Differential Rent

However, land is not a homogenous resource, and that important complication cannot be skipped over. It is the basis of the theory of rent, first proposed by English economist David Ricardo,

and still considered the correct theory of rent by just about all economists.

Some land is more fertile than other kinds of land, or more profitable because it is closer to markets; and some land is more suitable to one kind of crop than another. These differences in fertility will be reflected in the marginal productivities and therefore in the demands for the different kinds of land. Let us think of a very small economy with just three kinds of land: good, fair, and bad. There are just 10,000 acres of each kind of land. The supply and demand for each kind of land is shown in Figure 6 below:

Figure 6: Marginal Productivity of Land with Different Fertilities

The demand for good land is pMP_A, for fair land pMP_B, and for bad land pMP_C. The supply of land of a particular quality is always a vertical line, because "they're not making any more of it" -- the supply of land cannot be increased no matter how high the price. Since there are 10,000 acres of each sort of land, the three kinds of land have identical supply curves, all shown by the vertical line at S.

In a supply-and-demand equilibrium, then, the rent per acre of good land will be R_A. For fair land it will be R_B, and for bad land zero. The bad land in this example is what Ricardo called "marginal" land -- good enough to be cultivated, but only if it can be had free of rent.

Thus, the rent on fair land is just enough to offset its greater productivity relative to the marginal land. Similarly, the rent on good land is just enough to offset its productivity advantage over marginal land. If the rent of good land were any lower than that, no-one would want to use fair or marginal land, but all would compete for the limited supply of good land -- forcing the rent on the good land up until it is large enough to offset the productivity advantage of that good land. Similarly, the difference in rent between the good and fair land is just enough to offset the productivity differential between them. This is called the "differential" theory of rent -- that the rent of any land is just large enough to offset its differential productivity relative to marginal land. To stress the basis of land rent, it is often called differential rent.

This idea -- that rent is based on differential productivity, which is given by nature and not the result of the landowner's action -- is what led the American social activist, Henry George, to propose that land rent ought to be largely confiscated by taxation.