David Ricardo's Law of Rent ｜ Understanding Real Estate

In 1817, David Ricardo observed that wheat prices were increasing and so were land prices. He pondered whether rents drive prices of goods or prices drive rents. What actually sets the rent? He studied this very carefully and found that the price of goods is not high because rent is paid, but rather rent is paid because the price of goods is high. David Ricardo concluded that users stand to make the profit from using the land that drives their willingness to pay rent. This unearthed the extraordinarily unique land quality as a unit in the overall production. It is able to capture all of the residual value of all other economic activities. Rent is defined as a tenant's payment to a landowner for the use of the property. Rent is paid to be used to do something. Land is the common ingredient for all economic activity. Even with the advent of the digital revolution and shared economy, land is necessary for economic activity to happen. It is the only economic resource that is not being shared. One person cannot occupy the same space and owners have the exclusive right to a piece of land. As David Ricardo realized that the profit that users stand to make from using land drives their willingness to pay rent, we look into three components of pricing power that gives landowners the power to set prices. First, the aspect of indispensability is straightforward. You cannot grow produce without land. Apart from being necessary, the second quality of land that gives it power is scarcity. An abundance of land gives landowners little pricing power that tends to create a reverse bidding and price war. Scarcity of land then offers landowners high levels of power and stimulates competitive bidding. Lastly, the final component of pricing power is based on productivity. The quality of the land may differ and superior land can increase yield and productivity for farmer tenants, thereby increasing profit. This creates a situation wherein a strong desire for superior land leads to scarcity compared to the average land flowing in abundance. This provides landowners the leverage to increase rent for the high quality land, but by how much? The fundamental pricing principle of what is the next best alternative must be evaluated. If a farmer is looking at renting superior land, he or she is going to ask how much can he or she pay in rent for superior land and still be better off than the next best alternative than settling on average land. Determining what the rent will be for the superior land will be based on its value addition. The assumption here is that a superior land yields 10 bushels per year versus the average land producing only 6 bushels a year. Operating cost is $20 per acre and the price of corn is $10 per bushel. Heading out and working in a different industry will provide $15 a year. If a farmer rents an average land, he or she will be earning $60 revenue less $20 for harvesting costs and will be profiting $40 a year. Average land is assumed to have zero rent. If a farmer rents a superior land, he or she will be earning $100 revenue less $20 harvesting costs, providing him or her an $80 profit before rent in a year. This results in a $40 difference where the rent price for the superior land can be determined. As long as the profit of the superior land less rent expense is greater than or equal to the profit from the average land, it is still a viable option. $40 rent becomes the indifference point wherein the average land and superior land will result in the same profits and both alternatives become equal. In a situation where all land is rented, even the average land becomes scarce. Bidding wars for the rent of average land will commence. The alternative of working in another industry for $15 a year must be considered. Farmers must evaluate that their profits from average land minus the rent must be greater than or equal to $15. He or she can pay any amount of rent such that he or she is making at least $15. This would determine a possible rent price of up to $25 for an average land. However, this increased rent for average land will also increase the possible rent for superior land because of the marginal difference in profits. There is profit after rent that farmers can get, so they will bid the rent up to access the land to earn higher profits. Superior land rent would be able to shoot up to $65 a year and be at equal profits for working in another industry or renting an average land. An equilibrium has been reached where the operators are indifferent between renting superior land for $65 per year, renting average land for $25, or working in other industries. This example shows that prices drive rents. The rent of the superior land was driven by its potential profits. Thus, people were eagerly bidding up the rent. Farmers were better off paying the rent and earning more. Rent in San Francisco is high because of its access to high-paying job opportunities. Thus, renters are bidding up the price of land to get access to the things that that land gives you access to in every market. This represents how prices drive rents. And finally, we see that landowners ultimately capture the residual value created by all other economic resources. The economic activity of farming generates a lot of profit, but generally the profit does not really go to the farmer, it goes to the landowner. The increased bidding of rents to achieve higher profits for farmers ultimately increases the profits of landowners, as they enable the farmers to grow in higher yielding lands. The superior land serves as their competitive advantage to earn higher than others. It's the land that creates productivity. Therefore, the value of that productivity flows not to the operator, but to the landowner. No other economic resource captures that residual value of all economic activity like real estate.