Introductory Economics

Introduction to Rent Theory

Introduction to theory of Rent

Introduction:
In economics, use of rent is restricted to the payments made to the factors of production which are in imperfectly elastic supply. The different concepts of rent are:

Ricardian concept of rent:

• According to David Ricardo, rent is that portion of the produce of earth, which is paid to the land lord for the use of the original and indestructible power of the soil. Thus rent is the payment for the use of land only

Joan Robinson’s concept of economic rent:

• Payment made to the factor of production which is in excess of the minimum amount required to keep that factor in its present employment. In other words, economic rent is the surplus that arises due to the difference between the actual earning and the transfer earning of the factor. Thus the concept of rent is applicable to only to land but to all factors of production.

Alfred Marshall’s concept of Quasi-rent:

• Marshall extended the concept of rent to manmade machines and appliances, whose supply is fixed in the short run but variable in the long run. In the short run, when their demand increases, they earn income over and above their normal price, which A Marshall termed as Quasi-rent.
• Hence, Quasi-rent is defined as the extra payment made to those factors of production, whose supply is fixed in the short run, but variable in the long run. Quasi-rent is a short run phenomenon and in the long run it disappears.

Classical Theory of Rent:

• Classical economist like, David Ricardo, West, Malthus Torrents formulated the differential theory of rent, though their ideas of rent were fundamentally the same.
• However, David Ricardo gave comprehensive theory of rent in his book: Principle of Political Economy and Taxation” According to him, rent is that portion of the produce of earth, which is paid to the land lord for the use of the original and indestructible power of the soil.
• He stated that the payment made to the landlord by the tenant is the contract or gross rent. It includes the price paid for the capital invested by the landlord. The remaining portion of the payment is called pure rent which is made to the landlord for the use of only land or the original and indestructible power of the soil.

Assumption of the Theory:
David Ricardo made the following assumptions to explain the theory.

1. Land has certain original and indestructible powers and rent is the payment for the use of these powers,
2. There are different grades of land that differ in respect of fertility and location
3. He assumed marginal or no rent land The rent of the superior land is measured above from this no rent land.
4. Superior land s cultivated first and then next grade land is cultivated. The most inferior land is cultivated in the last.
5. The supply of land is perfectly inelastic from the point of view of the society as a whole.
6. There is perfect competition in the market for land. In other words, there are large numbers of landlord, who are willing to give their land on rent and there are large numbers of farmers who are will to get the land for agricultural purposes.
7. The law of Diminishing return operates in agriculture.
8. Cost of cultivation is same in term of land and labour, whether it is superior or inferior land. In other words, it is same for each grade of land.
9. Land is used for the cultivation of corn and there is no alternative use of land.
10. Rent arises due to difference in quality of various lands in term of fertility and location.

Ricardo explained the theory in two situations i.e. under extensive cultivation and intensive cultivation.

Emergence of rent under extensive cultivation:

• When more land is used to increase the production, it is called as extensive cultivation. Ricardo explained the concept of rent under extensive cultivation with the help of newly colonized country.
• Let us assume there are three grade of land in a country i.e. Grade A, grade B and grade C. Grade A land is the superior land followed by grade B and Grade C is the most inferior land. Suppose one hectare of grade A land produces 10 quintal of corn by employing certain amount of labour and capital which costs Rs 480. As far as demand for corn is met by cultivating grade A land only, rent will not arise on it. If the demand for corn increases with the increase in the population of the country, grade B land is brought under cultivation. Suppose by employing same amount of labour and capital, one hectare of grade B land produces 8 quintals of corn it means that grade A land can produce 2 quintals of corn more than grade B land. Thus the price of corn will be Rs 60 (Rs 480/8). Hence the rent on one hectare of grade A land is equal to the market value of 2 quintals of corn.e.120 (2X60).
• Grade B land is marginal and thus earns no rent. Now suppose that demand for corn increases further, so that grade C land is brought under cultivation. Suppose by employing same amount of labour and capital, one hectare of grade C land produces 6 quintals of corn. It means that grade A can produce 4 quintals of corn more than grade C land. Now the price of corn will be Rs 80 (Rs480/6) Hence the rent on one hectare of grade A land is equal to the market value of 4 quintals of corni.e.1320 (4X80). Rent on one hectare of grade B land is equal to the market value of 2 quintals of corn i.e. 160 (2X80).Grade C is marginal land and earns no rent.
• The same can also be shown graphical in the figure below. In the figure ACA, ACB ACC are the grade wise average cost curves and MCA, MCB and MCC marginal cost curves. When demand for corn is initially less, only grade A land is put under cultivation. Since there is perfect competition in the market, equilibrium price will be where ACA and MCA are equal to the price of corn. This condition is satisfied at point E1, giving OP1 as equilibrium price.
• Now suppose that the demand for corn increases due to increase in the population and grade B land is brought under cultivation. Now the price of corn is determined by the average and marginal cost curves of grade B land. New equilibrium takes place at point E2 giving OP2 as equilibrium price. At this point grade B land has no rent whereas rent arises on grade A land.

Rent on grade A land = Total Revenue – Total Cost (on grade A land)

= Price X Output – Average cost X output
=OP2 X OQ2 – SQ2 XOQ2
=OP2RQ2 –OTSQ2
= TP2RS

Similarly it can further be extended to grade C land and so on.

Emergence of rent under intensive cultivation:

• Intensive cultivation means applying more and more units of capital and labour on the same piece of land. As it assumed that Law of Diminishing Returns operate in agriculture, every additional unit of labour and capital yield less and less return. Thus a farmer will employ more and more units of labour and capital till the marginal return obtained from these units is equal to their marginal cost. The unit of labour and capital whose marginal return is equal to marginal cost is called as marginal dose.
• And all the units prior to marginal dose are called as intra-marginal doses. All the intra marginal doses yield rent which is equal to surplus output by these doses over the marginal dose. This concept can be explained with the help of figure as shown below. X-axis measures the successive units of labour and capital whereas output is presented on Y-axis. First dose of labour and capital produces 10 quintals of corn. Second, third and fourth dose produce 8, 6, 4 quintals of corn respectively.
• Let us suppose that fourth dose is marginal. As stated above, rent is equal to the surplus output by the intra marginal doses over the marginal dose. Thus, rent on first, second and third dose will be 6, 4 and 2 quintals respectively.

Emergence of rent under extensive and intensive cultivation:

• Let us suppose that grade A land is put under cultivation to meet the demand for corn. If the demand for corn increases two course of action can be adopted. Grade B land can be brought under cultivation or grade A land can be cultivate intensively.
• The farmer will bring grade B land under cultivation if the increased price of corn will cover the cost of production on grade B land. In other words if the price is lower than the average cost of production on grade B land, farmer will not cultivate Grade B land. If the farmer are just covering the cost of cultivation by bringing the grade B land, then grade B land is on the extensive margin of cultivation.
• Besides extending the margin of cultivation on grade B land farmer will also use grade A land more intensively by employing more and more units of labour and capital. In other words margin of intensive cultivation will be pushed forward. Thus in reality, both intensive and extensive margins are pushed simultaneously in order to meet the increase in demand.

Criticism of Ricardian theory of rent:
The theory has been criticized on the following points.

1. Fertility of land is neither original nor indestructible
2. Ricardo considered that there exists marginal or no rent land in each country but critics’ points out that in a thickly populated country even marginal land fetches rent due to scarcity.
3. Rent does not enter into the price. According to Ricardo, rent is earning over and above the cost of production, as rent does not enter into cost of production, it does not determine price. Critics point out that rent must be considered as part of cost of production and thus rent enters into the price also.
4. According to Ricardo, rent is paid only on land but according to modern economists, like Robinson, rent is paid not only for the use of land but also for the use of scarce factors of production
5. Ricardo assumed perfect competition among landlords and tenants. But this assumption is not correct as in real world perfect competition does not exist.
6. Alternative uses of land were not considered in the theory. Hence transfer earning of land are considered zero.
7. According to Ricardo, rent arises on account of differences in the fertility of land, but critics point out that rent does not arise due to differences in fertility but due to scarcity of land. Thus, if land is scarce, rent will arise even if all lands are of homogeneous quality.