Sunday, December 19, 2010

Land, Rent and Wages

"Thanks to the meritocratic ideal, multitudes were granted the opportunity to fulfill themselves. Gifted and intelligent individuals, who for centuries had been held down within an immobile, caste-like hierarchy, were now free to express their talents in a more or less level playing field. No longer were background, gender, race or age impassable obstacle to advancement. An element of justice had finally entered into the distribution of rewards." Alain de Botton. ("Status Anxiety", page 86).

The quote above, from De Botton's 2004 best-selling book, concisely expresses the basic promise of the economic, political, social, philosophical and ideological transformation in Western societies since the Industrial Revolution.

Justified or not, this belief that people get what they deserve sustained capitalism some 300 years ago, when it displaced older forms of production and social organization.

It still does to this day, being all the more cherished the more it seems distant.

This ideal is behind such common contemporary expressions and sayings as "there is no such a thing as a free-lunch", "the fair go for all", etc. When someone infringes this ideal, one says this person is a "free-rider" or a "free-loader", with all the implicit reproach that implies, and that this person "will get his/her comeuppance".

And although the change from the post-feudal regime to a capitalist one brought some degree of fulfillment to the promise, at least for a time, the idea of meritocracy always had a sting in its tail:
"But there was, inevitably, a darker side to the story for those of low status. If the successful merited their success, it necessarily followed that the failures had to merit their failure. In a meritocratic age, justice appeared to enter into the distribution of poverty as well as wealth." (De Botton, p. 96)
These considerations lead to the question: is it true that the capitalist "meritocracy" necessarily leads to rewards going to those earning them?

A beginning of an answer will be offered here. To avoid controversies, the theoretical tools used by one of the greatest early proponents of capitalism will be used in this blog.

But before proceeding, a little background is needed. While it's true that Adam Smith started the study of economics, people have written about economics long before him.


Background

During the XVIII century the predominant currents of economic thought were the Physiocrats and the Mercantilists.

Physiocracy, more active in France, extolled the virtues of agriculture. Authors in this tradition were often noblemen and landlords, owing their position and wealth to agriculture, which was the main national economic activity in France.

In Britain, although there certainly were aristocratic landlords, merchants of non-noble origin were dominant. Unsurprisingly, Mercantilism was the more active school. Authors from this school, often merchants, advocated for sustained international trade surplus. During this period England finally displaced the Netherlands as dominant maritime  trading nation.

In any case, both schools advocated for Government intervention (as tariffs, import quotas, and similar) as a mean to foster the activity of landlords and/or merchants, in the national interest, often seen as equivalent to that of the sovereign.

However, during the XVIII century, the Industrial Revolution started in Britain (a common landmark is the invention of the steam engine), and with it manufacturing, controlled largely by the British "middle-class", became increasingly the dominant productive activity. And manufacturing did not benefit from the kind of Government intervention common at the time.

Against this backdrop first Smith and then Thomas Malthus and David Ricardo studied the economy. Their departing point was a value judgement: growth was an unmitigated positive (consequentially, anything hindering growth was negative).

Ominously, Smith and especially Malthus envisaged tendencies for growth to stall in the long run.


David Ricardo

Ricardo started his professional life as a stockbroker (another illuminating profile, here). After amassing a considerable personal wealth, Ricardo retired early. Encouraged by James Mill, Ricardo dedicated his retirement time, among other things, to his economic studies.

David Ricardo

Ricardo wrote about different subjects. He is considered a proto-monetarist a la Friedman, for instance. Here only his theory of land rent will be touched.

In fact, Ricardo's theory of land rent was highly indebted to Malthus. And, although both men sustained opposed views on many things, they were close friends.

Ricardo studied rent generated in two ways:
  1. Considering that fertility varies among properties, rent was generated in the process of extending the agricultural frontier, incorporating less fertile (marginal) land;
  2. But even if all land were equally fertile, the intensification of economic activity within each given plantation would still generate rent.
The focus here will be in the first way rent can be generated. The second way, more familiar to mainstream economists, leads to "the law of diminishing marginal returns" and, although mainstream economists would deny this, is controversial.


Ricardo-Malthus land rent

Landlords earned rent from their land, by leasing it to tenants and it was the tenants who actually labored in the field.

So, imagine you want to grow "corn". Choose an arbitrary numeraire in order to compare inputs and outputs; for the present purposes, any numeraire will do.

For the same investment, you could expect that a more fertile land produced a greater gross output:


If the marginal land were to be considered a feasible alternative, the output produced should at least be able to cover investment and produce a profit:


It's easy to understand what the item "costs" means: wages, fertilizers, seeds, etc.

What are the profits? One might consider profit as the opportunity cost of the investment: say, what a term deposit for the same amount would return as interest over the investment period. If the output produced were not enough to at least cover costs and this opportunity cost, you would be better off by simply depositing your money in a bank.

As equal investment is assumed in both cases, the best land possible not only covers the same investment and its corresponding profit, but it produces a surplus, above and beyond the profit.

What is the origin of this surplus? Clearly, the differential fertility of the land, which, to use Marshall's expression, is a "gift from nature": it's due neither to the tenant nor to the landlord.

Landlords themselves do not personally add any value to the production, although they legally own the land, and, thus, are entitled to lease it and charge for its use. However, whether the landlord is the Earl of X, the Duke of Y, or the very Flying Spaghetti Monster, it doesn't affect the fertility of the land.



If you changed the property relation, then the right to charge a rent disappears: if you happened to be the owner of the land, in addition of being a "corn" grower, the surplus would be yours, even though you didn't produce it, any more than the landlord did.

Based on the previous reasoning, it becomes apparent that nobody really earns that rent: this gives a whole new meaning to the "gift of nature" expression.

However, your landlord is conventionally, legally entitled to receive rent, and, if you got a surplus, the landlord will be claiming it through a rent increase. In that case, you should be willing to pay as rent anything up to the magnitude of the surplus.

And landlords are also entitled to dispose of this revenue as they see fit, which in Smith, Malthus, and Ricardo's views usually meant non-productive extravagant personal consumption.

Ricardo and Malthus, as Smith before them, considered that this would reduce growth and, thus, was a negative. Note a subtle thing: this is a value judgement, too. Deliberately or not, consciously or not, they were putting themselves in your shoes, as a tenant and an entrepreneur.

Let's look at this situation from a different perspective. To produce the exact same output in a marginally fertile land, you would need a larger investment:


If the rate of profit is equal among all investment opportunities, your larger investment will produce a larger absolute profit than the one generated by the smaller investment required by the best land. But both profits will keep the same proportion: the equalized profit rate.

Again, the surplus makes up for the difference among both outputs.

What happens if the price of "corn" were to fall? The output evaluated at this price would not be enough to cover both costs and profit and you would not accept the deal: that land would not be cultivated. That would also diminish the rent of the best land, but would be unlikely to eliminate it entirely.
 
At the other hand, what if prices rise? Your costs (including opportunity cost, which is the equalized profit) remain the same, and you still cover them, but now there is a surplus on top of the right-hand column of the chart above (and a larger surplus on the left-hand one). The marginal land became capable of producing rent.

Note the logical sequence: price changes precede surplus/rent changes and determine their direction; this sequence contradicted the usual view at the time: rent changes determine price changes (i.e. rent as a cost). And this is important (more on this in the concluding section).

Further, falling prices reduce the area cultivated, raising prices expand this area.

Let's make a pause to evaluate the theory. You'll surely admit it's a rather clever idea.

But it's far more than clever. Let's apply Ockham's razor to it. It assumes few things (differential soil fertility as main determinant of surplus, more fertile land cultivated before less fertile land, tenants and landlords prefer more to less and an equalized rate of profit: the opportunity cost). Neither landlords nor tenants need to be incredibly sophisticated calculating devices, endowed with prodigious ability to gather and process huge amounts of information. All this is good, according to Ockham.

Further: these things can be empirically measured with ease. One would only need access to the tenants' and landlords' accounting books and price statistics.

One could object that the tenant may feel tempted to transfer the rent to the consumer. This is a potentially good objection, depending on the specifics of the situation (more on this in the concluding section)


How does the theory fare in reality? It would be outside the scope of this blog to deal with this. However, let's consider this: Ricardo did not study only agricultural production, but also mining. Readers familiar with the oil industry may find the behavior described obvious: oil prices go up, marginal oil wells are re-activated; oil prices go down, they are abandoned. This behaviour is easily explained in this framework.

Not bad for a guy who wrote about 200 years ago, and didn't use complex maths.

One could probably add that there seem to be a negative feedback loop involved, as well: marginal wells are activated, oil supply increases and oil prices fall. As oil prices fall, some marginal wells are abandoned, supply shrinks and oil prices rise, etc.



Rent, the RSPT and growth

Australian readers might associate the discussion above with the RSPT proposal that cost former PM Rudd his office. The interested reader should try to use the second and third charts above, to speculate on the effect of redistributing surplus from a super profitable mine to a less profitable one. What effect it could have had on production? Would that output be sustained or would it fluctuate over the long run? Can one understand the position of the big miners? What about the small, arguably marginal, miners?

Imagine now, as Ricardo did, that "corn" is the numeraire. Ricardo justified this on the grounds that "corn" was a required input (as seeds, for instance: capital); it could also be used to pay eventual workers (who, after all, were on subsistence wages).

In this scenario, and considered in isolation, suppressing the differentiation tenant-landlord, agriculture in fertile/rent-producing lands was a perpetual motion machine: it produced more than the inputs required.

Clearly, this was an impossibility, as Smith understood. In the long term, Smith considered that primary products would be increasingly demanded, as intermediate inputs for manufacturing and for final consumption, by a growing population. This should increase their prices and the subsistence wages paid to the working man. But this should cut profits down.

Ricardo added another channel to this: rents would increase, as seen above. But there was no warranty that increasing rent would be spent productively (as investment). 

As profits and investment fell, growth should stall: production (and industrial capitalism) couldn't grow forever.

To ameliorate this situation, Ricardo developed his views on international trade (which, together with his theory of rent, is still widely accepted today), and as an MP, actively opposed the infamous Corn Laws as a means to cut rent, among other objectives.

In using his public profile to advocate for his economic ideas (which he did quite successfully) Ricardo was hardly the first to use a public/official platform to further economic goals. However, his personal reputation as reasonable, learned and credible expert made him particularly effective. In this sense, Ricardo was also ahead of his time. But all these are a matters for an eventual future blog.


Concluding remarks: free lunches, anyone?

And what about the question: is it true that the capitalist "meritocracy" necessarily leads to rewards going to those earning them?

Clearly, not. To the extent that Ricardo's rent theory is valid, it specifically identifies one group benefiting from a "gift of nature" (i.e. not earning the reward they receive): landlords.

Perhaps the reader will object that, nowadays, farmers own the land they use. To that one could answer that farmers who own their land are likely benefiting directly from a "gift of nature", instead of the landlord of Ricardo's day.

The reader could further object that farmers, who know their business best, would be surprised by Ricardo's views and object to them as absurd. To this one could say that the farmers would be reacting like Moliere's bourgeois gentleman, who was surprised to learn that he had been speaking in prose all his life, without knowing it.

Finally, the reader may object that the decision to acquire fertile land is rewarded by the rent achieved: it showed perspicacy. To this one could reply that this may be so; however, this does not change the fact that the fertility of the land is not due to the decision of the purchasers, however perspicacious they were.

Additionally, one could argue that it does not really require that much perspicacity to realize that a fertile land is preferable to a less fertile one. That's why Ricardo assumed this ability as a given!

Further, consider small businesspeople, renting their shops. They pay rent and their relation to landlords is analogous (although not identical) to the one described: just replace "fertility" with "location".

What's more, against appearances, in general small businesspeople are not free to transfer rent to their customers and patrons: if they tried, they would probably turn customers away. So, they need to cover rent through increased sales. This was the objection raised initially on the section Ricardo-Malthus land rent, above.

But one need not stop at this level of abstraction.The key element in the landlord/tenant relation is the property of the land, as repeatedly remarked above.

Landlords, as a set of individuals, have a monopoly on land and are legally entitled to charge for its use (i.e. the rent we have studied).

Capitalists, as a class, also have a monopoly over capital and are legally entitled to charge for its use (i.e. the profit we have already found).

Land is a productive factor and, according to Ricardo, it can produce rent in excess of production costs. But labour is also a productive factor, and according to Ricardo, it produces value.


Up to this point, the parallels between land and labour, as seen through Ricardo's eyes, are strikingly obvious.

The surplus due to land's fertility was, evidently, generated by the land itself and was due to nobody (if we exclude God or the Flying Spaghetti Monster), but, in Ricardo's times, it was conventionally appropriated by the landlords.

Ricardo believes labour produces value, but labour is only rewarded by its own cost (i.e. the amount paid as wages). Does labour also generate a surplus? In which case, who appropriates it?

As mentioned above, Ricardo, wittingly or not, assumed as his the role of entrepreneur/tenant and in this role advocated for the abolition of the Corn Laws, as mentioned. That might explain why he never saw this rather evident connection, let alone investigate it.

But Marx did. To make Marx's view justice would require at least a whole blog. Thus, it will not be covered here. Suffice it to say that, just like landlords in Ricardo's times, someone could be enjoying a free-lunch, and the relation between price and surplus, that Ricardo found when considering land rent, does not apply when considering labour.

Update:
11/11/2012 I struck through a portion of the text. As written originally, I find my text was confusing and long. Hopefully, this edition shall make my meaning clearer.

1 comment:

  1. If anyone here gets involved with others of like mind, please visit the Progress Report, sign up for headlines, join the Democratic Freedom Caucus, and reach out to Left Libertarians, if you haven't already. All the best,

    ReplyDelete