" values. For example, many rock musicians spend years "paying their dues"---working for peanuts in smoke-filled bars and generally hustling just to get by. If they hit it big and begin to pull down seven figures annually, there is an enormous difference between their superstar incomes and the small amounts for which they were once willing to perform. Economists view such differences as economic rents. Land is about the only resource, however, that generates "pure" economic rents.
Pure Land Rents
One unique characteristic of land is its absolutely fixed supply. The land available to society cannot grow even if payments to landowners rise to infinity; the supply is perfectly inelastic at Qs in Figure 1. If demand is D0, rent per acre will be t0 and total rent is area 0acf.
If new technology enhanced land's physical productivity, or if higher output prices boosted the derived demand for land to D1, rent per acre would rise
Figure 1 Economic Rent for Raw Land
to t1, yielding total rent equal to area 0bef. What will rent for raw land be if demand is D2? Zero, and some land will be idle (df). Owners of this vacant land receive negative rents; they must shell out payments (taxes and maintenance) to keep the land. In summary, all payments received for the fixed supply of land are pure rents determined solely by demand.
The purest examples of economic rents are payments for use of unimproved land. (Recall that any improvement increasing the productivity of natural resources is classified as capital. Thus, people create capital, not new land when, e.g., they drain swamps.) Consequently, the supply of land is perfectly inelastic, so changes in demand yield proportional changes in land rents. Location and physical attributes cause differences in demands and rental rates for parcels of land.
Why is a vacant block in Manhattan worth more than an acre of prime Kansas wheat land? Transportation costs are a major reason because differing customer populations create different values. One facet of location rentsis that if a seller can locate so that customers bear lower transportation costs than are incurred in buying from a competitor, the advantageously located seller can charge more for its products.
Suppose you replicated a block of downtown Manhattan on the north forty of an isolated Kansas farm, including a hamburger stand. If you undercut prices at the New York burger stand by half and put on an ad campaign worthy of Ronald McDonald, your sales would still fall far short of those by your New York rival. New Yorkers would become regular customers only if you charged such low prices that transportation costs were overcome. Fat chance!
Another facet of location rents is that a firm is able to pay lower prices for inputs if it locates so that its input suppliers (workers, for example) have lower transportation costs than if they sold to a competitor. When operating at a particular location enables a firm to charge more to its customers or to pay less to its suppliers, the location’s owner will become aware of these advantages and charge rents sufficiently high that the firm receives only normal profits.
For example, suppose you lease a building in a run-down area of Chicago to establish a fancy French restaurant. Then suppose a huge luxury hotel unexpectedly located in the next block—business would boom and you might profit immensely in the short run. When your lease is up, however, your landlord will raise your rent to capture this increased profitability. Economic rents of this type, known as location (or site) rents, are illustrated in Figure 2. Actual rents per month for a two-bedroom flat in selected cities are shown in the table in this figure.
Marginal productivities and the rental rates of parcels of land reflect differences in fertility or the values of minerals the land holds. Some land is not used at all. Windswept deserts and Arctic tundra are examples of land so barren and remote that its marginal productivity is effectively zero.
David Ricardo, who originated the theory of pure rent, observed that marginal (barely useful) land commands zero rent whenever equally productive parcels are vacant. For example, you could always live "rent free" at an oasis in the Sahara if at least one comparable oasis were vacant. If the owner tried to charge any positive rent, you would move to a vacant oasis. The production cost saved by using more productive land versus marginal land equals the rental value per period of the more productive land.
Competition for cost reductions from particular sites permits a landowner to charge rent reflecting the productivity differences between superior land and the marginal (zero rent) land. Ricardo viewed land rent as an unearned surplus because its fixed supply would be available even at a zero price. Henry George (see his Biographical Sketch) gained fame by arguing that this unearned surplus to landowners could be taxed without creating economic inefficiency.
Figure 2 Value of an Acre of Land, Depending upon Location
The concept of economic rent originated with David Ricardo's analysis of corn and the land used to produce it. Economic rents are received, however, whenever a resource owner is paid more than the minimum necessary to induce a given amount of the resource. Thus, many owners of scarce resources earn economic rents. The economic rents received when resource supply curves are imperfectly elastic are illustrated in Figure 3, which portrays a positively-sloped labor supply curve for professional wrestlers.
Equilibrium occurs at point e when 450 wrestlers work for annual incomes averaging $80,000, but only very reluctant wrestlers (those making up the labor supply near point e) are paid the bare minimums necessary for their services. Other wrestlers would work for less and so receive economic rents as surpluses above their minimum acceptance wages. For example, if Zorba were willing to work for $50,000 annually (his actual salary is $80,000), his economic rent is $30,000. Total rents to wrestlers equal the shaded area above the supply curve but below the wage rate.
Figure 3 Economic Rent and
Economic rent is any surplus to a resource owner when income exceeds the opportunity cost of providing the resource to society as a whole. Economic rents are fairly common because most productive resources are at least partially fixed: their supplies are not perfectly elastic for the entire economy. This "fixity" generates economic rents.
People who view the income distribution as unfair often target high incomes from interest, profit, or rent. Referring to multimillion-dollar-a-year sports figures or movie stars, expressing sentiments such as "No one is worth ___." Do rents serve any purpose beyond enrichment of the owners of land or specialized talents? If not, these surpluses can be completely taxed away with no net loss to society. But both the short- and long-run consequences of taxing economic rents might actually cause inefficient resource allocations.