Note on Rent: Modern Theory of Rent

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Rent

Economically, rent means the payment made by tenants to landlords for the use of a building, or machinery, or a rent. Rent in economics always means economic rent. It is the part of national income which goes to land as a factor of production. According to David Ricardo, “Rent is that portion of the produce of the earth which is paid to the landlord for the use of the original and indestructible power of the soil.”

 

Modern Theory of Rent

This theory was propounded by Mr. John Robinson. According to him, “The essence of the conception of rent is the conception of surplus earned by a particular part of a factor of production above and over the maximum earnings necessary to induce it to its work”.

The theory is based on following propositions:

  1. Rent is derived from all factors of production.
  2. The difference between actual earnings and transfer earnings of resources is considered as rent.
  3. Rent is determined by the interaction between demand for factors and supply of factors
  4. Rent is the result of specificity nature of resources i.e. scarcity and relative importance in different productive uses.

Actual earnings are the economic value obtaining from present use (or best use) of resources. But transfer earnings are the amount of money which any particular unit could earn in its next best alternative use. Transfer earning is the opportunity cost of resources. In other words, transfer earning is a minimum payment that induces a factor to remain present use.

Thus, Economic rent = Actual earning – Transfer earning

Suppose, a small piece of land is yielding maize of Rs.250 and its next best use rice makes Rs.150. The transfer earning is Rs.150. Therefore, it is giving a surplus of Rs.100 in its present use.

Now, transfer earnings are defined as the minimum amount, which must be paid.

We can also define transfer earnings as the minimum sum which must be paid for a unit of a factor of production in order to induce it to stay in its present use or employment. In the above example, the amount of at least Rs.150 must be paid for the land in order to retain maize; otherwise, it will shift to rice, which is its next best alternative use where it can make Rs.150. Actually, this small piece of land is earning Rs.250, i.e. Rs.100 in excess or extra of its transfer earnings. This is economic rent. Economic rent in this sense is thus the difference between the present or actual earnings and the transfer earnings.

This concept of rent is applicable not merely to land but also to all factors of production i.e. labor, capital and entrepreneur’s earnings too. They can all earn economic rent in the sense that the modern economists use the term ‘rent’.

Demand factors (or inputs): Demand for inputs is derived demand. Generally, demand for inputs varies inversely with price. Higher the price, lower the demand for inputs and vice versa. Hence, the input slopes downwards to the right.

 

Supply factors

When factor supply is perfectly inelastic: It refers to a situation when the factor owners are willing to supply a fixed quantity whatever the price is. Here, the supply of factor would not change at all in response to change in the price of the factor service.

Supply is perfectly inelastic
Supply is perfectly inelastic
 

In the figure, E is the equilibrium point where DD demand curve intersects SS supply curve which is vertical. Here OS is the quantity of land used. OR is the equilibrium supply price per unit. OSER is the total earnings. Since land is fixed in supply and cannot be transferred to any other use, its transfer earnings are zero. Hence its entire earnings OSER are rent as surplus over transfer earnings.

For the economy as a whole, the land has no alternative use at all. Hence the transfer earnings of land, from the point of view of the economy as a whole, are zero and all the earnings are rent.

When factor supply is perfectly elastic: When the factor supply is perfectly elastic, the whole of the factor’s income turns to transfer payment. A perfectly elastic supply of a factor means that the factor owners are willing to supply any no. of units at a given price, but even a small decrease in price offered would lead all units of the factor to move elsewhere.

Supply is perfectly elastic
Supply is perfectly elastic

In the figure, the supply curve SS of land is a horizontal straight line which is perfectly elastic. DD is the demand curve. The two intersect at E. In this case, OM land is put to use. The rent per unit is OS (=EM) and the total earning is OMES. The transfer earning is also OMES. If this firm does not pay OS rent, the land will be transferred to some other use or firm. Since transfer earnings and actual earnings are equal, there is no surplus or rent.

When factor supply curve is positively sloped: The perfectly elastic supply and perfectly inelastic are the extreme situations. The more usual and realistic situation is that of the positively sloped supply curve. Since economic rent is a surplus of actual earnings over minimum supply price. Generally, a factor of production due to its scarce supply in relation to its demand gets a reward which is more than its transfer earning. For non-specific factor (i.e. elastic but not perfectly elastic), the supply curve is positively sloped or it is elastic. It states that if the factor is not paid the minimum supply price, then it will leave the present use and will enter into its next best paid alternative use. In other words, actual earnings of such a factor are always greater than its transfer earnings, due to its relative importance into different productive uses. In a real sense, only this type of factor yields economic rent.

Supply curve is positively sloped
Supply curve is positively sloped

In the figure, SS supply curve is somewhat elastic. It cuts DD demand curve at E. In this case, OM land is used and the rent per unit is OR (= ME). The total earnings are OMER and the transfer earnings are OMES. If we deduct transfer earnings OMES from the actual earnings OMER, we get RES (shaded area). This is surplus or rent.

 

Reference

Koutosoyianis, A (1979), Modern Microeconomics, London Macmillan

 

 

  • Rent means the payment made by tenants to landlords for the use of a building, or machinery.
  • Modern theory of rent states, “The essence of the conception of rent is the conception of surplus earned by a particular part of a factor of production above and over the maximum earnings necessary to induce it to its work”.
  • Actual earnings is the economic value obtaining from present use (or best use) of resources.
  • Transfer earnings are the amount of money which any particular unit could earn in its next best alternative use.
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Prajwal Thapa

This theory was propounded by Mrs. Joan Robinson not Mr. John Robinson


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