Microsoft Chairman Bill Gates is the richest man on the planet largely because the compatibility issue prevents rival vendors from competing effectively in the many software markets his company dominates.
Yet many people have become fabulously wealthy, even in markets without obvious barriers to entry. If market forces push economic profit toward zero, how can this happen?
The answer to this question rests on the distinction between economic profit and economic rent.
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Most people think of rent as the payment they make to a landlord or supplier for a dorm refrigerator, but the term economic rent has a different meaning.
Economic rent is the part of the payment for an input that is greater than the supplier’s reservation price for that input.
Suppose, for example, that a landowner’s reservation price for an acre of land is $100 per year.
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That is, suppose he would be willing to lease it to a farmer as long as he received an annual payment of at least $100, but for less than that amount he would prefer to leave it fallow. If a farmer gives him an annual payment of not $100 but $1,000, the landowner’s economic rent from that payment will be $900 per year.
Economic profit is like economic rent in that it can also be thought of as the difference between what someone is paid (the business owner’s total income) and their reservation price for staying in business (the sum of all its costs, explicit and implicit).
But while competition pushes economic profit toward zero, it has no such effect on economic rent for inputs that cannot be easily replicated.
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For example, although land rents may remain well above the owner’s reservation price year after year, new land cannot be brought to market to reduce or eliminate economic rent through competition. There is, after all, only a limited amount of land to own.
Example
As the following example illustrates, economic rent can accrue to people as well as to land.
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What economic rent will a talented chef earn?
A community has 100 restaurants, 99 of which employ chefs of normal capacity with a salary of $30,000 a year, the same amount they could earn in other equally attractive professions.
But the 100th restaurant has an exceptionally talented chef. Because of her reputation, diners are willing to pay 50% more for the meals she cooks than for those prepared by ordinary chefs.
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The owners of the 99 restaurants with ordinary chefs each receive $300,000 in revenue per year, which is just enough to ensure that everyone makes exactly a normal profit.
If the talented chef’s opportunities outside of catering are the same as ordinary chefs, how much will she be paid by her employer at breakeven? How much of his salary will be economic rent? What economic profit will his employer gain?
Because diners are willing to pay 50% more for meals cooked by the talented chef, the owner who hires him will receive total revenue not of $300,000 a year but $450,000.
In the long run, the competition should ensure that the talented chef’s total salary each year will be $180,000 per year, the sum of the $30,000 that ordinary chefs receive and the $150,000 in additional income that she is solely responsible for.
Since the talented chef’s reservation price is the amount she could earn outside of the restaurant industry—assumed $30,000 a year, the same as for ordinary chefs—her economic rent is $150,000 per year. The economic profit of the owner who hires him will be exactly zero.
Given that the talented chef’s opportunities outside the restaurant industry are no better than those of a regular chef, why is it necessary to pay the talented chef so much?
Suppose his employer only pays him $60,000, which they both would consider a generous salary since it’s twice what ordinary chefs earn.
The employer would then realize an economic profit of $120,000 per year since its annual income would be $150,000 higher than that of ordinary restaurants, but its costs would only be $30,000 more.
But this economic profit would create an opportunity for the owner of another restaurant to outbid the talented chef. For example, if the owner of a competing restaurant were to hire the talented chef with a salary of $70,000, the chef would earn $10,000 per year and the rival owner would earn an economic profit of $110,000 per year, rather than his current economic income. profit of zero.
Additionally, if the talented chef is the only reason a restaurant is making a positive economic profit, bidding for that chef should continue as long as there is economic profit remaining. Another owner will pay him $80,000, another $90,000, and so on.
Equilibrium will only be reached when the talented leader’s salary has been offered to the point that there is no economic profit left – in our example, at an annual salary of $180,000.
This bidding process assumes, of course, that the reason for the chef’s superior performance is that she possesses a personal talent that cannot be copied.
If it was instead the result of, say, training at a culinary institute in France, then his privileged position would erode over time as other chefs sought similar training.
SUMMARY ECONOMIC RENT VERSUS ECONOMIC PROFIT
Economic rent is the amount by which the payment to a factor of production exceeds the supplier’s reserve price. Unlike economic profit, which is pushed to zero by competition, economic rent can persist for long periods of time, especially in the case of factors with special talents that cannot be easily duplicated.
