TP18. The Cat that got the Cream – Law of Rent

Before we come to consider what the Law of Rent states, and why it is important, it is useful to begin with a true modern story.

A modern illustration.

This is the experience of a small shopkeeper in a suburb of London in the late 20th Century. Only the names have been changed. Let us call the shopkeeper David and the owner of the property which he rented Goliath.

In 1980, David signed a 15-year lease on a shop with a small flat above it. He agreed to pay £500 per annum in rent for the complete property. The rent was to be· reviewed every five years. David was to pay all building, repair and maintenance costs, all business rates and insurance on the building. With a loan from the bank, he set about the work of running a retail hardware shop.

At first his income was low, but things got better with the years. He began to feel the benefit of the boom in local house building when an estate of 100 small dwellings was built within walking distance of his shop.

In 1985 his first rent review descended on him, and he told that the annual rent would now be £2,500. The net effect of this was to reduce his take-home pay back to its 1980 equivalent. Nevertheless, he continued in business. But over the next few years, the local population grew and more business was obtained.

1990 came, with another rent increase to be faced. This time it rose to £4,800 p.a. When the next rent review came in 1995, David was presented with a demand for £10,000 p.a. He knew that he could not generate enough turnover to meet this burden on his business and Goliath was informed to that effect. The response David received was to find a ”To Let” notice fixed above his door, and the instruction that he was to pay up or get out. However, this time Goliath had misjudged his strength. After a month the “To Let” notice was removed and David was offered the chance to continue in business at a rent of £6,900 p.a. Clearly Goliath had not found anyone else who could afford the rent, and David stayed on.

So how do we explain the fact that the rent went up almost fourteen-fold in fifteen years? Inflation will account for some of that increase. A large part was due to local builders and the activities of numerous people who moved into new houses in the district. The one person who contributed little or nothing to the enormous increase in rent was Goliath, who was indeed the “cat who got the cream”.

How did all this happen?

The story of David and Goliath is one example of much bigger injustices affecting not just a single shopkeeper but hundreds of millions of people all round the world and operating over thousands of years of human history. To understand how the system works, it is necessary to go to the very root of economics. As in science or law, It is necessary to define terms, and stick to the definitions. Also as in science and law, words are often given a special meaning in economics which is not the same as the looser meaning they are given in ordinary speech. In the remainder of this Topic Paper, words which are defined in a special way in economics are put in inverted commas.

All wealth is produced from two sources. One of these sources is the work of human beings. Economists call that work “Labour”, a word which includes not only manual effort but also intellectual and managerial work. The second source of wealth is natural resources, which economists call “Land”. “Land”, in this sense, includes not only the ground itself but also such things as wildlife, minerals in the ground, air and water and electromagnetic wave bands.

Sometimes people use their “Labour” on “Land” to produce things which make their “Labour” more effective. A person may carve a stick to help him dig the ground, or he may weave natural fibres to make a net to help him catch fish. These things, which have been produced from “Labour” and “Land” are called “Capital”. If “Labour” has access to “Land”, it can produce “Capital” in virtually limitless quantity.

In the example of David and Goliath which has just been considered, the shop and flat which Goliath provided at the beginning were partly “Land” (the ground on which the building rested) and partly “Capital” (the building itself). David provided “Labour”. He used effort and judgement to buy things and then sold them in his shop, and in other ways worked up his business. He also provided “Labour” in maintaining the building, so that it did not deteriorate in value. Then another factor came into the story. The local authority gave planning permission for a new housing estate, and this brought many potential customers into the area.

How, then, did Goliath become the principal beneficiary of all this activity? Not because of the “Capital” he provided. Allowing for inflation, the building was worth no more at the end than it had been at the beginning. What went up enormously in value was the “Land” on which the building rested. And this increase in value was due to the efforts of the many people and organisations who built the new housing estate and provided the transport and other facilities needed by the growing population.

Defining terms.

When we go into the matter more deeply, we see how all this related, not just to David and Goliath, but to a great many other people and problems as well. But first it is necessary to explain a few more terms.

The return which a person receives for providing “Labour” is called “Wages”. Often “Wages” are paid by an employer, but sometimes – as in the case of David which has just been considered – these “Wages” are received directly by the person who provides the “Labour”. The word “Wages” includes salaries, professional fees and ­as in David’s case – what people sometimes call the “profit” of a business.

The return which a person receives for providing “Capital” is called “Interest”. If somebody hires a machine to help him manufacture goods, he pays “Interest” on the “Capital”. Part of the money which David paid to Goliath was “Interest” on the building which Goliath provided. “Interest” need not be money. It may be goods. If one man lends a spade to another to help him dig his allotment and the other gives him a bag of potatoes in return, the potatoes are also “Interest”. Another important word also needs to be understood – the word “Rent”. This word is also used in a special way in economics. “Rent” is payment for the use of “Land”. The so-called “rent” which David paid to Goliath was partly true “Rent” in the economist’s sense of the term, but it was also partly Interest on Capital. “Rent” may be paid to another person, but it may also be enjoyed by the producer himself. If, for example, David had been the freeholder of his shop instead of the tenant, the extra “Rent” which derived from the presence of the housing estate would have accrued to him and not to Goliath.

TheLaw of Rent.

The economist David Ricardo (1772-1823) worked out a rule which is known as the Law of Rent. This states that in a freely competitive society the “Renf’ of “Land” is the excess “Wealth” that can be produced after “Labour” and “Capital” have been used and paid to utilise a site to its maximum “Rent” producing capacity.

What does that mean?

Imagine a small group of farmers living on a large and fertile island. There is plenty of “Land” available for everybody to use. The value of the “Wealth” which each farmer produces is partly the “Wages” of his “Labour”, partly the “Interest” on his “Capital”. There is no “Rent”, because there is abundant “Land” for anybody to use.

Now take a variant of this example. There are a great many farmers this time, and the “Land” is of variable quality. Some is good arable fields, some is mountainous and useless for anything, even rough grazing. All of this “Land”, good or poor, is owned by landowners who will only allow farmers to use “Land” if they pay for it.

A landowner can get nothing in “Rent” for barren ground and very little in “Rent” for rough grazing ground, but he can get a great deal of “Rent” for good arable fields. It is important to remember that “Rent”, in the economists’ sense, means payment for the “Land” alone, and does not include payment for farm buildings, hedges, drainage or anything else which humans have created. These things are “Capital”, not “Land”, and payment for them is “Interest”, not “Rent”. As in David’s case, “rent” in ordinary speech includes both true “Rent” and “Interest”.

The Law of Rent applies not only to rural “Land” but to urban “Land” as well. Goliath was able to force up David’s true “Rent” again and again, but eventually a point was reached when neither he nor anybody else could afford to pay any more. In other words, the maximum “Rent” producing capacity of the site had been reached.

How valid is the Law of Rent?

There is an important assumption underlying the Law of Rent: that people are constantly trying to maximise their economic welfare. But there are many qualifications to this rule. People give to friends or to charity when they have no expectation of economic reward and are actually reducing their economic welfare. People refuse to invest in tobacco or armaments or ecologically harmful activities for moral rather than economic reasons.

This applies to the case of David and Goliath. Many landlords would have behaved more generously than did Goliath towards a good and enterprising tenant. Even David was able to save something out of the transaction. His payments were revised at five year intervals and the shopkeeper was able to secure some benefit from changes which operated during the course of a five year period.  

There are also more subtle factors at work which require us to interpret the Law of Rent with care. One is the gradual rise in expectations. To some extent, technological improvements and social changes do lead to increases in “Wages”. People in a developed country today are unlikely to accept jobs at a “Wage” which would not allow them to own or hire a television set or a refrigerator, which was not the case fifty or a hundred years ago. Welfare schemes like unemployment pay and social security push up the minimum level of subsistence.

Another factor at work is competition between landowners. If Goliath had driven David out of his shop, it is quite possible that David would have found another landowner nearby who would have been able to offer similar accommodation at a somewhat lower rent.

These points are of both practical and theoretical importance and, to a degree, they qualify the strict interpretation of the Law of Rent. But they do not reduce the force of the essential argument. The cat that gets the cream (or most of the cream at any rate) is the owner of “Land”.

In other Topic Papers in this series, we show how this fact bears on a great many modern problems: housing and homelessness; unemployment; booms and slumps; transport and communications and so on.

Further reading

David Ricardo, On the Principles of Political Economy and Taxation, (London 1817 and later editions)

The BEE, vol vi (Edinburgh 1791)

Henry George, Progress and Poverty

Fred Harison, Ricardo’s Law; house prices and the great tax claw-back scam (Shepheard-Walwyn, London, 2004. ISBN 13:978-0-85683 214-3 and ISBN 10:0-85683-241-3)