Rents vs. Rent-Seeking

If this post sounds confused, it is probably because it is. I'm trying to work through what people mean when they use the word "rent." They seem to slide between rents and rent-seeking, which are connected but different things.

Few words in the discussions of inequality are more of a non-sequitur than "rents." Going back to Ricardo, the word conjures up images of landed aristocracy charging high prices to the poor who work the land. Because rents are sometimes used as on the face of it evidence of a problem, I try to be cautious anytime the word is thrown around.  It's too easy for me to get mixed up. So when I saw a new paper from Dean Baker (HT: Nick Bunker)  on rents, I needed to make sure the terms were clear.

First, what do we mean by rents? Let's take Baker's definition.

“Rent” is used to refer to an income that is generated that exceeds what would be needed to meet the same economic purpose given an alternative set of institutional arrangements. (p. 2)

Right away, I'm confused. Is it helpful to talk about the "same economic purpose" under different institutional arrangements? If we are playing a different game (chess vs. checkers), how does one tell what actions have the same purpose? Making a ten ton steel nail in the Soviet Union is not the same thing as making that under capitalism.

For sake of generosity of reading, let's say we can define the same economic purpose. Now the question is what is the "alternative set of institutional arrangements"? If I make $15,000 teaching undergrads, but would make $0 teaching under an institutional arrangement that permits slavery, is it useful to say my whole teaching salary is rent? I guess we could define rents that way, but I don't think we want to.

I'm guessing that's why I've never seen "rent" defined (as Baker defines it) in any economics textbook or course.

Defining Rents

From what I've learned which is admittedly little, rent is almost the economic equivalent of "profit." It's market value minus cost.

That is, economic rent is the difference between the actual payment received (the hire-price) and the lowest payment the owner would have been willing to accept. (Hirshleifer et al. 2008, p. 402)

Defined as a return in excess of a resource owner's opportunity cost. Tollison (1982)

An economic rent is simply the market value of resource in its highest valued use minus its market value in its second highest use. Thinking in pure dollar terms, it is the price paid minus what it could have been sold for in another market. If people define value and cost properly, economic rents are equivalent to economic profits. Reading Baker's piece with this definition in my mind, I don't see the connections that he makes.

Rents get associated with "excessive" fees and income in the Baker paper. With my definition, it's not clear that rents have anything to do with "excessive" prices.

Excessive can't simply mean greater than zero. In one way, rents are always greater than zero. Trivially, the highest valued use is above the second highest valued use. This can't be what people are worried about when they worry about rents. The fact that 10 > 8 is nothing to get worried about. There must be something else that worries people.

Perhaps, it is not any rents that matter, but only "excessive" rents means an increase in rents. That seems to be Baker's focus. But that can't be it either, since rents are neither necessary, nor sufficient for high incomes, which is the connection that Baker tries to make.

To see how rents are not necessary for high income, consider an extremely skilled person such as LeBron James. To simplify matters, let's assume he only cares about money. (This isn't an important assumption, but helps with the clarity.) According to Google, his salary is $24 million for 2016. Clearly, that's a high income by any standard.

Does that mean he has high rents? Not necessarily. That would be like seeing high revenue and saying a company has high profits. They're conceptually distinct. To see if he has rents, we'd need to know the cost side for him. If he wasn't playing in Cleveland, would his salary be much lower? It's not clear to me that it would be. Therefore, his opportunity cost of playing for Cleveland is high also, whether we are talking about alternatives that include playing for Miami, playing in the NFL, or making commercials. Therefore, any increase we see in his salary does not imply there is an increase in rents.

Do higher rents mean a higher salary? Not necessarily. What if opportunity costs drop dramatically? That would mean a higher rent without any change in income. In fact, you could see a drop in income associated with higher rents. Consider supply and demand drawn below. The rents are the difference between price and marginal cost (the supply curve). If opportunity cost drops, that leads to a shift of the supply curve. Price, which is income in a labor market, drops while rents for each person increase.

So we have neither a necessary, nor sufficient connection between rents and income. That's the reason I'm hesitant anytime someone is trying to make the rents-inequality connection. Maybe it's obvious to others. It's not to me.

However, the empirical work that Baker presents is about income increases. Rents are a trickier thing to deal with.

Rent-Seeking

Do people mean "rent-seeking" when they discuss rents and inequality? Rent-seeking for government protection does involve a logical connection between rents and income, if the right assumptions are made on the cost structure. Tullock taught us this back in the 1960s. (Well I didn't learn it until years later, given that I wasn't born yet in 1967...) People will lobby for government protection to limit quantity in a market, such as the AMA restricting the number of doctors. The reason they engage in this rent-seeking is to drive up their own profits or rents.

I think that's what Baker is getting at. At least, that seems his focus in the sections on patents and on professionals.

In the last three decades as a matter of policy, these monopolies have gotten considerably stronger and longer. (p. 5)

The most highly educated professionals, most notably doctors, enjoy far higher pay than their counterparts in other wealthy countries. This is due to the fact that they have been largely able to protect themselves from both domestic and international competition. (p. 16)

If that's the argument Baker is pushing, he needs to provide empirical evidence on the rent-seeking behavior, not the income. He hints at rent-seeking and gives some estimates of savings from ending patents, however these estimates don't seem to be based on calculations of rent-seeking. But again, I'm not sure what people are usually talking about since they use odd definitions or slide between different terms.

I'm not sure of much though...

 

4 thoughts on “Rents vs. Rent-Seeking

  1. Pingback: Profits under Competition | Econ Point of View

  2. I think you make some important points on the Baker piece. However, I don't think I am on board with your description of economic profit and rents. First, even though economic profits and rents have very similar definitions, I think they are different concepts and it is better not to equate the two. Second, on a related point, I don't you can just assume that the area behind the long-run supply curve is producer surplus enjoyed by the firm. I'll try to illustrate both points with an example.

    Say we have a competitive industry (P=MC) with barriers to entry. Specifically, let's say we're looking at the taxi cab market in New York City and the barrier to entry is that you must own one of ~13,000 taxi medallions to operate a cab in NYC. Since it is illegal to operate a taxi without a medallion, surely these taxi companies are being protected from competition earning significant economic profits (P>>> AC), right? I would not expect so. That's because there are really two ways to enter the market. The straight forward way is to start your own taxi service, but that strategy is illegal. The second way to enter the taxi business is to buy someone else's company and specifically the medallion that they already owned.

    So what I would expect to happen is for large economic profits to attract entrepreneurs to enter the tax business by buying existing companies (their cars, medallions, etc). This would drive up the price of medallions because their supply is perfectly inelastic even in the long-run (unlike say cars). In fact, I would expect the price to bid up until entrepreneurs were indifferent between entering the taxi business and not entering some other business. In other words, I would expect economic profits to fall to zero and for all the gains of creating barriers to entry to accrue to medallion holders (who are very often investment banks and not taxi firms). And I think that is one of the big differences between economic profits and pure rents. Proftis can be competed away, but rents cannot.

    I think this is also related to my second point about the supply-and-demand graph. You say that the area behind the supply curve is producer surplus enjoyed by firms. I think you are imagining a scenario where you have firms with decreasing returns to scale technologies and that supply curve is just the sum of the marginal cost curve for each firm. But the industry supply curve will only be equal to the sum of marginal cost curves if the price of all factors is exogenous. But in a case like the medallion example, that may not be the case. So i would expect that area behind the supply curve is actually equal to the the payments going to the owners of fixed factors in the form of rents.

  3. Looking back at my previous comment, I can tell I wrote it in a hurry. It could definitely be clearer. To make up for my own short-comings, here are two specific readings I would recommend.

    First, I would recommend checking out Varian's Intermediate Textbook for the best discussion I've seen on the difference between economic profits and rents. I am sure that my description is just a bad imitation of Varian's. Specifically, see Chapter 23 on Industry Supply.

    Second, you will find a more formal description of why the industry supply curve is not necessarily the sum of firm marginal cost curves in Stigler's Theory of Price, Chapter 10 (under the section on External Diseconomies). I think this is an important point because it means you can't simply attribute the area behind the industry supply curve to producer surplus. This is also indirectly discussed in Becker's textbook in Lecture 18 on external effects.

    • Dallas,

      Thanks for your comments and sorry for the delay in responding. I'll make sure to check out those references. Which edition of Stigler are you referencing? It's not that section in my version.

      There is a lot going on in this conversation and I've forgotten all the points we have touched on.

      Let me be more clear with the definitions I'm working with (or at least trying to work with). Profits go to firms. If total revenue is above total opportunity cost of all the resources it uses, then the firm earns a profit. Rents go to resource owners. In the taxi cab example, whoever owns the medallion might receive a rent. In my simple, S&D example I don't distinguish the two. I believe that is okay, if the firm owns the resources it uses. That's how I am trying to use the terms. I'm sorry if I am not consistent.

      Now, I'll try to work through your taxi cab example. First, indulge me and let's assume for simplicity that the taxi cab companies can't "rent" the medallions, but must own them. Suppose the taxi cab market it competitive, as you say. You claim that the free entry will drive up the opportunity cost of running a taxi company, so that economic profits are zero. That's absolutely true for the marginal entrant. It need not be true for the average entrant. The average entrant might have lower opportunity costs, meaning that there are profits in taxicab market.

      Now suppose the taxi companies don't necessarily own the medallions. Then part of the surplus will go to the medallion owner, but the analysis above still holds. Since there is not free entry in the medallion market, it might not be that competitors will bid up the opportunity cost of the medallion so that the marginal medallion owner earns zero rents. Rents might remain for the scare resource "medallions." However, given the price of a medallion, it is just another input and the above paragraph holds. The marginal taxi won't earn profit, but the other's might. If there is no resource that the firm owns that separates it from the marginal taxi, the surplus will all go to resource owner rent and none to profits.

      Finally, I agree completely with your final paragraph in the first comment.

      I don't know if that clarifies what I'm trying to say or not.

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