Land and Economic Rent

Land is a major factor of production.  As with the other inputs, the basic framework for describing the price of land is the supply-demand model.   Demand is similar to what we see in the other markets - as the price rises there will be less demand for land.   On a graph this negative relationship between price and quantity would show up as a negatively sloped curve.  

What is unusual / unique about land is its supply, which can be thought of as independent of price.  This would be a situation where there is a perfectly inelastic supply and we would graph the supply curve as a vertical line.   If we combine this supply curve and demand curve we find the equilibrium rent is R*.  Furthermore, if there is an outward shift in demand, then rent rises to R** with no change in the volume of land sold.  In this situation any change in the price of land is determined solely by a change in the demand for land.

Market for Land

Now that you understand the basics, let's look at how we can relate this to the rent you might pay for a retail store front to sell those Terrible T shirts. You have decided on a Main Street location and have to choose between a first floor location and a second floor walk-up.  Despite your inexperience at sales, you know the two units are not the same even though the square footage and location are the same. They are not the same because more people will visit the first floor store than will visit the second floor store, and even fewer will visit the third floor.

Now let's assume you had some market research done and found out the monthly profits (revenues-expenses) you could expect would be $0 for the third floor, $500 for the second floor and $2,000 for the first floor.  Knowing this information, what is the maximum you would pay as rent for the two stores.

For the first floor, you would pay up to $2,000 since anything less than that for rent would give you a profit.  If the rent were $1,000, you would clear $1,000 in profit.  The maximum you would pay for the second floor would be $500 and you would be willing to pay nothing for the third floor.  If you paid any rent on the third floor unit, then you would lose money since profit without rent was zero. 

What would end up being the rent on the units?  If there were perfect information, your landlord would know this situation and probably charge $2,000, $500, and $0 for the rents.  One of the things that emerges from this example is a concept of rent.  Rent can be viewed as the difference between the value created in any unit of land and the value created in the marginal unit where profit equaled zero.

As a test of your understanding of the concept, what would be the likely impact of an increase in demand for the retail space - the result of your area being recognized as an 'in' place. You could expect the following:

• greater foot traffic would translate into higher sales volumes which would show up as larger profits. In this case we might find profits would be $3,000, $1,000, and $200 for the three floors. This would translate into higher rents. It also might make the conversion of the back shed of the third floor profitable for a retail store.
• the higher rent will result in the substitution of other factors for the more expensive land. In our earlier discussion of the choice of inputs we saw how firms would tend to substitute the cheaper for the more expensive inputs. In this case the owner of the land could build more floors and add an elevator to reach the upper floors. This would increase the use of capital in the production process and would result in higher sales / profits for the parcel of land. This is why we tend to have skyscrapers in the center of large cities where land is extremely expensive.

This analysis of rent also allows us to gain some insight into the changing uses of land in many cities.  Under most situations you could expect there will be competitive uses for land - it could be a park, a farm, a factory, an office, or some residential homes  - and the land will end up going to the highest bidder.  But who is the highest bidder and what happens to the bids over time? 

If you return to our simple example, the most someone would be willing to pay for the land is equal to the profit generated from the land.  Let's think of two potential uses - growing corn or a retail mall.   In the beginning, the land was sparsely settled and the 10 acres of land is used for corn with each acre producing 1000 bushels of corn that sell for $3 a bushel.  There really was no interest in using the land for a mall since there would not be enough customers to generate enough revenue to cover the costs. The maximum rent that could be charged for the land was $3,000.  Anything above that, the farmer would be earning a loss.

What would happen if there was a new highway built through the farmland that brought with it new housing developments.  Now there would be enough potential customers to consider opening a mall.  Let's assume that in the same ten acres, a mall with 20 stores could be opened with 10,000 square feet of retail space where each foot of space could generate $100 of profit a year.  The total revenue that could be produced by the land would now be $1,000,000. 

You should be able to see what happened in the past few decades. Enormous sums of money were made by individuals who saw this coming and went to the farmers and made them a deal.   They would pay the farmers more than $4,000 for the land and the farmers considered this a good deal since it was $1,000 more than they made farming. [Ignore the future profits at this time.  They are real, but they do not change the essence of the issue].  Once the new owners had the land, they could turn it into a mall and charge $900,000 in rent because this would still allow a profit to be made on the land.   

A second feature of many large cities, at least those cities on the east coast, has been the conversion of downtown waterfronts from wharves, warehouses, and factories to retail shopping districts and condominiums. Three of the best examples are Fanuell Hall in Boston, South Street Seaport in New York City, and Baltimore's development on the inner harbor. But how do you explain this change, and why did it take place when it did?  This is not the time for a complete answer, but we certainly know the general framework for looking at the issue. The change has taken place because the land was more valuable as retail space than as wharves and warehouses.  You can see this in Downtown NYC in 1999 as empty office buildings are being converted to high end condos. 

But why now?  The significant changes in transportation technology increased the importance of trucks and decreased the importance of ocean transport and railroads.  This reduced the revenues that can be generated from the ocean transportation which will reduce the rents that they can pay for prime waterfront property.  Similarly, the growth in office workers downtown has increased the number of potential shoppers which increases the retail revenues that would come from any shopping district.  Furthermore, if you placed the development near the water, then you might be able to make it a tourist / shopping destination which would further increase the potential retail sales.  The result was that the profits earned from the land when used as warehouses and wharves became lower than the profits generated from retail shops, and the conversion of the space followed.

Just when you thought you were done. Before we move on to our next factor of production, a few additional comments on the concept of economic rent are in order. First, you will find the term economic rent is more broadly defined than the price of land. Economic rent can be broadly defined as "any payment made to a factor above the amount necessary to induce any of that factor to be supplied to its present employment."  If you have ever watched Michael Jordan play basketball you can understand he received far more than other players for a reason - and far more than the minimum necessary to induce him to play.

Second, you will likely find instances of rent-seeking behavior. Consider the situation on Main St. where Terrible Ts is making a HUGE profit and this is not lost on Terrific Ts who is looking for a spot for a new store. They are considering a location across the street from Terrible Ts, but first they must get zoning approval. Terrible T's owner is convinced that the zoning application could be defeated, but it would cost $20,000 in legal fees. Should they fight the application?

The first question would be: why would Terrible Ts fight it? Because it would reduce their profits. If they thought their 'monopoly' position was worth $30,000 in extra profits, you could expect they might pay up to $30,000 to keep the competitor out. This is called rent-seeking behavior - Terrible Ts is spending money in an effort to maintain its monopoly profit - what we might call the rent associated with the monopoly rights.