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Economic Rent

This is a more complete discussion of the concept of economic rent, than we could cover within The WelderDestiny Compass newsletter. It is part of a wider discussion to help us understand how certain businesses and platforms can gain huge amounts of value in a very short amount of time. You can read the complete edition #010 of The WelderDestiny Compass e-zine by clicking here...

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Economic Rent - The Window on the Economy

When we turn on the telly, we are constantly bombarded with economic news and views. There are channels that only do that day in and day out. The same talking heads that last week told us why the market was on the up, and heading for the skies, will today be telling us why the sky is falling on our heads. (Watchout below!)

It all seems so logical and predictable... in hindsight! In all the years of listening to these bank economists and stock market gurus, never have we heard them talk about the economic rent. When we look for this term in economic texts, the definitions and explanations tend to not really leave us much better off in our understanding. In fact, it appears that there are a number of different directions taken when defining this term. Here is one of the clearer definitions we could find:

"The extra amount earned by a resource (e.g. land, capital, or labour) by virtue of its present use."

Here is another definition, which seems to confound more than clarify:

"Economic Rent refers to income earned from a factor of production which is greater than the minimum necessary to bring the factor of production into operation."

Within our current discussion, here is my best attempt at a definition:

"Economic rent is value added to an asset without the owner of the asset having to invest further capital."

Let us look at this by way of an example in real estate. We use real estate, because it is relatively simple to see the concept in action:

We buy a plot of coastal land 20km from the closest town. It has beautiful sea views, but is only accessible by way of a 15km long dirt track. In the rainy season the land is essentially inaccessible. We pay $10 000 for this plot of land.

After a year or so, the state government develops a paved road which passes close to the property. This road is going to the next town down the coast. The value of the property now jumps to $30 000, because it is more accessible, so more people are prepared to live there. This additional $20 000 in value was in no way paid by us. We did not make any improvements to the property, nor did we perform any hard work for this additional $20 000, but we will be receiving it if we sold.

After another year, a developer builds a housing estate in the vicinity of our property. We now have other residents in the area and there is also a store within easy reach. The value of the property is now $70 000. Again, we did not actually have to do anything to generate this additional wealth, but non-the-less it will be flowing to us if we decided to sell the property.

A year later the local government decides to "re-zone" our plot of land from a "rural / agricultural" zoning to residential. A property developer approaches us, with an offer of $1 000 000 because she wants to subdivide the plot of land and build 20 houses on it. This last jump in land value from $70 000 to $1 000 000 happened at the stroke of a pen. There was no sweat, construction or energy expended to add this value. We look at our investment: It has grown from $10 000 to $1 000 000 in just a little over 3 years. We are pleased with the return on our investment, so we take the offer and sell.

Now we need to ask ourselves: Where did the $990 000 profit come from? There can be a lot of discussion about supply and demand etc. but in the final analysis this increase in value was the economic rent associated with all the other activities taking place around our property. The paved road paid for by tax payers; The development of the housing estate paid for by the residents buying those houses; The re-zoning by the local government, again resulting in additional payments by those buying the houses from the developer who bought the property from us.

This process of getting one party to pay for the "capital gains" of another party is deeply engrained in the whole capitalist economic model, and is obviously very susceptible to manipulation and corruption, but that is a subject for another day.

We see all around us the manipulation of the economic rent in somewhat less obvious ways. Less obvious only if we are not looking for it. For example, when the government "helps" first home buyers by way of a grant, we see that the average price of houses rise by about that amount. In essence the tax payers are paying this economic rent to the current land owners. The home buyer is not actually any better off.

If the interest rates come down, “to make housing more affordable”, then the price of the houses increase. In essence the depositors in the banks (who then earn lower interest for their deposits) are paying the economic rent to the land owners, thereby increasing their property values. Again, the home buyer is not really any better off, because the increase in house prices off-set the reduction in interest charges, therefore the affordability remains approximately the same.

When the government allows negative gearing for people investing in rental properties, "to help the poor renters", then the property values go up again. In this scenario, the general tax payer is subsidising the land owner through the tax breaks that accrue to the land owner. All of these examples are where the economic rent is being manipulated to take value from one party and transferring it to another.

Considering the examples above, it becomes obvious that this manipulation of economic rent has been going on for centuries. (How do you think all those land barons got so rich?) What does this have to do with the information revolution, I hear you ask? To answer this question, we need to understand that economic rent is not only accrued on property, but in all walks of life and businesses.

There is however some merit in the argument that all economic rent eventually makes its way into land values, as this is generally the final long term store of wealth, due to the tax advantages associated with capital gains on land.

To understand how the information economy impacts the economic rent, let us look at another typical and very topical example.

The taxi industry is a regulated industry. Ostensibly this regulation is needed because customers need to be protected against unscrupulous taxi drivers that could not only rip customers off financially, but could also fall into the category of some social deviant. (Think axe murder etc...) OK, so there appears to be good ground for issuing taxi licenses. However, what we see is that these taxi licenses take on a value of their own, because they are limited.

Maybe it cost the original taxi license holder $100 to acquire the license, but over time the value of this license may climb to be worth tens of thousands of dollars. I believe that at its peak, a New York taxi license was worth in excess of a million dollars. So, what made the value of the taxi license increase? Obviously, the supply and demand equation pushed the price up. Who ends up paying for this? The taxi clients and taxi drivers. The clients pay in higher fares. The taxi drivers pay, because the license owners no longer drive their own taxis. Instead the license owners typically own a number of licenses that they "hire" out to drivers.

Now enters Uber, the "lift sharing" application. Uber has a business model that links car owners to people that want a lift somewhere. Ostensibly this is not a "taxi" service, it is a "ride sharing" service, but in effect Uber has managed to provide the platform for operating a taxi service to anybody that meets their selection criteria.

Not only have they managed to provide the commercial platform, but their model also addresses the safety and trust concerns of both their drivers and "lift seekers". Within the Uber model, everyone appears to be better off, excepting the taxi license holders. Possibly the current taxi drivers also feel threatened, because there is no way to enforce "scarcity", so over time as more and more drivers register with the Uber service, the number of fares per driver will no doubt drop until an equilibrium is reached. This equilibrium may be at a significantly lower income level than is currently experienced by taxi drivers. As we are yet to reach this point, we can only speculate on the final outcome.

Within this model, the Uber founders have managed to move the economic rent that was captured in the taxi licenses, over to Uber, as the provider of the new ride sharing platform. The value of taxi licences in the areas where Uber operates have dropped dramatically, while the enterprise value of Uber has risen to over 18 billion dollars. Once we see how the economic rent is captured through regulation, and how the infrastructure provided by the internet and mobile computing can be used to re-direct the economic rent, we realise the tremendous power of the information revolution to disrupt almost every sector we can imagine.

Think about Airbnb for holiday accommodation. Over the long term, how will this affect the value of hotel licenses and the value of hotels as a business model in general? How will this influence the value of residential property close to tourist attractions?

Falling in a similar category are the opportunities afforded by internet platforms like Facebook, YouTube and eBay. These have become platforms for enterprising individuals and companies to make serious money. Some YouTube entrepreneurs make in excess of a million dollars a year from posting videos! This all rides on the back of the advertising dollar and the value being created from "big data". Where is the economic rent for this coming from? Mainly from "old school" media companies and bricks and mortar retail and service companies.

Time will tell how this all plays out, but it is clear that the current holders of the economic rent will not want to let go of it without a fight. Consider the protests by taxi drivers and their attacks on Uber drivers and their passengers in cities like Paris and London. Also moves to block the Airbnb business model at local government level in selected locations. While there is still much water to flow under this bridge, I believe the adoption of the "sharing economy", as it has been dubbed, will inevitably win out. The exact form it eventually takes will no doubt be in a somewhat modified incarnation to its current form.

Think music sharing sites that finally gave way to iTunes. - Lots of economic rent juggling throughout that whole process!

So, we hear you ask, how does this affect the welding and fabrication industry? In many areas, our industry is highly regulated. This regulation enabled business models that captured economic rent that was linked to the regulation. Think of the economic rent associated with code compliance. Think of the economic rent associated with qualifications and certifications. Think about how your personal "market value", or the business model of a company you are involved with is affected by the current regulations and associated economic rent.

Now think how such economic rent could be impacted by a "welding Uber".

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