The Cat that gets the Cream
or
Understanding the Law of Rent




Many problems one cause
If someone tells you that they know why our nation suffers from unemployment, economic slumps and booms, extremes of wealth and poverty, as well as a permanent housing crisis, then you have every right to raise a sceptical eyebrow. Nor are your doubts likely to be reduced if they go on to say that collecting the rent of land as the principal source of public revenue would play a major part in curing those evils. The problems seem massive and the proposed solution simplistic. Yet both statements are made with conviction in this series of pamphlets. It is hard to accept that such large problems could be so readily solved. However, that difficulty is greatly reduced once the 'Law of Rent' is understood.

A modern illustration
A contemporary story based on the experience of a small shopkeeper in a suburb of London gives the first clue as to what the law of rent is and why it is so important in the economy. Let us call the shopkeeper David and, with a small degree of poetic licence, we will call the owner of the property which he rents, Goliath. The facts of this story are true as reported by David when the author enquired in 1995 why a 'To Let' notice had appeared above his shop door. 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. In addition he would 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. The rent was to be reviewed every five years.

During the first five years David's take home pay was equivalent to the pay earned by a storekeeper of a small manufacturing business. Things got better with the years and 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 was presented with a new annual rent of 2500. The net effect of this was to reduce his take home pay back to its 1980 equivalent. Nevertheless, he continued in business. Clearly Goliath knew just how hard he could squeeze before David would throw in the sponge. But over the next few years, the local population grew and more business was obtained. Once more David felt that he was in a well paid self-employed job, justifying the long hours and hard work he was doing.

1990 came with another rent increase to be faced. This time it rose to 4,800 p.a. His feelings can be summed up in the sentiment that every time he thought he was winning, Goliath knocked him down again. When, in 1995, the next rent review came, David was presented with a demand for 10,000 p.a. this was too much, and he knew that he could not generate enough turnover to meet this burden on his business. He got his lawyer to tell Goliath that a rent set at that level would simply push him out of business. The response he 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 had the capacity to make a living in that location which would support the proposed rent of 10,000 p.a. That is the postion today and, if David continues to work hard and attract the necessary turnover, he will survive for another five years. But what then? Another large increase in his rent and he will again have his income forced down to where it equals the earnings of anyone else in comparable employment. 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, for David was responsible for keeping the building in good repair and for working up the business. Goliath was indeed the 'Cat who got the cream'.

How did all this happen?
This 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 roots of economics.

All wealth is produced from two sources. One of these sources is the work of human beings. Economists call this 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.


Fig.1

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 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 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, use of 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'.

But 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.

Two Bakers
These economic ideas are rendered much easier to grasp if they are illustrated by means of an example. For this purpose, therefore, imagine two bakers' shops. One is situated in a quiet rural village while the other is located in the main street of a big city. Each is run by a baker who both bakes and sells bread etc. on the premises. Each works in a freely competitive economy. For the sake of clarity in this example, we will assume that no taxes of any sort are collected. Other pamphlets in this series discuss the effects of various taxes, but they do not alter the operation of the natural law we are explaining here.

Profit & Loss Account - Village Bakery
Income from bread etc.
(700 Customers @ £1.00 each)
700
Wages (1.5 people)300
Raw materials (flour etc.)210
Shop and equipment60
Depreciation50620
Rent of Land80

Profit & Loss Account - City Bakery
Income from bread etc.
(4800 Customers @ £1.00 each)
4800
Wages (5 people)1100
Raw materials (flour etc.)1440
Shop and equipment90
Depreciation772707
Rent of Land2093

Fig. 2

Figure 2 is a simple Profit and Loss account for both the village baker and for the city baker. The following notes help to explain how the hypothetical figures were developed.

  1. 700 customers per week visit the village bakery while 4800 per week shop in the city bakery. Each customer spends an average of 1 per visit. Note the implicit assumption that bread and cakes have about the same price in each location.

  2. Because there is more work to be done in the city bakery, more staff is needed and they tend to get a sightly higher average wage because of the additional costs of getting to work. (An average of 5 per hour in the village and 5.50 per hour in the city). With minor variations, however, the pay of people who do not have unique skills is assumed to be very similar everywhere because of the free market in labour.

  3. The capital needed in the two places is different because of the need to deal with different levels of through-put. The raw materials such as flour and fuel, is one capital cost. The interest on the buildings and equipment, valued at 50,000 in the village and 75,000 in the city, is charged at 6% p.a. Finally, the building and plant is depreciated over 20 years. Note the assumption that the interest rate paid for the Capital is the same in both places.

  4. The bottom line of each Profit and Loss account shows the Rent which the owner of the site can demand and still leave the two businesses operational.

The result of this comparison is to show that the owner of the city site, who does not necessarily need to own his building, can collect 26 times more weekly Rent than the owner of the village site. The example stresses the point which everyone knows, that the Rent of Land is determined primarily by its location. (For example: in 1995 the ground rent of one of the shoe shops in London's Regent Street was 3,800 per week.)

The Law of Rent
What rules determine how much Rent may be charged for a piece of land? The 19th century economist David Ricardo (1772-1823) worked out a rule, which is still valid, which is known as 'The Law of Rent'. This states that in a freely competitive society, the Rent 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.

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 land, some is mountainous and useless for anything, not even rough grazing, and there is everything in between. There are also landowners who will only allow farmers to use land if they pay for it.

A landowner can get nothing for barren Land and very little in Rent for rough grazing Land, but he can get a great deal of Rent for good arable Land. Rent, we must remember means payment for the land alone, and does not include payment for farm buildings, fences, hedges, drainage or anything else which human beings have created. Those things are Capital not Land, and payment for them is Interest not Rent.

The 'margin of production' is the limit of the Land which can be obtained, for practical purposes, Rent free. Within the 'margin of production' the better the Land, the more the Rent. Figure 3 is an elementary way of expressing the Law of Rent as a diagram. It illustrates how Rent is a surplus which is creamed off after Wages and Interest have been paid.


Fig. 3

The 'Law of Rent' applies not only to farmers, but to bakers as well. The village baker cannot be charged more than 80 a week for the Rent of the site, because if the landlord were to demand more, the baker would go out of business. This is what almost happened to David in the first case considered. By contrast, the city baker can be charged up to 2093 a week for Rent, but no more.

Technical and social Innovation
Suppose that the village baker installs a vending machine for the automatic sale of bread etc. during hours when his shop is normally closed. After doing this he experiences an increase in turnover of 10% to 770 per week. The vending machine will involve an addition to his Capital of say 40 per week. For a while the baker's income would be 30 per week more. The baker will of course gladly pocket this improvement in his income. However, his success will quickly be advertised by the vending machine company. They will advise other bakers and other shops to follow suit in order to sell or hire more of their machines. Thus vending machines will be installed wherever they prove to be worthwhile.

In fact, this improved income is Rent, which the landlord has yet to recognise. In course of time, Rent reviews would reflect the fact that other bakers, content with normal wages, will pay more for the use of the site and the return to Rent would rise to 110 per week.

Similarly, suppose that the city baker rearranges his shop on a self-service basis. If this now enables him to maintain the same turnover with one shop assistant reduced to part-time working, he can reduce his wages bill by 110 per week. But before long this gain in his earnings, which he will initially pocket, will be reflected in a rise in the Rent for exactly the same reason.

The generalisation of these two examples leads to the significant conclusion that in a freely competitive economy, the benefits from all technical progress end up as increases in the Rentable value of Land. In fact, this is not strictly true: a point to which it will be necessary to return later. In all the cases considered, David and Goliath, the farmers, the bakers, the economic rule is essentially the same, and it is the Law of Rent, recognised by Ricardo. Unless other factors are also at work, all kinds of improvement ultimately result in increased rent.

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. Broadly speaking, that is true but, again, anybody can think of qualifications. 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 examples we have considered. In the David and Goliath case, for example, many landlords would have behaved more generously than Goliath did, and would not have tried to squeeze the last drop of Rent out of a good and enterprising tenant.

Even in that case, David was able to save something out of the transaction. His payments to Goliath were revised at five year intervals, and the shopkeeper was able to secure some benefits from changes which operated during the course of a five year period. In the same way, the bakers were each able to derive some benefit from the vending machine or the self-service rearrangement of the shop, and the farmers would be able to derive some benefits from various improvements they introduced in their productive techniques.

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 improvement and social changes do lead to increases in wages. People in a developed country today are unlikely to accept a job at a wage which will not allow them to own or hire a television set or a refrigerator, while fifty or a hundred years ago, that was not the case. This is because crude methods of redistributing wealth have raised people's expectations. Unemployment pay and social security also form a lowest tolerable level of existence. Unemployment pay is the modern day equivalent of living at the margin of production.

Another factor at work is competition betweeen landowners. If Goliath had driven David out of his shop, it is quite likely that David would have found another landowner nearby who would have been prepared 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 the Land. It requires us to focus our attention less on agricultural Land and more on the Land under our cities, businesses and homes, for that is where 90% of Rent is collected by landowners.

In other pamphlets in this series, we show how this fact bears on a great many other problems; housing and homelessness, unemployment, booms and slumps, transport and communications and so on. More important still, we show a way in which it is possible to ensure that all the cream should go collectively to those who are performing a useful function and not to people who are merely deriving benefit from the rich fund of nature and from the initiative and exertions of others.

Published by:

HENRY GEORGE FOUNDATION