Rent

Compensation paid for the use of land, building or a mine is called as Rent. It is important to note
that this payment is not for the transfer of the ownership rights over land but only for the right to
use the land for a specific period.
Gross Rent and Economic Rent
In economics Rent is classified as Gross Rent and Net Rent or Economic Rent.
The total compensation paid to the landowner is called as Gross Rent. But quite often it is seen that
many other assets are attached to the land and it is not possible to separate them from the land. Eg.
A Building constructed on a piece of land or a well dug into a piece of land cannot be separated from
the land. In such situations, the total rent paid for the use of land is called as Gross Rent. But some
part of the total rent is for the use of land while the rest of it is for the use of the building that has
been constructed on the land. This has to be deducted from total rent to arrive at the net
remuneration paid for the use of land. Such net rent arrived at after deducting the rent paid for the
use of building is called as Net Rent or Economic Rent.
In order to arrive at Economic Rent following items should be deducted, if present in, the Gross Rent
(i) Interest on Capital (eg. Capital invested in constructing the building) (ii) Compensation for the
risk undertaken by landowner (in giving the land to another person to use) (iii) Compensation for the
Management expenses incurred by the landowner (eg. To put in place a system for collecting rent)
(iv) Labor input rendered by the landowner and any such other expenses should be deducted from
the Gross Rent in order to arrive at Economic Rent.
In economics whenever a reference is made to Rent, it implies Economic Rent.
Theories of Rent
Theory of Rent or the basis for determining the compensation to be paid for rent has a special place
in the overall Theory of Distribution. Among the Various Theories of Rent advanced so far, the most
important have been =
(a) Ricardian Theory of Rent
(b) Modern Theory of Rent
Ricardian Theory
David Ricardo has defined Rent purely in terms of land and further only in terms of land for
agricultural use
Ricardos Definition of Rent Rent is that part of the produce of land which is paid to the landowner
for the use of original and indestructible powers of the land.
Explanation
Not all land in a given region is of equal fertility and quality. When people decide to settle in a
particular region, they first start cultivating the best quality land. But such land is limited in supply.
As the population of the region grows, land of lesser fertility is brought under cultivation. Thus as the
population of a region keeps increasing, there is more demand for food and lesser and lesser quality
of land has to be brought under cultivation. According to Ricardian Theory, in such a situation, Rent
will be determined in the following manner
Type of Land Cost of
Production
Production Price Income Rent
A 250 100 10 1000 500
B 250 75 10 750 250
C 250 50 10 500 0
A, B and C are three parcels of land, each of
different quality. Land A is of highest quality
while B is inferior to A and C is inferior to B.
When people begin their settlement in this
region, they first start using Land A for
cultivation. In this period Land A does not get
any rent.
As population grows, the demand for food-
grains increases. Land of type A being limited
in supply, people have to bring land of type B
under cultivation. Assume that on investing
Rs. 250 on land A, one is able to produce
100 kg of wheat. Market price being Rs. 10
per kg, the total income is Rs. 1000. Land B
being of inferior quality, the same amount
of investment yields production of only 75
kg of wheat resulting in an income of Rs.
750. The difference in the incomes between
land A and land B is the rent enjoyed by land
A. Thus in the given situation land A will now
enjoy a rent of Rs. 250 (1000-750) while
land B will not get any rent. Such land which
does not get any rent is called as Marginal Land or No Rent Land. Rent, therefore is the
excess earned by a given parcel of
land over and above the income
earned by the Marginal Land.
As population grows further, the
society has to start using land C
which is inferior to land B and A.
Thus on investing the same amount
i.e. Rs. 250 land C gives a yield of 50
kg of wheat giving an income of Rs.
500. In this situation land C becomes
the Marginal Land and will not get
any rent. Whereas the excess of
incomes earned by land A and B over and above the income earned by Marginal Land C is
the rent. Thus land A will get a rent of Rs. 500 (1000-500) and land B (which in earlier
situation did not get any rent) will now start getting a rent of Rs. 250 (750-500).
Assumptions
(1) Long Term Theory According to the Ricardian theory, as the population of a region grows,
inferior quality of land is brought under cultivation. Growth of population takes place over
the longer term. Thus the Ricardian theory would be able to explain the long term trends in
Rent.
(2) Supply of Land Limited Ricardo assumes that the supply of land in any given region is
limited by nature. He further assumes that the supply of different quality of land is also
limited. It is because of this that when there is growth of population and demand for food
increases, the society has to bring in inferior quality of land in use.
(3) Difference in Quality of Land Ricardo assumes that there is a difference in the quality of
different parcels of land. He further assumes that quality of land is a gift of nature and it is
not humanly possible to alter the quality.
(4) Quality of Land fully known Ricardo assumes that the quality of different parcels of land in
a given region is fully known by the people concerned and they are in a position to
completely classify the lands accordingly. Ricardo does not give any particular importance to
the time and cost involved in acquiring the knowledge about the quality of different parcels
of land.
(5) Best Quality Land is Used First He further assumes that while choosing the land for
cultivation, people, after being fully aware of quality of all the lands, choose the best quality
land first.
(6) Marginal Land Exists The most inferior quality of land that is brought under cultivation at
any given point of time is called the marginal land. Rent for all other lands in the region is
calculated as excess of earnings over the income earned by the Marginal Land. Thus,
Marginal Land does not get any rent. Ricardo assumes that such a land exists.
(7) Rent only for Land Ricardos Definition of rent is completely centered around land. He
defines rent as the compensation for the use of original and indestructible powers of the
land. Thus according to Ricardo, no other factor of production will earn rent.
(8) Original and Indestructible Powers Ricardo in the above definition assumes that there are
certain original and indestructible powers of the land. Powers which can neither be modified
by the efforts of the landlord nor can be destroyed by the use of land. Thus rent is earned by
the indestructible powers of the land.
(9) Rent due to difference In Quality According to Ricardo, Rent accrues to land on account of
the difference in quality of land. As population increases and more land is brought under
cultivation, the quality of the subsequent parcels of land is inferior to the previous ones. As a
result more fertile land tends to earn rent. When lesser quality land is brought into use,
lands which are of better quality start getting rent. The amount of rent is determined by the
quality of the marginal land.
(10) Increase in Population Constant increase in population is one of the important factors in
the Ricardian theory. As population rises, the demand for food and thereby the demand for
land also increases. As better quality land is fixed in supply, land of inferior quality has to be
brought in use. Thus rise in population is one of the important assumptions of the Ricardian
Theory.
(11) Law of Diminishing Returns Ricardo assumes law of diminishing returns is applicable in the
production process. The importance of this assumptions becomes clear while applying this
theory in case of intensive cultivation.
Criticisms
(1) Long Run Theory In this theory, rent accruing to a parcel of land changes when there is
change in demand for land. This would happen in case there is rise in population. The theory
is therefore useful in explaining the long run changes in the amount of rent. However, the
theory cannot be used in explaining and forecasting changes in rent in the shorter time
periods.
(2) No-rent Land does not Exist Ricardo assumes that the at all times there exists a marginal
land which does not get any rent. However, in real life it is seen that no such land exists. No
land can be used without payment of appropriate compensation to the land-owner. Here
the theory is removed from reality.
(3) Quality of Land It is assumed that the people of the region exactly know the differences in
the quality of lands and further are in a position to serially order all lands on the basis of
their quality. However, in real life it is seen that this information is either not easily available
or one has to spend considerable amount of time and efforts in acquiring such information.
Ricardo does not factor in these time and costs anywhere in his theory. Further, it is seen in
real life that as this information is not available while contracting the rent, people often get
cheated in the process.
(4) Priority of Cultivation From the above criticism it follows that, if the quality of lands is not
known, it would be difficult to use that factor for deciding which land is to be taken for
cultivation first. In this decision it is often seen that other factors such as proximity, etc. are
given more importance.
(5) Original and Indestructible Powers of Land According to some critics, land does not have
any original and indestructible powers. Fertility of land, though original, is not indestructible.
Similarly, proper use of fertilizers, irrigation, etc. can enhance the fertility of the soil not only
in the short term but also in the medium to long run period.
(6) Rent not only to Land Modern economists are of the opinion that rent is not only accrued
to the land but can also be used to explain excess remuneration paid to most other factors.
Ricardian theory on the other hand defines rent only in the context of land.
(7) Law of Diminishing Marginal Returns Technological changes can prevent the setting-in of
the law of diminishing marginal returns. In such a situation Ricardos Theory will not apply to
cases of intensive cultivation.
(8) Effect of Rent on Prices In the Ricardian theory, the price of the produce is decided before
arriving at rent. Rent is determined after taking into consideration the difference in revenue
accruing to different pieces of land. Thus rent does not play any role in determining prices.
This is contradictory as it is difficult to imagine how price can be decided without knowing
the cost of production. Rent being an important part of cost of production, it will have to be
fixed before arriving at the price of the product. Thus, the theory leaves the problem of
distribution unresolved.
Conclusion
Ricardo had expounded the theory in 1830. It was perhaps appropriate for the kind of agro-based
economy prevailing in those times. But the theory is inadequate to explain the changes in the
concept of rent in accordance with the changes in the nature and use of the land in modern
economy.
Modern Theory of Rent
According to Modern Theory rent is not only earned by land but by all factors of production. Modern
economists have defined rent in a different way
Modern Definitions of Rent
Alfred Marshal If supply of a particular factor is limited in a given time-frame and if it is not
possible to increase the supply through human effort. In such cases, it would be appropriate to call
the income earned by such a factor as rent rather than profit.
Joan Robinson An excess earned by a factor of production over and above its minimum transfer
earnings is called as rent.
Explanation
Transfer Earnings The minimum amount of compensation necessary to keep a factor engaged in a
particular production activity is known as the minimum transfer earning of that worker or its
opportunity cost.
Factors of production can be put to various alternative uses. In each of these uses, the factor is likely
to get some compensation. If they are to be induced to leave these various opportunities and shift to
a new activity, then they will have to be paid more than the next best remuneration that they would
have earned in any of the above alternate uses. This is the minimum transfer earning or the
opportunity cost that will have to be paid to the factor to induce it to leave its present occupation. If
the factor of production gets this level of remuneration it would be willing to offer its services. Thus
this minimum transfer earning or opportunity cost is an important determinant of supply curve of
the factor.
The actual compensation or price earned by the factor is decided on the basis of demand and supply
forces in the market. i.e. the equilibrium price fixed in the factor market.
According to the Modern Theory of Rent, the difference between the minimum transfer earning of
the factor and the actual price it receives in the market is the rent earned by that factor.

Diagrammatic Representation
In the adjoining diagram DD1 is the
demand curve of the factor of
production and SS1 is its supply curve. E
is the market equilibrium wherein W is
the equilibrium compensation paid to
the factor and the quantity demanded
and supplied is OQ. OWEQ is the total
remuneration earned by the factors of
production. This can be divided further
into two parts. OS1EM constitutes
minimum transfer earnings below
which the supply of factors will not be
available. S1Weis remuneration earned by the factor in excess of the minimum transfer earning and
should therefore be termed as rent according to the modern theory.
This can be further elaborated by considering the example of the unit of factor Q1. Factor Q1 is
willing to supply its services if the remuneration level is at W1. However, due to the market
conditions, it gets and actual remuneration of W. The difference between W and W1 is the rent
earned by the factor.
Rent and Elasticity of the Supply Curve
From the above explanation it can be inferred
that the region between the Supply curve of a
factor and its equilibrium price is rent.
Therefore as the supply curve becomes more
elastic, this region shrinks and finally in case of
a Perfectly Elastic Supply Curve, the Rent is
Zero. i.e. all compensation paid to the factor is
in the form of transfer earning.
Similarly in case of a Perfectly Inelastic
Supply Curve, all compensation paid to the
factor is in the form of Rent. The supply of
land is assumed to be fixed. The supply
curve is therefore Perfectly Inelastic. In
such a situation all remuneration earned
by land is in the form of Rent. Ricardo
assumed that land will be used for only
one purpose i.e. agriculture. On the basis
of this assumption it can be said that there
being no alternate use of land, there was
no possibility of an opportunity cost or minimum transfer earning.
Specific Use of a Factor
Certain factors are more suitable for specific uses. Eg. Some land can be better utilized for cultivation
of rice, while another for cultivation of wheat. It is this specific use that creates scarcity of that
particular factor. Thus there may be plenty of land available, but not all land would be suitable for
cultivation of rice. According to modern economists, it is this specificity of use that creates scarcity
for a particular factor and thereby gives rise to rent.
Comparison of Ricardian Thoery and Modern Theory
(1) Rent only for land
Ricardo in his definition of rent mentions that rent is the compensation paid for original and
indestructible powers of land. Thus according to the Ricardian Theory rent can be accrued
only to land and to no other factor.
According to the Modern Theory any factor of production can earn rent. When the supply of
any factor becomes scarce, it tends to earn remuneration in excess of its minimum transfer
earnings. i.e. rent. Thus according to the modern theory any factor can earn rent.
(2) Reason for Earning Rent Difference in Quality OR Scarcity
In Ricardian Theory rent is accrued to land on account of the differences in quality of
different lands. Because of this difference in quality, a piece of land would earn income in
excess of that earned by the Marginal Land, thus giving rise to rent.
On the other hand, as per the modern theory rent is earned by a factor on account of its
scarcity. If a factor is short in supply, its market price increases and it tends to get
remuneration in excess of its minimum alternate earnings. Thus scarcity of factor is the
cause of rent according to the modern theory.
(3) Original and Indestructible Powers of Land V/s Specificity
According to Ricardos Theory, rent is paid for the use of original and indestructible powers
of land. Thus, the land-owner earns the rent without putting any effort on his part.
On the other hand modern rent accrues to a factor on account of its specific use. It is quite
often seen that specific use of a factor is on account of special efforts taken by the factor in
gaining a particular skill or expertise. Thus it can be said that the efforts taken by the factor
do play a role in determining the level of rent.
(4) Rent and Price
In Ricardian Theory rent is fixed on the basis of income earned by various pieces of land,
which in turn is dependent on the price of the produce. Thus rent is fixed after fixing the
price of the produce of land. Thus rent has no impact on the price of the product.
On the other hand modern theory does not need price of the product or income from the
land in order to fix rent. Rent is fixed solely on the basis of the market price for the factor
and the minimum transfer earnings required for that factor to keep it in its present
occupation. Thus rent is fixed before fixing the price of the product. Rent can therefore have
an impact on fixing the price of the product produced using that factor.
(5) Rent as Cost of Production
In Ricardian Theory Price is fixed before determination of rent. Thus rent plays no role in
determining the price and cost of production of a good.
In Modern theory, rent is fixed before determining the price of the good. Rent thus plays an
important role in determining the cost of production as well as price.
(6) Cost incurred for Land
According to Ricardo, land has no cost associated with it. This is because rent accrues to land
for the original and indestructible powers of land. Thus, land has no production or
maintenance costs. Also as agriculture is the only use that land can be put to, there also no
opportunity cost associated with land.
According to modern theory, there is a opportunity cost associated with all factors of
production. Similarly, the theory is also silent on the original and indestructible powers of
the land.
Quasi Rent
The concept of quasi rent is attributed to Alfred Marshal. According to Marshal, factors where the
supply is fixed in the short run will tend to earn quasi rent.
Apart from land, supply of machinery, building and such other fixed assets cannot be increased in
short term. As a result they are likely to earn additional income on account of their short term
scarcity. This excess income can be called as quasi rent.
For example if there is an increase in demand for software engineers, their supply cannot be
increased in the short term. It will take atleast 5-7 years for students to opt for and complete the
software engineering degree. In the interim period supply of trained software engineers is limited.
This leads to the phenomenon of quasi rent earned by the present software engineers.
Some modern economists also view quasi rent as income earned in excess of the short-run Average
Variable Costs. In the short-run, quasi rent can be understood as the difference between Total
Receipts and Total Variable Costs.
In the long run as supply adjusts to the changing demand, quasi rent vanishes.
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