The determination of rent

Transfer Earning and Economic rent

Transfer earning of a factor is the minimum amount that the factor must earn in order to prevent it from transferring to another use. Thus transfer earning is the minimum amount that must be paid to a unit of any factor to hold it in its present use or to keep it in existence.

Economic rent is any excess over transfer earning that a factor actually earns, i.e. that part of the return to the factor which is over and above the minimum amount requited to induce it into its present employment.

Anticipated (expected) returns to resource = Transfer earnings + Economic rent

Cost is the highest-valued option forgone, it is the maximum amount that a factor can earn among its alternative uses. In order to keep the factor in its present use, a minimum amount which is equal to what the factor can earn in its best alternative use must be paid. Hence, transfer earning of a factor is equal to its opportunity cost.

Example, suppose Peter owns a factor which have three options to use, by option A can be earn $2000, by option B can be earn $4000, by option C can be earn $6000. Obviously, we can predict Peter will choose the option C as it is the high value option, $4000 is the transfer earning that necessary to keep it in its present way of using. Thus, $2000 is the economic rent earned by choosing option C.

Composition of Transfer Earning and Economics Rent

The intersection of the factor demand curve and the factor supply curve determines the market-clearing price of the factor. If a factor has an upward-sloping supply curve, given the market-clearing price, all units of the factor except the last one would be prepared to remain in the industry for a factor price below the market-clearing level. In this case, the transfer earnings are shown by the area below the factor supply curve. Economic rent is shown by the area above the supply curve and below the factor market clearing price.

In most cases, the actual earning of a factor of production will be  composite of transfer earning and economic rent. However, it is possible to have cases in which all earnings are either one or the other.

1. All earnings are transfer earnings

If an individual firm or an industry is faced with a perfectly elastic supply of a factor of production (in a price-taking factor market), it will be able to obtain all units of the factor it wants at the going factor price (P). The whole income earned by the factor represents transfer earning. (infinite number of use of a factor; total income=transfer earning; no economic rent)

2. All earnings are economic rent

If a factor of production is fixed in supply and has only one use, it will be in perfectly inelastic supply. The amount offered for sale will be the same whatever the price of the factor. The whole of the factor income (P*Qf) is economic rent. This is because even if a zero price is paid, the factor will not transfer to an alternative use, since it has no alternative. (total income = economic rent; no transfer earning)

Hence, whether a factor payment constitutes economic rent or not depends on the elasticity of its supply on its alternative uses. The more elastic the supply of a factor, the smaller the proportion of its earnings ascribed to economic rent and the larger the transfer earnings. (more alternative use of a factor, more elastic of its supply)

Some Remarks about Rent

1. It is important to avoid confusing rent which refers to factor payment in excess of transfer earning and rent which refers to the payment made by a tenant to a landlord for the hiring of land and/or a building.

2. Rent may be earned by any factor. Rent may be earned by human or man-made resources, such as labour or capital goods.

*3. High rent is a result, not a cause, because demand for land is a derived demand. The higher the price of the product produced by the use of the land, the greater will be the demand for land. Hence, price is not high because a rent is paid, but a rent is paid because price is high.

4. Rent is part of the cost. Given the market demand for a factor and its market supply, the cost of the use of the factor is equal to its market price. If a firm in the industry is not willing to pay the market price of the factor, it will be outbid (X) by other firms in the industry. Since the factor price may include rent and transfer earning equals factor price, rent is part of the cost in using the factor. On the other hand, cost is the highest-valued option forgone. For an operator of a firm, the highest-valued option includes an outright transfer of ownership or an outright sale of the business. For the operator to stay in business, he or she has forgone the rent which can be captured from such an outright sale; therefore rent is part of cost.

5. Rent has the function of allocating the factor to the highest-valued competing uses. It reveals which uses are the highest valued and directs the factor to those uses.

6. Rent denotes stickiness in supply. Rent is the cost which, when changed in some dimension, will not affect supply. If refers to inelasticity of supply to some extent. For example, if you cut the wage of a school teacher, he or she may stay in the profession of teaching if the wage is still above what could be earned in an alternative employment.