Economic Rent

Economic-Rent

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Source: Economic Rent (wallstreetmojo.com)

Economic Rent Definition

Economic rent refers to the amount that is paid to the owner of a factor of production in excess of the cost that is to be necessarily incurred on utilizing such factors 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 earned in the normal market scenario.

Explanation

If we procure anything from a producer, we need to pay a consideration for the same to him. In an economic sense, when the amount that is 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 are either having access to some important economic information that others are not having, or they are technologically more advanced than the other producers in the market, which makes them low-cost producers. They are thus able to fetch better prices for their produce.

Formula

Economic Rent = Agreed Price – Free Market Price

The formula suggests that the value of economic rent can be derived by deducting the free market 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 amount that the producer would earn in the normal market.

Example of Economic Rent

A recruitment agency contacts an unskilled worker for the post of a security guard. Although the guard is willing to work for $400 per month, the labor union of which he is a part states that no person can be recruited for less than $450 per month. This 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 that is 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

We have seen in the above example, how the presence of a labor union and the situation of scarcity of labor helped the worker to 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 remuneration, they are offered a salary as per the company’s budget and policies. As a result, the employee earns more than his expectations, and this gives rise to 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, which attracts more audiences than the other property. This is why the landlord of such property situated in the prime location is charging 30% more rent than the rent charged by the landlord or other property. Due to location benefit, one landlord is able to fetch better rent than the other for a similar property. This 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 in excess of what he expected to earn or what he should reasonably earn 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 deduction of all expenses. 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, then 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. The phenomenon of economic rent is very common and may be traced in our day to day lives.

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