Theory of Rent

Rent, in ordinary usage, means any periodic payment for the hire of an asset -- a house, a machine, a shop. In economics, however, rent has a narrower, technical meaning that this chapter develops through three ideas: the Ricardian theory, the modern (scarcity) theory, and Marshall's idea of quasi-rent.

Ricardo's theory of rent. David Ricardo, writing about English agriculture, defined economic rent as the payment made for the use of "the original and indestructible powers of the soil" -- a payment that arises purely because different parcels of land differ in fertility and location. As a growing population raises the demand for food, cultivation is pushed from the most fertile land available towards progressively poorer land. The marginal (or no-rent) land -- the least fertile land that is still just worth cultivating -- yields a produce that only covers the cost of cultivation, leaving no surplus and therefore earning no rent at all. Any plot more fertile than this marginal land, cultivated with exactly the same amount of labour and capital, produces more purely because it is more fertile; this extra output is differential rent:

Ricardo also showed that rent can arise on a single plot at the intensive margin: applying successive doses of labour and capital to the same land eventually yields diminishing extra output, and the surplus earned by the earlier, more productive doses over the last (marginal) dose is also rent.

Criticisms commonly raised against Ricardo's theory: it treats land as a "free gift of nature" with no cost of production, ignoring genuine improvement costs such as irrigation and levelling; it is worked out only for agricultural land, though a similar surplus can arise for other factors too; it assumes a no-rent margin always exists, which need not be true once all cultivable land is already in use; and it explains rent purely through differences in fertility, saying nothing about scarcity as such.

The modern (scarcity) theory of rent. Later economists rebuilt the idea of rent around the concept of transfer earnings -- the minimum a factor must be paid to keep it in its present occupation, equal to what it could earn in its next-best alternative use. Whatever a factor earns above its transfer earnings is called economic rent:

Because this depends only on a factor's supply being inelastic relative to demand, economic rent is not confined to farmland -- a cricketer with a rare skill, a shop in a uniquely busy market location, or any resource in short supply relative to what firms want can all earn economic rent. This is why the modern theory is regarded as broader than Ricardo's, even though it keeps Ricardo's core insight that rent is, at bottom, a surplus. …