The Law of rent was formulated by David Ricardo around 1809, and presented in its most developed form in his magnum opus, On the Principles of Political Economy and Taxation. This is the origin of the term Ricardian rent. Ricardo's formulation of the law was the first clear exposition of the source and magnitude of rent, and is among the most important and firmly established principles of economics.
John Stuart Mill called it the "pons asinorum" of economics.
The Law of Rent states that the rent of a land site is equal to the economic advantage obtained by using the site in its most productive use, relative to the advantage obtained by using marginal (i.e., the best rent-free) land for the same purpose, given the same inputs of labor and capital
Ricardo formulated this law based on the principles put forth by Adam Smith in Wealth of Nations.
"The rent of land, therefore, considered as the price paid for the use of the land, is naturally a monopoly price. It is not at all proportioned to what the landlord may have laid out upon the improvement of the land, or to what he can afford to take; but to what the farmer can afford to give." - Adam Smith
Ricardian rent should not be confused with contract rent, which is the "actual payments tenants make for use of the properties of others." (Barlow 1986). Rather, the Law of Rent refers to the economic return that land should accrue for its use in production.
Being a political economist, Ricardo was not simply referring to land in terms of soil. He was primarily interested in the economic rent and locational value associated with private appropriation of any natural factor of production. The law of rent applies equally well to urban land and rural land, as it is a fundamental principle of economics.
Ricardo noticed that the bargaining power of laborers can never dip below the produce obtainable on the best available rent-free land, because whenever rent leaves them with less than they could get on that free land, they can simply move to the new location. The produce obtainable on the best available rent-free land is known as the margin of production. Since landlords have a monopoly over a given location, the only limiting factor for rent is the margin of production. Thus, rent is a differential between the productive capacity of the land and the margin of production.
Note that Ricardo's original formulation assumes that the best quality land would be the first to be used in production, and that goods are sold in a competitive, single price market.
This law has a number of important implications, perhaps the most important being its implication for wages. The Law of Rent implies that wages bear no systematic relationship to the productivity of labor, and are instead determined solely by the productive capacity of marginal land, as all production in excess of that amount will be appropriated by landowners in rent.
The iron law of wages predated Ricardo and is often associated with the writings of Thomas Malthus. However, Ricardo was an intellectual rival of Malthus on this point. The law of rent explains why the Malthusian doctrine consistently fails to predict actual wages: if there are highly productive land sites available free, wages will tend to be high, all things else being the same; if the only available free land yields little, wages will tend to be lower.
In contrast to Malthus's hypothesis of overpopulation, Ricardo explains mass poverty using deductive logic by noting that when there is no rent-free land, subsistence becomes the effective margin of production. Landlords will not charge more than this amount because it would entail no production at all, and thus no rent.
The law of rent makes it clear that the landowner has no role in setting land rents. He simply appropriates the additional production his more advantageous site makes possible, compared to marginal sites. The law also verifies the claim by Adam Smith that the landowner cannot pass on the burden of any cost such as land value taxes to his tenants, as long as such taxes truly do not bear down upon improvements and affect the relative productivity of his land compared to marginal land. For this to be true the tax must be levied on the rental value of land and not the rental income after it is taken by the landlord, otherwise landlords will be less inclined to rent.
Ricardo's theory results in one counterintuitive result: with scarce resources, like land, an increase in the amount under production can actually cause the price of goods to increase.
To illustrate, consider wheat farmers outside London (the prices are invented for clarity, and are not historically accurate). Assume there are three types of land outside London in 1759 that can be used to produce wheat:Good land near a river
Ordinary land somewhat close to a river
Bad land close to a polluted river
(In all cases, the cost of producing a bushel of wheat includes the amount of money paid in wages.)
In 1759 wheat will sell at the price it costs to produce on ordinary land (£1 10s a bushel) and 70,000 bushels are demanded by the 1 million residents of London (assuming the market is in competitive equilibrium). The following year, 1760, there are 10% more people, and so 80,000 bushels are demanded by the now 1.1 million residents of London. But since the market was already in competitive equilibrium the previous year, only 70,000 bushels can be produced if nothing changes: if a farmer wants to produce more wheat, it will cost him £3 a bushel because he will have to use the bad land to grow it: All the good and ordinary land is occupied. (Ricardo made the same assumption that the best land will be used first.)
A price rise in 1760 to £3, caused by the increase in the population of London, would have two effects:Although the total amount of wheat eaten would increase, each person would eat less wheat since it would cost more;
Bad land, where it costs £3/bushel to grow wheat, would suddenly become economically usable.
Although bad land would not make a profit, it would break even.
Since the increased cost of wheat will actually suppress demand, assume that in fact the people of London use 76,000 bushels of wheat in 1760. Those 6,000 bushels will be produced on the bad land at £3 a bushel. Since the market is in equilibrium, all the wheat produced on the better land, at lower cost, will also sell at £3 a bushel. The extra £2 that farmers of good land make – and £1 10s that farmers of ordinary land make – is called scarcity rent: money earned over the cost of production merely by virtue of owning a more efficient piece of land.