In this show we talk about David Ricardo's law of rents. And we examine how rent prices are set. Have you ever heard a business owner blame a price increase for their goods or services on increases in the cost of rent? Did you ever wonder if the price of a movie ticket went up because the theater’s rent went up? Or do you think perhaps the rent when up in response to rises in the price of movie tickets? Which one is it? Is it possible to know?
It turns out there is an answer and it was discovered by
David Ricardo (1772-1823) British Parliamentarian/political economist and laid out in his most famous work Principles of Political Economy and Taxation (1817)
Ricardian fields example.
1) New colony- land is free settlers take best land and plant corn
a) At this point no rent is possible since the only value to land is the depreciated value of the labor applied to it. (so people will only pay the value of the labor)
2) At some point all superior (level one land) is taken and new settlers are forced to “settle” for level two inferior land. Perhaps land that only produces 80 barrels of corn vs 100 at level 1 land
(Draw steps on white board) at this point a new settler would be willing to rent level 1 land as long as they net the same or more than if they take level 2 land therefore rents are worth the difference between level 1 and 2 or in our example 20 bushels
3) At some new point all level 2 land is taken and then level 3 land until we reach a boundary. At that point something really interesting takes place. New settlers will pay rent to any point that provides them an acceptable living condition for the level of risk they are taking. So for example if there next best alternative is to work in a bakery making 10 bushels of corn a week they would be willing to pay 90 bushels of corn in rent for superior level 1 land. And 70 bushels for level 2 land and so on. (Wages are equalized)
4) The fundamental point of this thought experiment is that in the end the land captures or extracts all of the residual value or profits from all related economic activities. In other words rents are raised to the point where they take the marginal benefits associated with the land itself.
5) Practical applications—
a) Land owners actually have very little pricing power, they are price takers they just happen to capture all the residual value of the all the economic activity (this can be very good or very bad for the land owner)
b) Land owner ends up giving just enough income to keep the tenant (since there are lines of other potential tenants to take that tenants place
c) Landlords with superior land can be and are very aggressive in limiting a tenant’s upside.
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