What Does Economic Rent Mean?

People know about renting an extension ladder, a car or even a house. That’s not the same idea  as economic rent.

“Economic rent is any payment (in the context of a market transaction) to an owner or factor of production in excess of the costs needed to bring that factor into production.” – Wikipedia.

You may hear economists g about rent seekers. Usually with a  least mild disdain. The level of disdain depending on where they fit on the capitalism to socialism scale. In simplest possible terms “Economic Rent” is profit. What they got paid in excess of what it cost to produce.

Economic rent is good to a point

People everywhere like a profit. If they can reduce costs they can usually outcompete others by lowering the price of the product or service. Total profit is a function of how much you make on one unit times how many you can sell. Suppose, it cost $7 to make a widget and you sell for $10. Suppose further you can reduce your cost to $6.00, maybe by buying a new machine. You could now sell for $9.00 and be as profitable. If your competitors are still at a cost of $7.00 they must lose a dollar per unit or surrender market share to you. The total cost of all product bought by the public falls, yet the total rent of the least competitive business falls, so the public is better off. The most efficient competitor is unharmed and presumably will continue to innovate.

If we go back 160 years we see how it works. When Rockefeller  started in the oil industry, kerosene price exceeded $20. As oil became more available it dropped to about $0.10 and as suppliers failed it recovered to $10. As Rockefeller became dominant in the downstream production of petroleum products, over the next 10 years it fell to about a dollar and stayed there until the 1950s. Despite Standard Oil’s 90% market share of refining and distribution in the late 1800s, the price fell and volume created enormous profits. Monopolies can be efficient when they spread their fixed costs around many more units.

Economic rent can be a problem

Monopolies can be a problem when they use their might to extract extra profit. “Rent.” You will often hear economists talk about “rent seeking” behaviour.

Suppose Standard Oil could produce kerosene for 50 cents and sell for a dollar. With their huge market share they could have charged $2.00 without losing much share. Why did they not? There are many reasons possible. From altruism, (unlikely,) to foresight. Higher prices make it easier for competitors to move in and who knows but one of them might be smart enough to take large shares of the market. Remember how Microsoft came to dominate the word processor market even though WordPerfect had more market share than all the others combined. You cannot enjoy both high rent and no competition.

At least not by economic means.

Where excess rent exists today, and it does, you will find political connections and money hungry politicians. The ways are many and some subtle.

Acquisition of potential competitors is easy enough. Any time you can solve a problem with a cheque, it is just and expense. The antitrust laws don’t seem to apply if the target is small compared to the acquirer, and the other entrants in the space. Another favourite is lobbying for regulation with high fixed costs. If you are large the price effect per unit is tiny. If you are not large  it could be enough to put you out of business. Union rules and permissions affect some more than others. Minimum wage laws affect some states more than others.

Most lobbyists are paid to find ways for businesses to gain advantage without imperilling their profit margins. A little advantage here, and a little disadvantage for the competitors there. It all adds up.

Politically advantage is a real thing and it works. Has any economist calculated the “rent” accruing to politicians, their parties, and the bureaucracy? Not that I’ve seen but it is most certainly there.

High operational leverage.

If it is very expensive to get into a business, but the cost per item or transaction after entry are very low, you have an operationally leveraged business. It is easy to view  rent in more than one way in these businesses.  Take the semiconductor chip manufacturing business. The first chip produced that works will cost at least $15 billion and perhaps more. The second and every one following less. Maybe a few dollars each. What is the fair price in terms of rent? It depends. How many are you going to make? If there will be a million, you will need $15,000 each. For a hundred million, $150. Pricing is  bit of an art-form in this environment.

The rent problem arises when the fab plant has recovered all their costs of making the first one. Should the price fall to $9.95. What if they keep the price at $300 or whatever, even though they cost $2 each to make. Drugs follow the same pattern until the patent runs out. A thorny problem. What should happen?

The customers fight back

Yogi Berra had a thought. “You can observe quite a bit just by watching.”

To wit #1 – Amazon has notified Visa they will refuse to accept their UK cards beginning in January 2022. There argument is the merchant’s card costs are out of control. Most retailers would agree. Visa is a highly operationally leveraged business. There communication and computer system is massively expensive and their fees are not insignificant either. It could be they have over recovered their startup costs and are enjoying excessive rent. Amazon’s merchant charges in the course of a year must be enormous. They would like to use their market influence to lesson that charge and they likely will.

To wit #2 – Berkshire Hathaway, The Buffett company sold a small part of their position in Visa and Mastercard during the third quarter of 2021. Buffett is known for refusing to participate in businesses about to face trouble with their profit margins.

Should you notice when the players customer – intermediary – supplier – government begin to interact to minimize the rent.

The takeaway

Excess profits or excessive economic rent is possible but where do you draw the line.

Some businesses have been enjoying the opportunity and may have problems continuing as competition rises and customers push back on price.

If a business start getting too much press on its pricing and profits, expect changes in their pricing policy. Think Pharma and payment processors like Visa for now. There are others too, but those will do for thinking purposes.

There are far more customers than rent seeking businesses. If government catch on to voters versus campaign contributors are competing with each other it won’t take politicians long to work out the calculus that favours themselves.

I build strategy and fact-based estate and income plans. The plans identify alternate ways and alternate timing to achieve both spending and estate distribution goals. In the past I have been a planner with a large insurance, employee benefits, and investment agency, a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business. I have appeared on more than 100 television shows on financial planning, have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, and Banks – from CIBC to the Business Development Bank.

Be in touch at 705-927-4770 or by email to don@moneyfyi.com

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