Law of rent
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The Law of rent was formulated by David Ricardo around 1809, and presented in its most developed form in his magnum opus, On the Principles of Political Economy and Taxation. This is the origin of the term Ricardian rent. Ricardo's formulation of the law was the first clear exposition of the source and magnitude of rent, and is among the most important and firmly established principles of economics. John Stuart Mill called it the "Pons Asinorum" of economics.[1] The Law of Rent states that the rent of a land site is equal to the economic advantage obtained by using the site in its most productive use, relative to the advantage obtained by using marginal (i.e., the best rent-free) land for the same purpose, given the same inputs of labor and capital[2]
Ricardian rent should not be confused with contract rent, which is the "actual payments tenants make for use of the properties of others." (Barlow 1986). Rather, the Law of Rent refers to the economic return that land should accrue for its use in production.
Being a political economist, Ricardo was not simply referring to land in terms of soil. He was primarily interested in the economic rent and locational value associated with private appropriation of any natural factor of production. The law of rent applies equally well to urban land and rural land, as it is a fundamental principle of economics.
Ricardo noticed that the bargaining power of laborers can never dip below the produce obtainable on the best available rent-free land, because whenever rent leaves them with less than they could get on that free land, they can simply move to the new location. The produce obtainable on the best available rent-free land is known as the margin of production. Since landlords have a monopoly over a given location, the only limiting factor for rent is the margin of production. Thus, rent is a differential between the productive capacity of the land and the margin of production.
Note that Ricardo's original formulation assumes that the best quality farm land would be the first to be cultivated, and that goods are sold in a competitive, single price market.
This law has a number of important implications, perhaps the most important being its implication for wages. The Law of Rent implies that wages bear no systematic relationship to the productivity of labor, and are instead determined solely by the productive capacity of marginal land,[3] as all production in excess of that amount will be appropriated by landowners in rent.
This is not the notorious iron law of wages, which predated Ricardo and is most commonly associated with the writings of Thomas Malthus. Indeed, Ricardo was an intellectual rival of Malthus on this point. The law of rent explains why the iron law of wages consistently fails to predict actual wages: if there are highly productive land sites available free, wages will tend to be high, all things else being the same; if the only available free land yields little, wages will tend to be lower.
In contrast to Malthus's hypothesis of overpopulation, Ricardo explains mass poverty using deductive logic by noting that when there is no rent-free land, subsistence becomes the effective margin of production. Landlords will not charge more than this amount because it would entail no production at all, and thus no rent.
The law of rent makes it clear that the landowner has no role in setting land rents. He simply appropriates the additional production his more advantageous site makes possible, compared to marginal sites. The law also verifies the claim by Adam Smith that the landowner cannot pass on the burden of any cost such as land value taxes to his tenants, as long as such taxes truly do not bear down upon improvements and affect the relative productivity of his land compared to marginal land. For this to be true the tax must be levied on the rental value of land and not the rental income after it is taken by the landlord, otherwise landlords will be less inclined to rent.[4]
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[edit]Increased production causing increased price: An example
Ricardo's theory results in one counterintuitive result: with scarce resources, like land, an increase in the amount produced can actually cause the price of that good to increase.
To illustrate, consider wheat farmers outside of London (numbers are made up, and are not historically accurate, for clarity). Say there are three types of land outside of London in 1759 that can be used to make wheat:
[edit]Good land near a river
Costs $1 per bushel to produce wheat. Owned and farmed by close friends of the king. Have been used for farming since 1541.
[edit]Ordinary land somewhat close to a river
Costs $1.50 to produce wheat. All this land was taken by 1718
[edit]Bad land close to a polluted river
Costs $3 to produce 1 bushel of wheat. Costs $1 to produce wheat from clean water, and costs $2 to clean the water. None of this land is used.
In 1759 wheat costs $1.50 a bushel, and 70,000 bushels are demanded by the 1m residents of london (assume the market is in competitive equilibrium). In 1760, there are more people, and so 80,000 bushels are demanded by the now 1.1m residents of london. But since we're in competitive equilibrium in 1759, only 70,000 bushels can be produced in 1760 if nothing changes: if a farmer wants to produce more wheat (of which 10,000 bushels are wanted but not able to be supplied), it will cost him $3 a bushel because he will have to use the bad land to make it. Recall that all the good and ordinary land is occupied. (Ricardo made this same assumption of best land used first).
Consider what would happen if the price in 1760 rose to $3. Two effects
- people would eat less since food would cost more
- bad land, which costs $3/bushel to make wheat, would suddenly be feasible
True, bad land wouldn't turn a profit, but it would break even. Remember that the cost of producing a barrel of wheat *includes* the amount of money paid to the various workers and laborers who work on the field. (So they would want to work)
Let's say that at $3 a bushel, the people of london in 1760 want to eat 76,000 bushels of wheat. New farms, operating on bad land, will fulfill the extra 6,000 bushel demand since at $3 they can operate and produce wheat.
So the end result? 6,000 more bushels were produced, and the price doubled. This is because land is a scare resource. Note that in 1760 the farmers on good land, who only spend $1 per bushel to produce it, are now getting $3. The extra $2 good land owners make is called scarcity rent—it's money earned over what it costs to produce something that someone earns merely by virtue of owning a specific piece of land.
Based loosely on [5]
[edit]Notes
- ^ H.D. Macleod The Elements of Economics (1886 D. Appleton) Vol. 2 p. 96
- ^ http://www.econlib.org/library/Ricardo/ricP1a.html#2.3 "On the Principles of Political Economy and Taxation – David Ricardo, Chapter 2"
- ^ Henry George extended the Law of Rent by recognizing that marginal productivity of labor on intramarginal land (the intensive marginal product) would equalize the extensive productivity of labor on marginal land: "the process will not stop until, either by the extension of cultivation to inferior lands or to inferior points on the same land, or by an increase in the relative value of manufactured products ... the yield to labour and capital [has] been brought again to the same level. ... And thus to say that rent will be the excess in productiveness over the yield at the margin or lowest point of cultivation is the same thing as to say that it will be the excess of produce over what the same amount of labour and capital obtains in the least remunerative occupation." See Progress and Poverty, "Rent and the Law of Rent".
- ^ Adam Smith , The Wealth of Nations, Book V, Chapter 2, Article I: Taxes upon the Rent of Houses
- ^ N. Hanley, J. F. Shogren, and B. White, Environmental Economics In Theory and Practice. New York: Oxford University Press (1997).
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