I. It's really a bargain!
Suppose that you woke up today feeling that you absolutely had to brighten the day of a theoretically-minded economist, or better yet, an economics major who had just taken a course in neoclassical microeconomics. You probably couldn't do much better than to ask her to explain rent, that is, pure rent, as opposed to the contract rent that we typically mean when we use the word in conversation. Rent is something that most people really care about, out of necessity, but also something that is understood rather differently in contemporary economics than everyday discussion. So it's an excellent topic for an economist who wants a chance to sound fancy.
Unfortunately, most economists don't have quite the clean and powerful understanding of the term that they would like to suppose they do. The basic concept of "pure" or "economic" rent is straightforward enough:
Begin by determining what it costs to preserve the condition of the thing to be rented (while still keeping it in use).
If you can get any more for it than that cost, the difference is your pure rent (from here on out I'll mean pure rent whenever I use the term 'rent', and I'll use the term 'contract rent' when that is what I have in mind).
But it has become very common to try and add more content into the definition of rent than the basic concept really entails. These additions mostly fall into two categories: claims about where rent necessarily always comes from, and claims about who is entitled to collect it. It is often claimed that rents come from distortions in the market, and yet it is also claimed that they provide incentive for investment. Such claims are very dangerous, because they can disguise political rhetoric as sober analysis or simple definition. Consider what happens when investopedia.com applies the concept of rent to labor:
For example, a worker may be willing to work for $15 per hour, but because she belongs to a union, she receives $18 per hour for the same job. The difference of $3 is the worker’s economic rent.
I don't mean to pick on Investopedia; this is a very common neoclassical analysis of the benefits of labor unions. But it is problematic because it is given so firmly from the perspective of the company providing the capital resources. I may capture essentially the same facts by saying:
For example, a company may be able to bring their products to market while paying each worker $18 per hour, but because it has successfully prevented the formation of unions, it need only pay $15 per hour for the same job. The difference of $3 is the company’s economic rent.
The first version implies that labor unions are distorting the market, while the second version presumes that they are likely to form and preventing them is what distorts the market. Neither version, however, obviously falls out of the definition of rent, so we'll have to ask a little bit more about where the gap comes from and who should get the "extra". In fact, we'll shortly see that this isn't actually rent, it's just profit. But first let's consider why it looks like rent.
You might identify the real floor for the worker's wage by simply asking "What is the minimum required for her to continue supplying her labor?" And this minimum will be whatever it costs to keep the worker fed and sheltered enough to be productive, perhaps along with some basic healthcare and one ticket per week to a cathartic action movie. Let us suppose that this is an expensive area by contemporary standards, with some pesky labor laws that limit how many hours in a week the worker can labor, and taxes take a chunk, so when all is said and done that comes to $15/hour. This is a hard limit, because if you pay anything less the labor supply will grow sickly and die, and there isn't time to train more. So that is what is required as pay for the worker, and anything more is arguably rent paid to the worker.
We can identify the real ceiling for the company by asking what the most they can pay a worker is while still being able to consistently bring their products to market at a price consumers will pay. Let us suppose that given other capital expenses such as maintaining machinery and so forth, this is $18/hour. This is a hard limit, because if they pay any more they will have to raise prices too high, or let machinery degrade and stop working, and they won't be able to hold up their end of the bargain: making capital resources available to workers. So that is what is required to sustain the business, and any money the company can save by paying the workers less is arguably rent collected by the company.
Each of these analyses, however, suffers from at least one severe flaw. On the one side, there is a sort of basic human point that is difficult for the economists to capture: deciding what to pay a human is not the same as assessing the cost of maintaining machinery. The baseline of a subsistence wage is not all that the worker is entitled to, and an increase beyond that baseline is not a distortion from the "real" market price. We probably shouldn't even think of animals, let alone humans, as something to be "maintained". So the concept of rent shouldn't apply here. And on the other side, the requirements of the company can't really be thought of as allowing for rent, because even in a relatively stable industry the flow of capital the company brings in will naturally fluctuate with the demand for their products, the rise and fall of competitors, etc. Rent can only be assessed in cases where the resource provided can be reliably maintained at a determinate cost. The material assets of the company can perhaps be understood in this way, but the flow of capital more generally cannot.
There's no rent to be seen here. What we really have here is a variable profit margin that is usually at least three dollars per worker per hour, and a bargaining problem about how to divide that profit. And that is what unions do, when they are functioning properly: they assist with bargaining. Our economic practices allow capital to concentrate in a way that labor simply never can; we allow people to become arbitrarily rich, and companies to become arbitrarily large (with some restrictions on market share in a given sector to prevent monopolies), but there are physical and metaphysical limitations on how much labor power can be concentrated in a single person. Because the interests of a corporation or wealthy individual business owner are inherently consolidated, the negotiators for capital interests can play workers against one another in the wage offers they make, and this means that individual workers need to also consolidate—unionize—lest they remain vulnerable to such tactics. Unionizing workers are not seeking rents, they are simply solving a problem in bargaining theory.
II. David, Karl, and Henry
I am far from the first one to point out that these distinctions are important and often overlooked. Some neoclassical economists have tried to distinguish economic profits that resemble rent in the ways I have discussed by calling them "Paretian Rents", after the great Italian economist Vilfredo Pareto. Pareto himself didn't give such an expanded theory of rent, and developed his own account on something closer to the classical grounds I'll be discussing shortly. But his ideas about economic efficiency might be taken to suggest that if any factor of production commands a price higher than what is required to sustain its use, something wonky is going on. An additional distinction can be made between pure rents and temporary rents that arise because of conditions such an asymmetry in information, a limited-duration patent, or a finite period of scarcity in some resource. The latter are sometimes called "Marshall rents", after Alfred Marshall, though he himself called them "quasi-rents". There's nothing wrong with discussing various more or less rent-like economic phenomena, as long as you don't treat people, abstract money, machinery, land, etc. as all having something in common that they really do not. But it would be helpful to have at least some central concept of rent to draw from, so that we know when what we have in mind is more of a metaphor or an extension.
The clearest and most internally consistent definition of economic rent is also one of the oldest, as it was developed by David Ricardo somewhere around 1815, and published in 1817. Economics isn't really a very old discipline, and while the celebrated Adam Smith did give an account of rent forty years earlier, it is not nearly as conceptually consistent or complete as Ricardo's. The latter discusses rent extensively, and devotes the better part of at least four chapters of On the Principles of Political Economy and Taxation to it, and to how his contemporaries were fairly confused about it. But one turn of phrase particularly stands out:
Rent is that portion of the produce of the earth, which is paid to the landlord for the use of the original and indestructible powers of the soil.
This naturalistic and utterly charming description actually captures something incredibly important. The "original and indestructible powers of the soil" are intrinsically an unearned benefit to the landlord. He did not create them, as they are original to the soil, and he cannot destroy them through the use of the land. Ricardo did not, of course, mean "indestructible" in the strictest sense, and he meant "powers of the soil" as a metonymy for the value of land in all of its myriad of uses. He understood that one could salt the earth, or make it in some way unsuitable for building, or otherwise degrade any particular virtue of any particular section of territory. What he meant was that using the land in its most productive capacity on one occasion will not diminish its usefulness on a future occasion. So when the landlord charges for using the land—when he collects rent—he is literally getting something for nothing. He still has the land at full value when all is said and done, along with his rental fees, even if he did no productive labor of any kind.
Ricardo himself, while he did a great deal of brilliant, seminal work on political economy and rent in particular, caught a bit stuck in the weeds in his analysis of the effects of rental markets. His concern with the differential productive capacity of individual plots of land distracted him from the realization that rental income could be extracted even from relatively undesirable land, and that this phenomenon was the most powerful single driver of inequality that the world had seen up to his point in history. Both he and Smith were aware of these historical patterns. But it would be their successors who would really develop the Ricardian notion of rent into its most important extensions.
The two greatest readers of Ricardo were not only remarkable theorists, but also tireless activists, and it is extremely unfortunate that they have both been slandered and dismissed for much of the last century. If you are interested in this sort of thing, you may have already guessed that I am referring to Karl Marx and Henry George. Marx's Capital is not merely famous, not merely infamous; it is legendary. Self-style entrepreneurs and even moderate economists use the word "Marxist" to frighten their children into behavior at the dinner table. And George's Progress and Poverty, among other works, should be far more read than it presently is. I'd like to turn to George first, but we'll get back to old Karl momentarily.
Henry George understood better than any thinker before him that the inequality produced by rent was a very bad thing, but that the indestructible powers of the soil are very good things. He used that distinction to lay out a sophisticated but elegant plan for how taxation and regulation of economic activity could be designed to redirect a certain amount of a society's productive output to infrastructure and public welfare, without distorting incentives to productivity or impeding the efficiency of industry. In fact, his single tax, a "Land Value Tax" on the usage to which land is put, gives a structured incentive to property owners to develop their holding to their full potential and maximize their own economic contribution. The account George gives is now incomplete, because land no longer represents quite such an overwhelming portion of the holdings of rentiers (those who collect rents). But his theoretical tools are so carefully deployed that this is a matter of revision, not replacement. His work can and should be revisited and adapted into a robust and current theory of socioeconomic reform. So far, none of his contemporary advocates seem to be up to the task, but there is no reason to think we won't see smart Georgist work in the near future.
Marx recognized the implications of Ricardian rent, but in Capital he treats it as almost literally an afterthought. His original contributions to the theory of rent don't appear until volume 3, which hardly anyone ever gets to. But he did something else, something very interesting and influential, early on. Karl Marx realized that land was only the first of the factors of production for which something like rents had been legitimized. Land was the vanguard, the test case for the wealthy to ask the question "How can we get something for nothing, day in, day out, and convince people that it is our right?" Before industrialization, land and the buildings constructed on it were the only forms of property that allowed you to reliably draw an income while doing no work, taking no risks, and having no idea what you were doing. Steel weapons and horses (and eventually guns) were good, but you had to know how to use them... ships were potentially highly profitable, but they got lost a lot before the industrial era. Usury was sort of prohibited by the church, though the history of banking more broadly is too complicated to get into here. But land was low risk free money for, well, anyone who happened to already have land.
The problem with land was that the supply was limited, and by the middle of the nineteenth century, you had to go somewhere pretty remote and actually work for a while if you wanted to get something for nothing by exploiting tenants. Right around the time that colonialism was fizzling out, industrial technologies started to offer intriguing new possibilities. Even if you couldn't afford good farmland, you might be able to afford the kind of land that Ricardo had thought would never be of much use. Rocky land, or land with bad soil, or plots too small to support a herd or a harvest. And you could improve that land far beyond its original and indestructible powers, using industrial machinery that would dramatically enhance its productive potential. This required more investment up front than just seizing some fertile ground. But at least the resources it required weren't already completely occupied, and moreover, their value wasn't understood by everyone at first. Of course, in the end, leveraging capital and leveraging land follow the same basic pattern:
Begin by determining what it costs to preserve the condition of the thing in use. If it's land, that cost might be close to nothing, and even for industrial capital, the cost can be small as a percentage of productive capacity.
Find people who need jobs, and give them jobs working your land or your factory. As long as they are producing more value than you need to maintain your assets, including your entitlement to their labor, you are getting something for nothing.
Ideally, find managers to do even the organizational tasks you were doing. You can pay them relatively well to protect your interests and still draw a considerable income.
Use that income to buy more property and repeat the process. After industrialization, a much more plentiful selection of territory is suitable for development, because it doesn't need to be good arable land.
Note that land doesn't drop out of this picture, even for industrial production, so Henry George is still highly pertinent. And yet, Marx really drives home that the extraction of something for nothing can happen at multiple levels. He could not have foreseen the plethora of quasi-rents and complex financial services that encrust every developed economy in our century, but he articulated with remarkable precision how the relationships between factors of production were changed as soon as agricultural land was no longer the most profitable thing one could own.
III. Productivity, Rent, and Risk
At the present time, we are surrounded by quasi-rents. Whenever a rights-holder charges more for some factor of production than is actually required to sustain it, a rent (or quasi-rent) is being extracted. Whenever a car is leased and subsequently re-sold, a quasi-rent is collected, because the total of the lease payments is significantly greater than the difference between the new and used sale prices of the car. This and similar business practices are also quite common. If a loan is only offered at a rate of interest higher than is required to account for inflation, administrative costs, and a reasonable assessment of risk, the difference is a quasi-rent. This is also relatively common, because there is an asymmetry of information between lenders and borrowers about how risk is calculated. Insurance is in the end a form of capital economically important for managing risks... and it is rife with something very similar to quasi-rents. Most services that provide needed capital, whether it is now (in the case of a loan), in an emergency (in the case of insurance), or at a future time (in the case of an annuity), include quasi-rents that the providers can extract. Sometimes lenders thinly justify these rents by overestimating the risks they are taking, while on other occasions (certain government-backed student loans, for example) the rents are simply blatant.
Intellectual property is the most characteristic quasi-rent of our times. First patents, and in the information age, copyrights, have become central aspects of entrepreneurship, with entire companies attracting capitalization solely on the basis of their IP holdings. Some parts of this process have mirrored the emergence of land rents to a remarkable degree. Just as the wealthy in eighteenth-century Britain enclosed the land and turned the commons into private property on which they could charge rent, business interests have attempted to enclose new forms of information, like digital source code and genetic code, so that they can charge rent on these resources. If these were moderate quasi-rents with a short duration, this wouldn't be a problem. They would be appropriate incentives for research, allowing the scientists who develop new technologies to recoup lost resources and be paid for their time. But the constant extension and expansion of copyright via legislation including the Copyright Act of 1976, the Copyright Extension Act (1998), and the Digital Millennium Copyright Act (also 1998), means that IP licensing charges come more and more to resemble true rents that continue to provide unearned income indefinitely. Of course, it will never be as difficult a problem as land rent, because the supply of intellectual property is vastly more elastic than the supply of land. Programmers, biologists and artists will never have their fundamental resources exhaustively stolen in the way that the freeholders of the eighteenth century did. But the future of science and culture is at stake.
One advantage of clarifying our understanding of rent is that it allows us to recognize why it is inimical to productivity. When a public commentator with certain political commitments suggests that we must keep capital free for investment, because investment grows the economy, your first question should be "What kind of investment?" By definition, any investment in property intended to yield rents grows the economy less than it could if invested elsewhere. If I spend $1 million dollars on printing equipment, I intend to produce a product, and I am growing the economy. If I spend $1 million on a small apartment building, however, I probably do not intend to add anything to the economy that wasn't already there. I just intend to sit back and collect rent. Of course, it is possible that I will build a bigger apartment building, but if I do that the money I collect in contract rent will temporarily amount to a profit, hopefully enjoyed in part by me and in part by my tenants and those in surrounding buildings, because housing will become more affordable for everyone. Eventually I will no longer be adding any benefit to the economy of the neighborhood or the city, nor will I be recovering my investment. I'll just be collecting rent again. Similarly, if I own a pharmaceutical company, and the company researches an important drug, a patent for a certain number of years will help recover the expenses from that research—and fund future research. But after a certain period, a patent just allows me to collect a quasi-rent by charging far more for the drug than it costs me to produce it. Eventually I'll realize that I can manage far more patents if I stop doing research altogether. So I'll either farm my research out to universities under partnership agreements that allow me to retain the patents and collects the rents, or I'll simply form an investment company that manages patent rights and produces nothing at all. Martin Shkreli is doing just fine, in case you were worried about him, and he is not unique. In fact, our economy heavily subsidizes his kind by protecting IP-generated quasi-rent.
These rent collectors want us to believe that we need them, that without them important research can't get funded. But if we were to return to a model where we publicly fund more medical research, giving universities more resources up-front in exchange for guarantees that they will amortize their remaining costs over the entire life of each patent and keep drug costs low, the development of new drugs would both subsidize higher education and help save our ever-fraught health care system. In general, intellectual property could do a great deal to ameliorate the costs of higher education in the arts and sciences, as long as we keep the rentiers out of it. And while we're on the topic of higher education, student loan debt is at crisis levels, so eliminating the quasi-rents from that as well would save massive amounts of money.
And yet the most alarming contemporary facts about rent may have to do with the ways in which rentiers increasingly fail to protect their own self-interests. The yields from rent are so great and so reliable that real estate has come to be seen as a nearly infallible form of investment, and we have seen some dangerous consequences emerge from that in recent years. The reasons that real estate is a superior investment—it yields pure rent both from the land and from the enduring value in any structures—also make it the source of a number of attractive prospects for quasi-rents, particularly because it makes very effective collateral. This causes small investors, including young families, to take great risks in pursuit of these benefits, and it also causes financial institutions to be willing to help them take those risks. Later, though, if a financial institutions gets nervous, it will often look for a way to unload the risk. Another financial institution may be happy to help with this, because after all, how much risk can there be? You have land as collateral. A few iterations of this, and the risk becomes really obscured... until it isn't, and things fall apart. This is much of why the 2008 crisis revolved around real estate: the perception that mortgages are always good bets because land is always good collateral (there's also the fact that derivatives and collateral have a weird relationship, but that's for another post).
But the scariest thing is not that so many investors overestimate the stability of land value, or that we have found so many ways to destabilize it. It is that even Ricardo's basic premises are under assault as they have never been before, not merely theoretically, but as a matter of changing conditions of a very fundamental kind. Even the pure rent that we could (and should) be harnessing for great social good, even the original and "indestructible" powers of the land, are declining at an accelerating pace. NASA and the JMA announced this week that this was the hottest October on record, making this almost certainly the hottest year on record, beating out last year... It is probable that there will be meaningfully less arable land in the world by the end of our lifetimes than at any other point in the last two hundred years. This may be reversible, and it may become possible to leverage previously unproductive territory, but the comparative inelasticity of land supply can no longer be assumed as it once could. Even without considering the plethora of other socioconomic and ethical questions that surround climate change, that alone is a dire possibility for the global economy.