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Ricardos Theory Of Land Rent Model Ricardos Theory Of Land Rent, Land Rent Theory In the process of analyzing

the issues raised by the Corn Law controversy, Ricardo, Malthus, West, and Torrens formulated the principle of diminishing returns, which has become an important economic concept. Actually, the principle of diminishing returns appears to have been first discovered by the French economist Turgot in 1765; and although a Scottish economist, Anderson, had envisaged the concept for the extensive margin by 1777, it was rediscovered in 1815. Diminishing Returns The principle of diminishing returns states that if one factor of production is steadily increased while the others are held constant, the rate at which the total product increases will eventually diminish. As we have seen, Ricardo assumed that the coefficients of production for labor and capital were fixed by technological considerations; so his examples assume a fixed quantity of land to which doses of capital and labor are added. In these examples he assumed that diminishing returns begin immediately, so that the marginal product of the second dose of capital and labor is less than that of the first. Rent Viewed from the Product Side Ricardo was primarily interested in explaining the changing amounts of total output received by the landlord and the capitalist in the long run; so it is crucial to his theory to make a clear distinction between rent and profits. Obviously, this distinction is easier to make in theory than in practice. Ricardo recognized that terms used in everyday language are not precise. A farmer pays a landlord a sum for the use of land that in commerce is called a rent, but the payment most likely contains elements of both profits and rents. If land has been improved by fencing, draining, or adding buildings, the so-called rent payment will represent, in part, a return to the landlord for these improvements. Ricardo maintained that rents exist because of (1) the scarcity of fertile land and (2) the law of diminishing returns: If, then, good land existed in quantity much more abundant than the production of food for an increasing population required, or if capital could be indefinitely employed without a diminished return on the old land, there could be no rise of rent; for rent invariably proceeds from the employment of an additional quantity of labour with a proportionally less return. Rent Viewed from the Cost Side It is instructive to consider rent from the point of view of costs of production rather than of product or output. In our example, the marginal returns on grade A land diminished as successive doses of labor and capital were applied. Another way of expressing this result is to say that the marginal costs of producing grain increase as the land is more intensively farmed. Marginal cost is defined as the increase

in total cost required to produce an incremental amount of final product. Suppose that a dose of capital and labor sells in the market for $100. The marginal cost of producing the one-hundredth bushel of grain on grade A land is then equal to $1.00 (the change in total cost of $100 divided by the change in total product of 100 bushels). As the intensive margin on grade A land is pushed down, the marginal cost of producing grain increases, so that the marginal cost of the one-hundred-ninetieth bushel is $1.11 (100/90) and the marginal cost of the last bushel is $1.25 (100/80). The marginal cost of the last bushel of grain produced on grade B and C land is also equal to $1.25. Brief reflection will show that this must be the case if perfectly competitive markets exist. As more grain is produced on grade A land, marginal costs increase and grade B land (where the marginal cost is lower) will be used. If marginal costs differed for the last units of output on the three grades of land, it would be economically feasible to reduce the total costs of production by shifting labor and capital. In long-run equilibrium, when marginal physical products are equal on the three grades of land, marginal costs at the margin must by definition be equal. From the cost side, rent can be measured not in bushels of wheat but in money. To compute rent in dollars, we need to find the total revenue from selling grain and the labor and capital costs of producing grain on each grade of land. For grade A land, the total revenue is $337.50, which is computed by multiplying the output of 270 bushels times the price of grain of $ 1.25 per bushel. How did we know the price was $1.25? In competitive markets there can be only one price. If farmer Jones sells grain at a lower price than farmer Smith, Smith will not sell any grain until he lowers his price. Competition between sellers will result in one price in the market, the price that equals the marginal cost of the most inefficiently produced grain. In competitive markets the supply curves of individual firms are their marginal cost curves, and the industry supply curve is the sum of the individual firms' supply curves. We have already concluded that the marginal cost of producing the last unit of grain on each grade of land is $1.25 per bushel, so this is the market price. Ricardo's statement of the principle that price depends upon the marginal cost of the last unit produced by the least efficient producer is as follows: The exchangeable value of all commodities, whether they be manufactured, or the produce of the mines, or the produce of land, is always regulated, not by the less quantity of labour that will suffice for their production under circumstances highly favorable, and exclusively enjoyed by those who have peculiar facilities of production; but by the greater quantity of labour necessarily bestowed on their production by those who have no such facilities; by those who continue to produce them under the most unfavorable circumstances; meaningby the most unfavorable circumstancethe most unfavorable under which the quantity of produce required, renders it necessary to carry on the production. Total revenue on grade A land, then, is price times the quantity of output, or $337.50 ($1.25 x 270 bushels). Total cost of labor and capital is $300, because three doses of labor and capital were used at a cost of $100 per dose, and rent is the difference between total revenue and total cost, or $37.50. Rent on grade B land is $12.50, because total revenue is $212.50 ($1.25 x 170 bushels) and labor and capital costs are $200. Rent on C grade land is zero, because the total revenue of $100 ($1.25 x 80 bushels) is just equal to the cost of one dose of labor and capital.

It was stated earlier that rent was the payment to the landlord that equalized the rate of profit on differing grades of land. Our computation of rent in dollars clarifies this point. Suppose that the $100 cost of a dose of capital and labor in our example includes $75 of labor cost. If grades A and B land do not receive rent, the rate of profit on the three grades of land will differ. For example, let us compute the dollar return per unit of capital on grade A land, assuming it receives no rent. Total revenue is $337.50, labor costs are $225 ($75 x 3 units of labor), and the residual left for profits is $112.50, or $37.50 per unit of capital. The dollar returns per unit of capital on grades B and C, computed in a similar manner, equal $31.25 and $25. In competitive markets, this would cause the farmers on grade C land to bid up the price (rent) of grades A and B land. When grade A yielded a rent to the landlord of $37.50 and grade B a rent of $12.50, the advantage of farming grades A and B as against grade C would disappear and the rate of profit per unit of capital would be $25 on all three grades of land. This simple agricultural model reveals several important points about the concept of rent and the workings of competitive markets: (1) competition among farmers in the market will force the price of grain to the marginal cost of the highest-cost unit of output; (2) competition for land will result in rents being paid to the landlords owning the most fertile land; and (3) competition will result in a uniform rate of profit on all grades of land. These same competitive forces play a part in determining prices, rents, and profits even in today's complex economy. Rent is thus price-determined, not price-determining, in Ricardo's scheme. The high price of corn was not determined by high rents; high rents were determined by the high price of corn. Import restrictions imposed by the Corn Laws could be seen to result in the intensive and extensive margins being pushed down because of the scarcity of fertile land and the principle of diminishing returns. The marginal physical products of added doses of labor and capital would decrease, which is equivalent to saying that marginal costs would increase and, consequently, both grain prices and rents would rise. A More General View of the Concept of Rent In his discussion of land rents, Ricardo was dealing with a very powerful tool of economic analysis. He limited his application of the notion of rent to agriculture because he thought that the amount of available land was fixed, with a perfectly inelastic (or vertical) supply curve, and that agriculture was the only sector of the economy to which the principle of diminishing returns pertained. But the concepts of diminishing returns and rent actually have a much broader application: they are the foundations of the marginal productivity theory, which explains the supply side of the forces determining the prices of all factors of production. It was not until the end of the nineteenth century, however, that economists were able to see that Ricardo's concept of land rent was a special case of a general analytical-theoretical principle. A discussion of these issues in detail will have to be postponed until we take up the economics of Alfred Marshall; but we shall now examine a more general concept of rent.

Today most economists would agree with Ricardo that to society as a whole, land rent is not a cost of production and therefore is not price-determining. The quantity of land is approximately fixed; thus, increases in demand will result in higher prices (rents) with no increase in quantity supplied. To Ricardo, who considered rent from the point of view of society as a whole, the opportunity cost of land was zero. From the point of view of any individual member of society, however, land rent is a cost of production and therefore is price-determining. A person who wants to use land in a production process or to use its site value must make a payment to secure and retain the services of that land in the face of competition with other possible users. To a farmer rent is price-determining, for he or she must pay rent to the landlord. The amount of rent will be equal to the opportunity cost of the landthat is, to the amount of rent that land could earn in alternative usesif it were planted with a different crop, for example, or subdivided. In short, economists today distinguish between the viewpoints of society as a whole and those of individual members of the society in deciding if a rental payment is price-determined or pricedetermining.