Before explaining economic rent, it is better to explain the different uses of term rent in different time phases. I think it will be more helpful to fully understand the meaning of land as used in economic profession. So, let’s first know what the term land refers to in economics.
What is Land?
The ordinary meaning of the land is the surface of the earth. But, in economic sense, the usage of the term is slightly different. It refers to all the free gifts of nature whose existence in the earth is without the human efforts. So the term land, as used in economics, implies the surface of earth as well as natural resources.
Land is one of major factors of production and it has passive characteristic because it alone cannot produce unless we combine other factors of production, especially labor.
One may puzzle, and may arise question why somebody has to pay a large sum of money when buying an acre of land in the urban area if it is a free gift of nature?
Of course, one has to pay but that payment is rather for the transfer of ownership of land or for the sacrifice of current usages. This is because land is freely available in the limited supply or freely available scarce resource. So, one seems to pay for land; but in essence, the payment is only for its scarcity, not for naturally gifted land.
Now, I think its a time to cover the main focus point of this article.
Different Usages of Rent in Economics
Basically, there are three uses of the term rent in economic sense: land rent, economic rent, and quasi-rent. Because of the concept of classical economist that rent is the price for the use of land and land alone, the term rent usually attribute to land. The classical economists consider the rent as the price paid to the fixed factor of production – land. It is the concept of land rent.
But, the modern view also incorporates the other factors of production to earn the rent, and this views relates to economic rent. Even there are others who argue that the rent is earnings of the fixed factors in the short-run, and this view belongs to quasi-rent.
So, the different usages of the term rent depend on how it is ascribed to.
What is Land Rent?
It is the use of the term by the classical economists that they argue it is the land that can earn rent. It is freely available without any human efforts but in fixed supply. No other factors can earn rent, because their supplies are not fixed as that of land. It is the concept of the lend rent: Land alone earns rent.
The supply of land is perfectly inelastic even in the long run, so they do not have the alternative uses and entire payment is land rent. That is, the earning of the fixed factor in the long-run is the land rent. This view considers the supply of land from the perspective of society as 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, there are some sorts of improvements such as drains, hedges, wells, irrigation and like in the land. And, they increase the productivity of land. These improvements are the man-made and constitute the capital investment. When we deduct the return on these improvements costs in the form of capital expenditure from the total price, we obtain the pure land rent.
That is, rent is the entire earning of land excluding the improvement costs in order of increasing the productivity of land. To the classicists, rent is surplus, superfluous, unnecessary, and function-less payment because rent is not necessary payment to bring land into existence or to make available in the 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 the land rent, it posits that all the factors 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 not paid the necessary payments. So, the transfer earning is 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. Fixed factor (such as land) from the viewpoint of a society as a whole may be the variable factor for the particular use, industry or individual.
That is, the supply of the fixed factor from the viewpoint of a nation or society as a whole may be elastic for the particular use, industry, or individual. So, for the individual producer the transfer earnings are similar to any other cost of production. Hence, at least that portion of the payment which is transfer earnings enters into the cost of production in modern view.
When economic rent appears?
For the individual producer, when there is perfect competition among the bidders of the factor, supply curve of the factor for individual will be perfectly elastic implying small change in price resulting in the entire movement of factor from one use or occupation to others. So, entire payment which 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 factor is less than perfectly elastic. Given the perfectly inelastic supply of factor, entire payment for factor is economic rent (also known as the pure economic rent). This is because there is nil transfer cost due to lack of opportunity cost of factors. Given the perfectly elastic supply, entire payment is the transfer earnings, because every factor have same transfer costs and no more surplus prevails. Finally, given the relatively elastic supply of factor, some parts of the payment is transfer cost while rest of the amount is economic rent.
This analysis conveys that factor units having smaller opportunity costs or transfer costs gain larger surplus while the factors having larger transfer costs smaller surplus. But, the marginal unit earns no surplus at all. Note that the usages of the term rent as price for the use of land, and rent as the surplus earning of land is a quite different concepts. They are equivalent only when the supply of the factor is perfectly inelastic. Also note that the economic rent has emerged based on factors’ ability to earn transfer cost.
Concept of Quasi-Rent
This concept of quasi-rent is the extended form of classical concept of land rent to the earnings of fixed factors (like machinery, building, etc.) in the short-run. This is Marshall who coined this view. Like the land, change in the price of machinery, buildings or the like does not alter their supply.
Once they are produced and used, it is very difficult to move these factors elsewhere to earn the transfer earnings in the short-run i.e., these factors has specific use and lack alternative uses. It means that such factors possess nil transfer earnings in the short-run. Hence, entire payment to the fixed factors (including land and others) over and above the nil transfer earning is the quasi-rent.
It is quasi-rent because it characterize as the rent from short-run fixed factors. But in the long-run, these short-run fixed factors are move-able elsewhere to earn the transfer earnings and their supplies are changeable because they are man-made. Accordingly, the quasi-rent is of the temporary nature and vanishes in the long-run.
It is logical that there needs some costs of keeping the machinery in the running order. Therefore, 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 the short-run production. So, it is quite reasonable to deduct the total variable cost from the total revenue to get the price of the fixed factors. Note that the short-run costs of keeping the machinery in running order are included in the total variable cost.
What is Contract Rent?
The contract rent is what we usually practice in our day-to-day life. Sometimes, it is referred to as the gross rent. It is the actual payment made to the owner of the factors. It is just like the periodical payment to the owner of the house, owner of machinery and equipment, owner of land, or the likes.
The determination of contract rent take place by the mutual agreement between 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 place in the form of capital expenditures. The rewards for these improvements in the form of interests for the capital expenditures undertaken by 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 likes.
Economic Rent Vs Contract Rent
In the modern economic literature, all the factors of production such as land, labor, capital and entrepreneur earn rent. This concept of rent is the economic rent. And it is the excess amount over the transfer earnings paid to the owner of the factors. Whereas in the practical sense, the term 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 with economic meaning of rent whereas contract rent concerns with the practical meaning of rent.
Classical Vs Modern Rent
The comparison between classical and modern views of rent proceeds with the identification of similarities and differences between these views.
- 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 classical view limits the concept of rent to the pure economic rent.
- Rent is price determined in both the concepts.
- Both views use the demand for and supply of approach in a determination of rent despite classical view being implicit.
- Classical view postulates that only land earns rent: land rent/pure economic rent whereas modern view argues that all factors of production earn rent.
- While rent is surplus, superfluous, and unnecessary reward for the use of land for classical economists, it is excess amount over transfer earnings for modern economists.
- Classical view does not identify the alternative uses of land, but modern view does identify the alternative uses of factors.
- Classical view is related to the long run whereas modern view is related to both long- and short run.
- Rent does not enter into the cost of production in classical view whereas transfer earning, which looks like rent in classical view, enters into the cost of production in modern view.
- While classical view uses a society’s viewpoint regarding the supply of land i.e., macro perspective; 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 classical view while it is to the extent that transfer earnings inter the cost of production in modern view.
- Classical view concerns with pure economic rent whereas modern view regards pure economic rent is a special case of the economic rent.