Sunday, May 6, 2007

Playing the Rent I

I’m pretty sure this is going to take more than one essay.

Because of some running commentaries on several economics blogs, especially the much esteemed Economist’s View, I’ve undertaken a review of Ricardo’s Theory of Rent. The problem, as I see it, is that economists these days are very much given to using phrases like “rent seeking behavior,” and other bits of jargon that depend upon a specific economics model, tied to a specific terminology (Ricardo’s) and which use the word “rent” in a different way from the way that it is commonly used.

“Rent” in ordinary parlance is a payment for the temporary use of a material good. You rent a house, a car, a woodchipper if you need one, and so forth. We also have words for payments for the temporary use of non-material goods. Rent on money is called “interest.” Rent on many other non-material goods, like a copyright, or part of the broadcast spectrum is called a “license.” Also, certain kinds of contracted rental arrangements are called “leases,” and those often include non-material goods, as when you “license a patent.”

But in economics jargon, all these things tend to be called “rents,” and a lot more besides. So let’s begin by reviewing Ricardo’s basic theory. In fact, let’s begin a little earlier with Adam Smith.

IN that early and rude state of society which precedes both the accumulation of stock and the appropriation of land, the proportion between the quantities of labor necessary for acquiring different objects seems to be the only circumstance which can afford any rule for exchanging them for one another. If among a nation of hunters, for example, it usually costs twice the labor to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer. It is natural that what is usually the produce of two days' or two hours' labor, should be worth double of what is usually the produce of one day's or one hour's labor. If the one species of labor should be more severe than the other, some allowance will naturally be made for this superior hardship; and the produce of one hour's labor in the one way may frequently exchange for that of two hours' labor in the other...—Adam Smith, The Wealth of Nations

This is sometimes cited as the origin of the “labor theory of value,” but Smith is very clear that this is only true for an “early and rude state.” In a hunter-gatherer society, the “commons” have not been privatized, and the accumulated capital is small, and may be said to be dominated by accumulated wisdom, skills, and lore. Interestingly enough, this makes such societies “knowledge-based,” something that technological societies are now said to in the process of becoming.

But the labor theory of value fails right at the beginning, with Smith’s description. I may well be, for example, that it takes as much labor to catch a mouse as a beaver. Does this mean that a mouse is worth as much as a beaver? No, it means that no one bothers to catch mice.

What Smith does, as with Ricardo later, is conflate a standard of value with the source of value. For hunter gatherers, labor is the primary standard of value; it’s the easiest way to get an indication of the value of things, with the exceptions noted by Smith.

There is, incidentally, a good rant that does the same thing in relating the value of gold to the labor it takes to obtain it, in The Treasure of the Sierra Madre:

A thousand men, say, go searching for gold. After six months, one of 'em is lucky - one out of the thousand. His find represents not only his own labor but that of nine hundred and ninety-nine others to boot. That's uh, six thousand months or five hundred years scrabbling over mountains, going hungry and thirsty. An ounce of gold, mister, is worth what it is because of the human labor that went into the finding and the getting of it. -- B. Traven

One could, of course, have men spend the same amount of time and effort searching for seashells of a particular shape, and at the end of that time, those seashells would purchase just about nothing, perhaps a mouse from a hunter gatherer, but probably not a deer.

The labor theory of value holds that all value derives from labor (though there is an occasional nod to nature and “natural resources). From there, it’s a short step to Marx’s exploitation theory, that any acquisition of wealth by means other than labor is, in some fashion, an exploitation of the working class.

Now I’ll allow for the existence of exploitation; in fact, I’ll stipulate that it occurs. As the man says, “Do I believe in baptism? Hell, I’ve seen it.” Well, I’ll say the same for exploitation. But there are any number of ways that the labor theory of value fails to capture reality, not the least being that it basically winds up saying that a bird in the hand (present value of an asset) is worth the same as two in the bush (future value of an asset). In this case we’re talking about the rent on money (interest), and whether or not it’s really necessary to wait the ten years before the trees bear fruit. Again, I’ve owned trees, and they give when they give and not before.

Ricardo did have an important observation that every economic theory needs to take into account, however. He was interested in the agricultural economy, because he felt that farmland was the most important limited resource. Ricardo noted that, as the demand for food increased, owing to population increases, land of lesser and lesser productivity would be brought into service. The owners of the most productive lands, therefore, could charge greater and greater rents to the farmers who farmed them (with the assistance of farm laborers who were the ultimate source of wealth in Ricardo’s view). And these rents were unearned; they just went to the owners for no other reason than their ownership or the land.

Now let’s skip forward a bit, to the development of the so-called “Perfect Competition Model,” (PCM). The PCM was developed during the last quarter of the 19th and first quarter of the 20th centuries particularly in the hands of Alfred Lord Marshall (1842-1924) at Cambridge University. It was so important in economics that it was also called The Standard Model or alternatively the Marshallian, Neoclassical or sometimes the Commodity Model.

The assumptions in the PCM are unrealistic at the limit, but there are quite a few commodities that approximate those assumptions fairly well. The commodities in question must have many producers, none of which can move the market by its own actions, e.g. reducing its own supply will have a negligible effect on supply. The product from any supplier can be substituted for any other supplier. And there must be no price-fixing or other interference in the pricing mechanism. It also turns out that practically every PCM commodity has inelastic demand; a fractional increase in supply results in a change in price by a greater fractional decline.

For producers, the results from PCM are pretty brutal. It basically says that, under most circumstances, increases in total supply result in less income to the totality of producers. If every producer becomes more productive, everyone makes less money. Alternately, this is a great deal for consumers. The market won’t absorb an infinite amount of the product, so at that limit, it’s price is zero. That limit never gets reached, because there is (almost always) some cost of production, so the producers get squeezed to the marginal cost of the least efficient producer. More efficient producers make a profit.

At some point or another, somebody noticed that the difference between the most efficient and least efficient producer looked like what Ricardo was calling “rents,” so economists began conflating profits with rents.

The problem, however, is that once you broaden the term “rent” to that extent, you get into the strange nomenclature where actual rent is considered to be a subset of “rent.”

I would say that the train leaves the rails right about there.

So I think we need some better terminology. I’ve done a fair amount of reflecting on the nature of the acquisition of material wealth, and I’d like to offer a series of terms for specific sorts of situations, qualitative models, if you will, that may get fleshed out into quantitative things if I ever have the inclination. My primary goal here is to develop a terminology that uses words as close to there ordinary meaning as possible, because while there are times when jargon is useful, it’s only after ordinary language has been exhausted.

Here are some of the terms I’m considering:

Tolls, winnings, jackpots, vigorish, fraud, insurance, house cut, fees, taxes, tax farming, premiums, good will (an old favorite), patents, licenses, and transfer payments.

I told you this was going to take more than one essay.

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