Economic Rent

What is Economic Rent?

By definition, economic rent is the difference between the marginal product and opportunity cost. When a firm controls valuable production resources such as land, labor, and capital, it will use the resources to bring it to its optimal production quantity. The optimal quantity is achieved when the firm’s marginal cost is equal to its marginal revenue, and it is able to generate maximum economic profit.

In such a case, the cost of employing more factors of production (the opportunity cost) is equal to the benefit received in the status quo (the marginal product). Thus, the economic rent of such a firm would be equal to zero, and the firm would be operating optimally.

Economic Rent Calculation

As defined above, economic rent is the difference between marginal product and opportunity cost. The relationship can be summarized with the following equation:

Economic Rent  =  Marginal Product – Opportunity Cost

The equation above can also be rearranged to solve for marginal product and opportunity cost.

For instance, if a company sets a target economic rent of employing an unskilled laborer of $5 per hour, it can use the equation to calculate the marginal product that the laborer will bring. Using the equation, the firm knows that to achieve its goal, the worker must contribute to the marginal product by $5 per hour more than his/her cost of employment. This can be achieved if the worker demonstrates higher productivity than expected or the worker agrees to be employed at a lower wage.

Economic Rent and Salaries

The concept of economic rent can be used to describe gaps in the incomes of individuals in a given economy. Generally speaking, firms see workers that provide them with a high marginal product as more valuable and thus are willing to pay them higher wages. By contrast, workers that provide a small marginal product are seen as not as valuable and will be paid less. It is often less related to the individuals’ competence, but more related to the function of their jobs.

The general rule of thumb is that firms are willing to pay skilled laborers about three times as much as unskilled laborers. Menial, repetitive jobs that do not involve a lot of cognitive processing are typically filled with unskilled laborers, whereas jobs that require a high level of cognitive processing are typically filled with skilled laborers. This is because such skilled laborers are able to provide a firm with more value by themselves, which represents a higher marginal product. Thus, skilled workers are compensated more.

Nonetheless, economic rent in such a context relies on the minimum amount that any worker is willing to complete the job for. Suppose that a canning factory wants to increase its output, and thus, it hires one additional unskilled worker at a wage of $15 per hour. The salary is determined to be less than what the firm’s increase in the marginal product would equate to in order to guarantee profitability in its hiring decision.

However, the firm does not know that the minimum wage the worker is willing to accept for the job is $10 per hour. Thus, the laborer would experience an economic rent of $5 per hour, whereas the firm would be “overpaying” the laborer and thus would receive an economic rent of -$5 per hour.

In the context of skilled laborers, economic rent can become distorted due to the laws of supply and demand. For instance, the average salaries for skilled medical professionals may be much higher than employing firms’ marginal product. It is because there is simply a more limited supply of such laborers in the workforce, which forces the price of these laborers up. Assuming that firms cannot easily outsource equivalent laborers from overseas, they are left with no choice but to pay a premium.

More Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)® certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following CFI resources:

• Activity-Based Costing
• Pigou Effect
• Supply and Demand
• Utility Theory
• See all economics resources