Economic Rent and Opportunity Cost

CFA Level 1 - Macroeconomics

Economic Differences of Small and Large Incomes

These differences are best explained by the concept of marginal revenue product, which we discussed earlier in the chapter. Remember that marginal revenue product of a resource is defined as the increase in a firm's total revenue attributable to employing one more unit of that resource. The increase in output due to adding one more resource unit is called the marginal product. The relationship between additional resources and output implies that skilled laborers are three times as productive as unskilled labor, and therefore, firms are willing to pay skilled laborers three times as much as unskilled labor.

Keeping this in mind, workers with large incomes are associated with a high marginal revenue product, while those with small incomes are associated with a low marginal revenue product. For example, a star baseball pitcher (skilled labor) will have a high marginal revenue product, while a dishwasher (unskilled labor) will have a low marginal revenue product. Very few people are qualified to pitch in Major League Baseball, while there are many people qualified to wash dishes.

Economic Rent and Opportunity Costs

Economic rent is the difference between what an owner of a factor of production (such as land, capital or labor) receives and the opportunity cost for that owner.

Let's suppose the factor of production is labor. In this example, the laborer receives $20/per hour for their job, and the minimum salary they'd be willing to work for (opportunity cost) is $16/per hour. This $4/hour difference is the laborer's economic rent. In the case of the superstar baseball pitcher, most of the salary earned may be economic rent. Most of a wages of a dishwasher is opportunity cost, since these types of jobs pay minimum wage.If the factor of production is a plot of land, the supply curve would be perfectly vertical, since there is no way for the landowner to supply additional land. In this case, all money received is economic rent.

The size of economic rent received by a owner of a factor of production is determined by the elasticity of supply for that particular good or service. 

• If the elasticity of supply is neither elastic nor inelastic, the supply curve will slope upward and the supplier's income would be split between economic rent and opportunity cost.
• If the elasticity of supply is inelastic, the supply curve would be perfectly vertical and the supplier's entire income would be comprised of economic rent. For example, if the supply were a particular plot of land, or a
• If the elasticity of supply is elastic, the supply curve would be perfectly horizontal, and the supplier's entire income would be comprised of opportunity cost.

Look Out! Do not confuse "economic rent" with "rent". The rent paid each month to live in an apartment, or to lease a car is not the same. Remember that economic rent is simply a component of the income received by a supplier of a good or service.

(See more) Monitoring Cycles, Jobs, and Price Level

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