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Introduction

  • Unlike variable factor, the marginal productivity theory of distribution fails to determine price of factor whose supply is fixed (e.g. land) or quasi fixed (e.g. capital equipment) as there is zero marginal product of fixed factor.
  • There exists separate body of theory, i.e. theory of rent which helps explain the pricing of these fixed factors.
  •  According to classical theory, rent is the price paid for the use of land. However, in modern theory, the concept of rent is not confined to land. It can be applied to any factor whose supply is inelastic in the short run.
  • There are three different concepts of rent: land rent, economic rent and quasi-rent.
  • The land rent is paid by the tenant to the landlord for hiring land and the landlord obtains this price because of the fact that the supply of land is scarce.
  • The concept of economic rent is widely applicable, in the sense that it is the price paid to any factor on top of what is required to retain the factor in its current employment. In other words, economic rent is a payment to a factor in excess of its opportunity cost.
  • The quasi-rent is the earnings of fixed capital equipment. The capital equipment are quasi-fixed factors in the sense that the supply of these factors are fixed only in short run, while their supply varies in the long run.

Theories of Rent

  1. Classical Theory of Rent
  2. Modern Theory of Rent

Classical Theory of Rent

  • David Ricardo, an English classical economist, first developed a theory in 1817 to explain the origin and nature of economic rent. 
  •  Ricardo defined rent as, “that portion of the produce of the earth which is paid to the landlord for the use of the original and indestructible powers of the soil.”
  •  Ricardo formulated this law based on the principles put forth by Adam Smith in Wealth of Nations. 
  • Ricardian concept of rent has two features. Firstly, it is payment to the landlord just for the use of land. It differs from contractual rent which accounts return on capital invested by the landlord. The portion of landlord’s earning which is spent for the improvement of land is considered as rent. Secondly, rent is generated due to the scarcity of land. That is, for an economy the area of land is fixed.
  • In other words, the supply of land is completely inelastic. Therefore a price (i.e. rent) must be paid for the use of land. Since, the land rent appears due to the scarcity of land given the assumption that all plots of the land are homogeneous, it is also known as scarcity rent.
  • When we relax the assumption that all plots of a land are homogeneous, another type of rent appears due to the different quality of lands. This rent is called differential rent.

Assumptions

The theory of rent given by Ricardo is based on the following assumptions:

  1. Fixed supply of land: Ricardo assumes that the supply of land is fixed; it can neither be increased nor decreased. Thus, it is a free, fixed gift of nature.
  2. Original Powers: Ricardo also assumes that the fertility quality of the soil is original. It means that the fertility of land is gifted by God, it cannot be affected by human effort.
  3. Indestructible Powers: Further, the theory assumes that the original fertility quality of land is indestructible. This means that the original fertility quality of a plot of land will remain intact forever, it will never diminish.
  4. Cultivation in Order of Fertility: It is also assumed that the different plots of lands are utilized according to their grade of quality. Thus, higher grade of land is utilized prior the lower grade of lands.
  5. Law of Diminishing Returns: Ricardo also assumes that the law of diminishing returns or increasing costs operates in agricultural field.
  6. Differences in Fertility: Another assumption of the theory is that different plots of land have differences in their fertility. Thus, some plots are more fertile than others.
  7. Free Gift: Land is a free gift of nature. It does not have any supply price.
  8. Perfect Competition: There is perfect competition in the market.
  9. Long-run: The theory is applicable in the long-run as well.
  10. Marginal Land: According to Ricardo, there is a ‘no-rent land’. This is the lowest grade of land and the return from this plot of land just covers its cost. This plot of land is also called ‘marginal land’.
  11. Different Situations: Different plots of land exist in different conditions. Some are nearer a market place, while others are distant from a market place. Thus, the producer nearer a market can save a lot of transport costs.

Explanation of the theory

  • Ricardo explained his theory with the help of an example of colonization. Let us assume that there are three grades of land in a deserted colony.
  •  If some people go and settle down in that colony, first they will cultivate the best lands. If more people go and settle down, the demand for land will increase and they will cultivate the second-grade lands.
  • As a result, the cost of production will go up. So the price of grain in the market must cover the cost of cultivation. In this case, the first grade land will get rent.
  • After some time, if there is increase in population, even third grade lands will be cultivated. Now, even second grade lands will get rent and first grade lands will get more rent but the third grade land will not get any rent.
  • From Table 1, it can be seen that at the first stage, when the first batch of people migrated to the new colony, they fulfilled their demand of food production while utilizing in the best grade land. Thus, in A grade land, they were able to get a production of 24 quintals of rice per acre of land. In this situation, the A grade land would command no rent. It would be like a free gift of nature.
  • Now, suppose population in the colony increases (owing to migration or internal increase in population). This will necessitate increasing the area under cultivation. Thus, in addition to the A grade land, the second quality land (B grade land) is also used. This B grade land yields 19 quintal of rice per acre of land. Now, the A grade land will yield a rent equivalent to the difference in the production of the B grade land. Thus, the rent earned by A grade land at this stage is 5 (24 – 19) quintals of rice per acre of land. The B grade land being the marginal land in this case, does not earn any rent.
  •  But the population continues to increase further. This will necessitate utilizing the remaining lowest grade (grade C) land as well. The C grade land yields 14 quintals of rice per acre of land. In this situation, both the A grade and the B grade lands will earn rent equal to the respective differences with this C grade land.
  • Thus, A grade will earn 10 (24 – 14) quintals of rice as rent per acre of land. Similarly, B grade land will earn 5 (19-14) quintals of rice as rent per acre of land. It is to be noted that the grade C land does not get rent and hence is termed as marginal land or no-rent land.

Diagrammatic Explanation of Ricardian Theory of Rent

The Ricardian Theory of Rent has been presented with the help of Figure 1.

Figure 1

Table 1 has been represented with the help of Figure 1. We can see from the figure that, A grade land being of higher quality earns more revenue than B grade land. C grade land does not earn any rent.

Criticisms of the Ricardian Theory of Rent

  • Ricardo tells that only the best lands are cultivated first. There is no historical proof for this.
  •  According to Ricardo, land has “original and indestructible powers”. But the fertility of land may decline after some time because of continuous cultivation.
  •  Ricardo believed that rent is peculiar to land alone. But many modern economists argue that the rent aspect can be seen in other factors like labour and capital. Rent arises whenever the supply of a factor is inelastic in relation to the demand for it.
  • Ricardo is of the view that rent does not enter the price of the commodity produced in it. But rent enters the price from the point of view of a single firm.
  • Ricardian theory does not take note of scarcity rent.
  • It is based on perfect competition. Only under perfect competition, will there be one price for a good. But in the real world, we have imperfect competition.
  • Though there are some criticisms against the Ricardian theory, we may note that it tells us that because of increasing pressure on land, we have to cultivate inferior lands.

Modern theory of Rent

  • Economists like Alfred Marshall; Joan Robinson criticized Ricardian theory of Rent and put forward a new approach.
  • According to modern theory, economic rent is a surplus which is not peculiar to land alone. It can be a part of income of labour, capital, entrepreneur.
  • According to modern version rent is a surplus which arises due to difference between actual earning and transfer earning.

That is, Rent = Actual – Transfer Earning (opportunity cost)

  • They believed that rent does not arise due to fertility of the land rather it arises due to Scarcity of a factor. Although land is free gift of nature but it is not free for a firm or enterprise. They have to pay for its usage and the price is decided by the scarcity i.e. more scare the factor more price for it. So the availability of the factor affects its price.
  • Here the concept of opportunity cost comes in play. Opportunity cost is the value of next best available alternative .A Factor needs to be paid minimum amount equal to its opportunity cost. Remember it is the minimum amount i.e. the lowest limit, actual amount may be much higher.
  • The actual amount to be paid depends on the scarcity and availability of that factor. If the factor is scare i.e. less available then the buyer has to pay more amount (Price) for that factor than its opportunity cost. This extra payment is nothing but Rent which depends on scarcity of a factor. Similarly for less scare factor buyer may pay an amount equal or slightly higher than its opportunity cost.
  • So rent is the extra payment over the opportunity cost (Minimum cost which has to be incurred). The scare factor attracts more rent as the difference in the opportunity cost and actual rent paid is more.
  •  Ricardo in his theory assumed that rent arises only on land but the advocates of Modern theory of rent believed that rent can arise on any factor of production.

What is Opportunity Cost or Transfer Earnings?

  • All the factors of production can be put to various uses. When we transfer on factor of production to another we have to sacrifice some income earned by it. This sacrifice of earning is called as opportunity cost or transfer earnings.
  • Suppose a teacher teaching in Lucknow receives a salary of rupees 50000 per month and now suppose if he moves to Delhi his salary would be 60000 per month. Then the rent earned by the teacher would be 60000-50000=10000. And if he moves to Delhi his opportunity cost would be 50000 that he is sacrificing to move to Delhi.
  • Whereas 10000 rupees that he is getting extra is due to its scarcity.
  • In this way rent can arise on all the factors of production and not merely on land.

Feature of Modern Theory of Rent

Some of the major features of modern rent theories are: 

  • Rent is a type of income produced through a difference of actual earnings and transfer earning. 
  • Rent comes from income of all the production factors. 
  • Rent is increased due to the scarcity of land in the particular area fundamentally speaking, rent is paid because the produce of the land is scarce in relation to its demand, and rent will arise even if all the land in a country is exactly alike. 
  • The demand also increases due to labor and overall economic conditions. 
  • Rent arises when the supply of the factor is inelastic or partially elastic.

Modern Concept of the Theory

Rent as Surplus over transfer earnings (Figure 2)

Description of Figure

In the above figure 2, demand and supply curve intersect each other at point E, where the price per unit of land is OR and quantity of land is OM. The total earning of the factor is OR multiplied by O, which is equal to OREM. Now we have to find out the opportunity cost or supply price. The supply price of the first unit is OS and the supply price of the last unit is EM. Hence, the total supply price of the factor is OSEM and therefore the amount of rent is SRE which is shown as shaded portion in the above figure 2. This rent shown as a shaded portion in the above diagram is due to the scarcity of the factor of production.

QUASI RENT

  • Marshall introduced the concept of quasi-rent.
  • It is the earning on capital equipment. It rises due to the inelastic supply of capital equipment in the short run. Unlike supply of land, the supply of capital equipment is not permanently fixed or perfectly inelastic; it varies in the long run. That is, in the long run the supply of capital equipment becomes elastic.
  •  According to Marshall this type of earning is defined as quasi-rent rather than the concept of rent defined earlier sections. It is a surplus earning enjoyed by the owner of capital in the short run due to an increase in demand for it and will be completely wiped out when supply will increase in response to the increase in demand.
  • Quasi-rent has also been defined as the excess of total revenue earned in the short-run over and above the total variable costs. Thus, Quasi-rent = Total Revenue – Total Variable Cost.

Diagrammatical Representation of Quasi Rent

Figure 3

Description of the Diagram

  • In the figure 3, P represents price.
  •  The firm maximises profit while it produces ON unit of output with 0PEN amount of total revenue. Now, the firm pays 0NBA amount of variable cost to the variable factor. This means that the residual of the total income, i.e., ABEP is the quasi-rent which goes to the fixed factor.
  • It is to be noted that the theory assumes that the firm operates under perfect competition.
  • The Quasi-rent can be divided into two parts. This has been shown with the help of Figure 3.
  •  In the figure, the area ABCD represents the total fixed cost, while PECD represents the excess (or pure) profit.
  •  Thus, Quasi-rent = TFC + excess profit. Or, Excess profit = Quasi-rent – TFC.
  • In the long run, as supply increases, Quasi-rent becomes zero and the firm is in equilibrium, earning just normal profit.

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