A theory of rents

Adam Smith described rents as income received by landowners who “love to reap where they never sowed” (The Wealth of Nations, 1776; book I, chapter VI). However, the analysis of rents by Smith was not consistent since he described rents sometimes as surplus and sometimes as costs without a clear analysis about the difference.

It was David Ricardo (1817) who is known for the first consistent theory of rents. Ricardo made a clear distinction between revenues to owners of scarce natural assets (e.g. land) that cover the costs of the asset, from other revenues to the asset owner, which result from the bare possession of a scarce or exclusive asset. The portion of revenues that is due to ownership only is rent, while rising revenues due to investment in improvements of the asset are not rents, but rewards for costs, risks, and effort. Ricardo’s analysis, which focused on natural assets such as land and mines, was followed throughout the 19th century.

In terms of Ricardo’s theory it is important to distinguish the owner of an asset versus the producer, for example the landowner versus the farmer. Sometimes the landowner and the farmer may be one and the same person, but also in that case it is important to distinguish the producer (the farmer) and the owner of the asset (the landowner). Likewise, many pharmaceutical firms in our time produce pharmaceutical products and possess patents of these products. However, this is not always the case: some firms own pharmaceutical patents but production is by other firms who pay a license fee to the patent owner. It is important to keep in mind that in all these cases it is the owner of the asset who receives a rent while the producer receives a profit.

John Stuart Mill remained close to Ricardo’s theory, and Mill’s book Principles of Political Economy (1848) was the major textbook in the second half of the 19th century. As such it was an important book to teach the theory of rents to students of economics.

In Capital volume I and II Karl Marx did not discuss rents in any detail, but he did so extensively in volume III, which was published by Friedrich Engels in 1894 after the death of Marx. Ricardo focused on ‘extensive rent’ or ‘differential rent’: the rent that is caused by the difference between the most fertile and the least fertile soil. Ricardo assumed that farmers on the least fertile soil do not pay a rent to the landowner. The more fertile the soil, the higher the rent that the farmer has to pay to the landowner, and this is called a differential rent. In addition to differential rent Marx distinguished intensive rent (rent on land with higher investments), absolute rent (rent on the least fertile soil, due to scarcity of land), and monopoly rent.

Henry George analyzed in Progress and Poverty (1879) the causes of the increasing gap between the rich and the poor in the USA, which may be compared to the modern discussion about the 1 percent versus the 99 percent. He attacked in particular rent-seeking by land speculators, and he proposed the single land tax as solution. His book was the most popular economics book among the general public in the late 19th century.

Alfred Marshall’s book Principles of Economics (1890) was the watershed between the classical economists (Smith, Ricardo, JS Mill) and the Neoclassical economists, who dominated the economics textbooks in the 20th century. Marshall introduced the concept of quasi-rents. He analyzed rents in the manner of Ricardo as being caused by scarcity of natural resources, and he defined quasi-rents as man-made, in other words: rents in manufacturing. Marshall assumed that such rents could exist in the short run, but would gradually diminish and disappear in the long run. Unfortunately Marshall was not always precise in his definitions, but he frequently mentions “producer’s surplus or rent”, that is: as meaning the same thing. Marshall’s concept of quasi-rents did not survive him in economic theory, but his concept of producer’s surplus is still used in most economics textbooks. However, the producer’s surplus is a differential rent, it does not cover monopoly rents, market power or political power.

John Bates Clark extended Marshall’s analysis of rent and quasi-rent in his book The distribution of wealth (1899). John Bates Clark and other neoclassical economists stated that Marshall was not consistent and incomplete when he introduced quasi-rent as separate from rent, because land is just another form of capital, so there should not be any difference in the analysis of land and capital. This idea resulted in the “marginal productivity theory”: the idea that the owner of any factor of production receives a return which is in accordance to productivity. This theory has many problems (see for example the discussion in Blaug, Economic theory in retrospect) but the marginal productivity theory discusses differences in productivity, that is: differential rent, and does not include monopoly rents or market power and political power. The Neoclassical concept of marginal productivity of every factor of production has been quite influential, and as a result the concept of rents faded into the background, and was hardly discussed anymore in economics textbooks. Many students of basic economics courses have not been exposed to the concept of rents, an example is the best-selling textbook by Mankiw.

In 1933 Edward Chamberlin published ‘The theory of monopolistic competition’ and in the same year Joan Robinson published ‘The economics of imperfect competition’. Needless to say, monopolistic and imperfect competition are related to rents, and indeed both books discussed rents in a chapter or an appendix. However, as Chamberlin described, rents are a revenue and not a cost for the asset owner, but rents are a cost for the producer like any other expense. Chamberlin and Robinson focused on producers, much more so than on asset owners, and consequently rent was only a minor topic in both books. Chamberlin did add something to the analysis of rents: he analyzed in particular urban rents as ‘spatial rents’, that is: related to the distance between a shopkeeper and locations with high density of people, such as for example metro lines.

The neglect of rents as a topic in economics during the 20th century changed when Gordon Tullock published a paper in 1967 and even more so in 1974 when Anne Krueger published her famous paper about rent-seeking. Her analysis of rents was in terms of Neoclassical economics, and she coined the word ‘rent-seeking’. Rent-seeking in this school of thought is any deliberate attempt by special interest groups to influence government regulations in their favor. An example is lobbying for import tariffs to maintain high prices in the home market. Methods of rent-seeking may be lobbying, nepotism or in a rather extreme case corruption.

Joseph Schumpeter (1883-1950) rejected the focus on equilibrium in Neoclassical economics. He argued that the nature of capitalism is dynamic and not about equilibrium, and his focus was on entrepreneurs, innovation and ‘creative destruction’. Innovation can create a competitive advantage and this may generate rents as above-normal profits. Innovation rents are also known as Schumpeterian rents. However, in competitive markets innovations will diffuse and innovation rents are therefore temporary rents.

Post-Keynesian and Real-World economists reject as quite unrealistic many assumptions in Neoclassical economics, for example the U-shaped cost curves which are very familiar to economics students. Most firms are not ‘price-takers’ but ‘price-makers’: they calculate prices as the sum of costs plus any markup. Post-Keynesian price theory analyses markup in relation to market power (for example Frederick Lee, Marc Lavoie).

An important trend in the 21st century is the rise of intangible assets and Intellectual Property Rights (IPR) as a source of rents. Examples of intangible assets are patents, licenses, copyrights, and brand names. Possession of intangible assets enable the owners to have higher markups and above-normal profits which are not proportionate to their investments ( ‘to reap much more than you ever sowed’ to paraphrase Adam Smith). In the economics literature there is much discussion whether IPR and patent laws protect innovation or incentivise rent-seeking, see for example Jaffe and Lerner (2011), Innovation and it discontents: how our broken patent system is endangering innovation and progress and what to do about it. There is similar ongoing debate about whether occupational licenses protect quality or protect rent-seeking, see for example Lindsey and Teles (2017), The conquered economy.

Summary: the state of rent theory

The analysis of rents by Ricardo in 1817 was limited to natural resource assets, in particular land rent, with a focus on ‘differential rents’: rents related to the difference between fertile land and marginal land (where rents are zero because there is no surplus). After Ricardo the analysis was extended with various kinds of ‘monopolistic rents’, and with ‘non-natural rents’ which are not related to natural resources, but which are related to intangible (non-physical) assets. All extensions of Ricardo’s theory of rents have one common denominator: rents are the result of scarce or exclusive assets which reduce the flexibility of supply to match demand, and consequently increase the price above the level in competitive markets.