Economic Rent

Updated on January 25, 2024
Article byNiti Gupta
Reviewed byDheeraj Vaidya, CFA, FRM

Economic Rent Definition

Economic rent refers to the amount paid to the owner of a factor of production over the cost that is to be necessarily incurred on utilizing such elements in the production process. These factors of production could include land, labor, capital, etc. It represents the amount earned by the owner over and above his expectations or what he would have made in the normal market scenario.

Economic-Rent

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Key Takeaways

  • Economic rent refers to the payment made to the owner of factors of production above the necessary cost of using those elements in the production process.
  • Factors of production include land, labor, capital, etc., and economic rent represents the surplus earned by the owner over their expectations or what they would earn in a regular market scenario.
  • Economic rent is a surplus amount that exceeds the factor market price.
  • Economic rent can arise due to scarcity of resources or a producer group having a competitive edge over others because of advanced technology or other factors.

Explanation

If we procure anything from a producer, we need to consider him. In an economic sense, when the amount paid for the procurement is more than what the producer was reasonably expected to receive, it amounts to economic rent. They can arise when a certain set of producers in the market have access to some important financial informationFinancial InformationFinancial Information refers to the summarized data of monetary transactions that is helpful to investors in understanding company’s profitability, their assets, and growth prospects. Financial Data about individuals like past Months Bank Statement, Tax return receipts helps banks to understand customer’s credit quality, repayment capacity etc.read more that others are not having, or they are technologically more advanced than the other producers in the market, making them low-cost producers. They are thus able to fetch better prices for their produce.

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Formula

Economic Rent = Agreed Price – Free Market Price

The formula suggests that one can derive the value of economic rent by deducting the free marketFree MarketA free market refers to an economic system free from government interventions and controlled by privately owned businesses.read more price from the agreed price of the factor of production. The agreed price is the price that is decided upon between the buyer and the producer. Further, the free-market price is the producer’s amount in the normal market.

Example of Economic Rent

A recruitment agency contacts an unskilled worker for a security guard post. Although the guard is willing to work for $400 per month, the labor union of which he is a part states that one can recruit no person for less than $450 per month. That is because there is a shortage of workers in that area, and the labor union wants to use the situation in favor of the workers.

Solution:

  • Agreed Price = $450
  • Free Market Price = $400

Economic Rent = Agreed Price – Free Market Price

= $450 – $400 =$50

The amount of $50 represents the excess income earned by the worker, known as unearned incomeUnearned IncomeUnearned income refers to any additional earnings made from the sources other than employment, such as returns on investments, dividends on bonds and equities, interest on savings, etc.read more.

Economic Rent and Salaries

In the above example, we have seen how the presence of a labor union and the scarcity of labor helped the worker gain income over and above what he was expecting. Similarly, they can arise in the case of salaries too. For example, it sometimes happens that when candidates are interviewed about their expected salary in their interview, they quote an amount that is less than the budget of the organization. In such scenarios, although the candidates are willing to work at a lesser remunerationRemunerationRemuneration refers to overall monetary and non-monetary compensation that employees or independent contractors receive for providing services to an organization or company.read more, they are offered a salary as per the company’s budget and policies. As a result, the employee earns more than his expectations, increasing economic rent.

Economic Rent and Facilities

Let us understand how this concept applies to facilities such as letting out a property. Suppose an organization is willing to rent a property. It comes across two properties in different locations. Both the properties are similar to each other and have the same features. However, one property is located in a prime location, attracting more audiences than the other. That is why the landlord of such a property situated in a prime location is charging 30% more rent than the rent charged by the landlord or other property. Due to location benefits, one landlord can fetch better rent than the other for a similar property. Here is also an example of economic rent.

Economic Rent vs. Profit

Economic rent refers to the income earned by the owner of a factor of production more than what he expected to achieve or what he should reasonably make as per the market forces. It represents a surplus over and above the market price of the factor.

On the contrary, profit refers to the surplus that a business earns from the revenue after deducting all expenses. Therefore, if we want to calculate economic profitCalculate Economic ProfitEconomic profit refers to the income acquired after deducting the opportunity and explicit costs from the business revenue (i.e., total income minus overall expenses). It is an internal analysis metric used by the organizations along with the accounting profits.read more, we must also include the opportunity costOpportunity CostThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It's essentially the cost of the next best alternative that has been forgiven.read more as a part of the cost.

Conclusion

They can arise due to various reasons such as scarcity of resources or a group of producers having a competitive edge over the others due to their advanced technology level or other reasons. However, economic rent is very common and may be traced in our day-to-day lives.

Frequently Asked Questions (FAQs)

What is pure economic rent? 

Pure economic rent refers to the surplus payment made to the owner of a factor of production over and above the minimum payment required to keep that factor in its current use. In other words, it is the excess payment that an owner receives for a factor of production due to its scarcity and high demand.

What are the types of economic rent?

The types of economic rent include differential rent, monopoly rent, and quasi-rent. Differential rent arises due to the differences in productivity of factors of production, while monopoly rent arises due to the monopoly power held by a producer. Finally, quasi-rent is a temporary form of rent that arises due to a sudden change in demand or supply conditions.

What is the difference between economic rent and contract rent?

Economic rent and contract rent differ in their nature and determination. Economic rent is a surplus payment made to the owner of a factor of production due to its scarcity, while contract rent is a payment made by a tenant to a landlord for the use of a property as per the terms of a contract. 

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