Economic Rent

What It Means

Most of us think of rent as the cost of borrowing, or using, something (an apartment, a car, a video) for a certain period of time. The concept of economic rent, however, is different and trickier to grasp.

In modern economics the term economic rent refers to the financial return on, or income generated by, an asset (in this case, a factor of production, such as a piece of land, a piece of machinery, or a worker) over and above its “next best use.” Consider, for example, Donald Brown, a professional football player who earns $1 million dollars per year. Were it not for his rare athletic skills, Brown’s next best employment option might be to work as a computer programmer for $100,000 per year. The difference between Brown’s most lucrative option (playing professional football) and the next best use of his skills (programming computers) is $900,000. This figure represents the economic rent Brown earns on his athletic ability.

Another contemporary use of economic rent refers to the amount of money, above and beyond the market price (a figure determined by the laws of supply and demand in a freely competitive buying and selling environment), that a supplier can get for his product when competition is restricted. In this scenario the seller, Parvin Tehrani, holds a patent, copyright, trademark, import license, or other government-granted permit that establishes her as the exclusive provider of Sevruga Iranian caviar in the United States. Tehrani’s permit enables her to charge $300 per ounce for her caviar, more than twice as much as the same caviar would garner in a competitive marketplace (let’s say $120 per ounce). The difference between Tehrani’s price and the regular market price is $180; therefore, it is said, $180 is the economic rent she earns by virtue of having the permit.

When Did It Begin

The concept of economic rent was first introduced by David Ricardo (1772-1823), one of the principal founders, along with Adam Smith (1723-1790) and Thomas Malthus (1766-1834), of the classical school of economics. A witness to the radical social and economic transformation of Western Europe during the Industrial Revolution (the widespread adoption of industrial methods of production that began in the late 1700s), Ricardo developed the idea of economic rent in response to changes in agricultural production.

Before the Industrial Revolution, population levels were relatively low and stable. Using only the land that was most fertile, easy to cultivate, and close to markets, farmers could grow enough grain and other crops to sustain the whole society. The Industrial Revolution, however, brought unprecedented population booms, influxes of people to urban centers, and the conversion of centrally located farmland into factory sites. Suddenly it became necessary to begin growing crops on less fertile, more difficult to cultivate, out-lying lands in order to generate enough food. Although the production and transportation costs were higher for crops grown on the inferior land, these crops still garnered the same price at a market as those crops that were grown more cheaply on superior land.

If a bushel of grain sells for $16 at a market, the person who spends only $4 to grow that bushel reaps significantly (3 times) more profit than the person who must spend $12 to grow it (all other factors being equal). Accordingly, Ricardo noted, a tenant farmer would be willing to pay a landowner more money (in this scenario, 3 times more) for use of the superior piece of land. Ricardo used the term rent to denote the difference between the fee for use of the superior land and the fee for use of the inferior land, noting, too, that the profits were reaped by the owner of the superior land, not the farmer who worked it.

More Detailed Information

Like the owner of a superior parcel of land, the football player and the caviar merchant earn economic rent by controlling access to something desirable (athletic talent and fine caviar) that is rare or limited in supply. There is an important difference between the two examples, however.

The football player’s talent is rare in the same way that intellectual genius is rare; people with such talent are often referred to as gifted. We may assume that the football player has competed intensively against other talented players in order to make it to the top level of his sport. The caviar merchant, on the other hand, is not in possession of uniquely superior caviar, nor has she competed to prove that her caviar is the best; rather, the “gift” she possesses is the special permit that restricts her potential competitors from entering the market. But how did Parvin Tehrani obtain this exclusive government permit? Did she win it in a lottery? Was she the highest bidder in a permit auction? Did she have an inside connection to someone in the government office that awarded the permit? In a situation where there is substantial profit (or economic rent) to be gained from holding such a permit, we can imagine that merchants, manufacturers, and other business entities might go to extreme lengths to acquire this privilege. The effort to obtain exclusive market power through a permit or other competition-limiting avenue is known as rent-seeking. The rent-seeker tries to establish a competitive advantage by manipulating the economic environment rather than by increasing the quantity or quality of his or her product or otherwise providing any benefit to the consumer (as the profit-seeker aims to do).

Nowadays lobbyists are hired rent-seekers, who petition the government for various kinds of regulations and permits that will favor the corporations or interest groups on whose behalf they work. Notably, one of the lobbyist’s main tools of persuasion is to promise campaign contributions to, or threaten to withhold them from, the politicians whose favor they seek. Under extreme circumstances, rent-seeking may even lead to outright bribes and other corrupt or illegal activities.

The concept of rent-seeking was first discussed by Gordon Tullock in an influential paper titled “The Welfare Costs of Tariffs, Monopolies, and Theft,” which was published in 1967; the term rent-seeking, however, was coined by another economist, Anne Krueger, in a 1974 paper titled “The Political Economy of the Rent-Seeking Society.”

Recent Trends

During a period of profound political, social, and economic transition (even upheaval) when power and influence are up for grabs, many people and organizations become more concerned with brokering deals to secure or advance their own interests than with devoting their resources to activities that are socially or economically valuable to the community. Since the collapse of the Soviet Union in the early 1990s, many economists have turned their attention to studying the rise and impact of rent-seeking behaviors in formerly communist countries. In Russia, although bribery and corruption were well-known facts of life under communism, rent-seeking practices became even more prevalent as the country attempted to establish a market economy.

Rent-seeking behavior in Russia is seen as a significant hindrance to the country’s social development and economic growth. It maintains the concentration of power in the hands of a minority elite (the poor, after all, are not in the business of offering bribes), and it undermines legitimate competition and leads to the severe distortion of social and economic priorities.