Economic Rent
What is Economic Rent?
Economic rent is the payment to a factor of production above the minimum necessary to keep it in its current use.
Economic rent is the surplus a factor earns over its next best alternative. For example, a worker may earn economic rent if their wage exceeds what they could earn in another job. Economic rent arises due to factors' scarcity or unique characteristics.
Economic Rent: a worked example
A welder at a shipyard is paid 72,000 dollars a year. Her next best offer, from a pipe fitting shop, pays 48,000 dollars, and she would stay at the shipyard for anything above that figure. Transfer earnings, the minimum needed to keep her in this job, are therefore 48,000 dollars, and economic rent is the difference, 72,000 - 48,000 = 24,000 dollars, one third of her pay. Let the pipe shop raise its offer to 66,000 dollars. Transfer earnings climb to 66,000 and her rent shrinks to 6,000 dollars, even though her shipyard wage never moved. Now let the shipyard cut her to 49,000 dollars while the outside offer sits at 48,000. She still stays, since 49,000 clears her transfer earnings, which shows that rent can be stripped away without the factor moving at all.
The mistake students make with economic rent
Students measure economic rent against zero, or against the worker's living costs, and so call the entire 72,000 dollar salary rent. The word invites that reading, since everyday rent is a full payment rather than a surplus. Economic rent is always measured against the next best use of the factor, so transfer earnings have to be found before rent can be. A second slip is treating rent as proof the factor is overpaid. A payment can be almost entirely rent and still be exactly what a competitive market produces when the factor's supply is fixed.
Economic Rent questions
How do you calculate economic rent?
Economic rent equals the payment a factor actually receives minus its transfer earnings, where transfer earnings are the minimum payment needed to keep that factor in its present use. For a worker, subtract the wage available in the next best job from the wage currently paid, then multiply by hours worked. On a factor market diagram the rent is the area between the wage line and the supply curve, while the area below the supply curve measures transfer earnings.
What is the difference between economic rent and transfer earnings?
Transfer earnings are what a factor must be paid to stay where it is, equal to its earnings in the next best use. Economic rent is everything paid above that floor, a pure surplus that could be removed without the factor leaving. Added together the two make up the factor's total income. A performer paid far more than she could earn in any other career collects mostly rent, while a temp worker paid the going rate collects almost none.
Why does inelastic supply increase economic rent?
Inelastic supply increases economic rent because a factor that cannot move to another use has low transfer earnings, so nearly any payment above zero is surplus. Land at a fixed location is the extreme case, since its quantity does not respond to price and, with no alternative use, its whole payment is rent. Where supply is elastic a small pay cut sends the factor elsewhere, so payment stays close to transfer earnings and little rent survives.
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