Explain Ricardian Theory of Rent

The theory of economic rent was first propounded by the English classical economist David Ricardo. David Ricardo in his book “Principles of Political Economy and Taxation” defined rent as “That portion of produce of the earth which is paid to a land lord on account of the original and indestructible powers of the sil.” Ricardo in his theory of rent has emphasized the rent is reward for the services of the land which is fixed in supply. Secondly it arises due to original qualities of land which are indestructible. The original indestructible powers of the gil include nature soil fertility, mineral deposits, climatic conditions etc.

Rent under extensive cultivation:

According to Ricardo, all the units of land are not of the same grade. They differ in fertility and location. The application of the same amount of labour, capital and other cooperating resources give rise to difference in productivity. The difference in productivity or the surplus which arises on the superior unit of land over the inferior unit is an economic rent. The Ricardian Theory of rent is explained by taking an example. Let us look at the following schedule.

Grade of Land	Yield in quintals Per Acre	Price per quintal	Total returns
A B C D	50 35 20 15	Rs. 500 Rs. 600 Rs. 700 Rs. 800	25000 21000 14000 12000

In the above schedule we assume that there are four grades of land in an uninhabited country. A grade level is more fertile than B grade land. B grade land is superior to C grade land and so is C grade land to D grade land. Following Ricardo let us assume a batch of settlers to migrate to this island. They begin to cultivate A grade land which yields 60 quintals of wheat per acre. The population of that island increases and A grade land is not sufficient to meet the food requirements of growing population. Then the people of that island brought B grade land under cultivation that yields 35 quintals of wheat per acre. A surplus of 15 quintals of wheat which arises with the same outlay on A grade land is an economic rent. B grade land being marginal land gives no rent. When owing to the pressure of growing population and a rise in demand for food. C grade land is brought under cultivation. It yields only so quintals of wheat with identical amount of labour and capital.

With the cultivation of C grade land the economic rent of A grade land is now raised to 30 quintals of wheat per acre. C grade land is no rent land as it is cultivated at the margin. If expenses of production on A grade land yielding 50 quintals of wheat are Rs. 25000 than A grade land only will be brought under cultivation. A grade land here is marginal land. If the price of agricultural produce increases (Rs. 600 per quintal) and the expenses of producing wheat on B grade land are equal to the market price of produce i.e. Rs. 21000 then B grade land which were hitherto neglected would be brought under cultivation. B grade land then become marginal land. Similarly D grade land will be the marginal land when it compensates the cultivator by giving a yield of Rs. 12000 and enjoys no surplus over cost. Marginal land is thus not fixed. It varies with the change in price of agriculture produce.

The Ricardian model is now explained will the help of diagram.

In the above figure the various grades of land in the descending order of fertility are plotted on the OX axis. The cultivated area due to pressure of population and the rising demand of food is pushed to D grade of land which is marginal land. The owner of A grade land get surplus or economic rent of 35 quintals of wheat on b 20 quintals and on C the rent is 5 quintals of wheat.

Rent under intensive cultivation:

The theory of rent which has been discussed above applies to intensive margin of cultivation. The surplus or economic rent also arises to the land cultivated intensively. This occurs due to the operation of the famous law of diminishing returns. When the land is cultivating intensively the application of additional doses of labour and capital bring in less and less of yield. The dose whose cost just equates the value of marginal return is regarded marginal or no rent dose. The rent arises on all the infra marginal dose. For example the application of first unit of labour and capital piece of land yields 25 quintals of wheat, the second dose gives 15 quintals and third dose down the 10 quintals only. The farmer applies 3 doses of labour and capital as the total outlay on the third dose equals its return. The rent when measured from the third or marginal dose is 15 quintals (25 – 10 = 15) on first dose and 5 quintals on second dose (15 – 10 = 5). The third dose is no rent dose.

What is Modern Theory of Rent?

The modern economists like Pareto, Mrs. Joan Robinson, Boulding, Singer, and Shepherd have tried to simplify and generalize the Ricardian Theory of Rent. According to them the Ricardian theory of rent is too closely related to land. This creates an impression that rent is a peculiar earning a land only. The fact however is that other factors of production i.e. labour, capital and entrepreneurship may also be earning economic rent. The determination of economic rent, the modern economists say, can be explained in the same manner as the reward of other factors, which is by demand and supply factor.

Demand and Supply Analysis

A) Demand for a factor: The demand for a factor which may be land labour or capital is a derived demand. Land say for instance is demanded for its produce. The higher the produce, the greatest is the demand for land. A firm will pay rent equal to the marginal revenue productivity of land. The rent diminishes as more land is used due to the operation of law of diminishing returns. The demand curve of a factor is therefore negatively sloped which means more land will be used only at lower rents, other things of course remaining the same.

B) Supply of a factor: The supply of land to a particular use, say industry is quite elastic. It can be shifted to other uses by offering higher than that being earned by it now. The supply of a factor to an industry is therefore rent elastic. If higher rent is paid, the supply of a factor can be increased by withdrawing it from other uses. The supply curve of factor (industry) sloped upward to the right.

Determination of Rent

The economic rent is determined by the representation of demand and supply curves for a factor.

In the above figure, the demand curve for factor says labour in a particular is D D' and the supply curve of workers is S S'. The wage rate of factor price of labour as determined by the market forces is OW. The total workers employed in a particular industry at OW wages rate is OL. The total earning of the workers employed is equal to the area OWEL. At wage rate OW there are workers who would work at lower pay but they are also paid at OW wage rate. Those workers whose transfer earnings are less than this wage rate will be getting economic rent. The total economic rent earned by all the intra marginal workers is equal in the area WES. The marginal worker i.e. L^th worker is not obtaining any rent or surplus.

C) Rent is a Surplus Return: The modern economists are also of the view that rent as a surplus can be earned by other factors also. It is not peculiar to land alone as explained by Ricardo. The modern theory of rent is that it is the difference between the actual earning of a factor until over its transfer earnings. The transfer earnings of a factor of production are the minimum payment required for preventing that factor for transferring it to some other use. It is called the factor supply price in it present occupation. For example a worker earns Rs. 6000 per month in a factory in the next best employment, he can excess of Rs. 1000 which a worker is earning over and above the minimum payment necessary for inducing him to work in present occupation is the economic rent.

Economic rent depends on the elasticity of supply of the factor of production.

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Concept Of Reverse Stock Splits

The company may want to reduce the number of share outstanding if its share price falls substantially. Number of share is reduced by reverse stock split. The reduction of the number of outstanding share increases both the par value per share and market price per share. Reverse stock split also increases earning per share and dividend per share. It is just opposite of stock splits.

Example,

Suppose, total shareholder's account of a firm is as follows:

A. Common stock (10,000 Shares @ $ 10).........................= $ 100,000

B. Additional paid in capital...................................................= $ 100,000

C. Retained earnings..............................................................= $ 300000

Total shareholder's equity....................................................= $ 500,000

Now let us assume that the firm announced 2-for-5 reverse stock split, which results into decrease in number of outstanding shares from 10,000 shares to 4,000 shares (i.e. 10,000 shares x 2/5) and increase in the par value from $10 per share to $ 25 per share ( i.e. $10 x 5/2). This keeps the value of common stock constant at $ 100,000 ( i.e. 4,000 x $25). Thus, total shareholder's equity account of the firm after 2-for-5 reverse stock splits appear as:

A. Common stock (4,000 shares @ $25 each).......................= $ 100,000

B. Additional paid in capital .....................................................= $ 100,000

C. Retained earnings ................................................................= $ 300,000

Total shareholder's equity (A+B+C)......................................= $ 500,000.

Concept Of Stock Splits And Its Value To Shareholders

A stock split is similar to a stock dividend in economic sense. When a company announces stock splits, it results into an increase in number of outstanding shares with a proportionate decrease in par value and market price of the stocks. Therefore, firms with exceptionally high market prices split their stocks in order to bring the market price within reasonable limits. As a result, small investors can purchase the company's share. With a stock split, total value of the shares of common stock outstanding remains unchanged along with no change in paid-in capital and retained earnings.

Example,

Suppose, a firm has the following total shareholder's equity account before stock split:

A. Common stock ( 4000 shares @ $10)...................=$ 40,000

B. Additional paid-in capital........................................= $ 20,000

C. Retained earnings ....................................................= $ 90,000

Total shareholder's equity (A+B+C)...........................= $ 150,000

If the firm announces 2-for-1 stock splits, it results into an increase in outstanding shares from 4,000 shares to 8,000 shares (i.e 4,000 shares x2) and reduction in the par value from $ 10 per share to $ 5 per share (i.e. $10 x 1/2). This keeps the value of common stock constant at $ 40,000 (i.e 8,000 shares x $ 5). Total shareholder's equity accounts of the firm after 2-for-1 stock splits announcement appears as:

A. Common stocks ( 8,000 shares @ $ 5 each)....................= $ 40,000

B. Additional paid in capital.....................................................= $ 20,000

C. Retained earnings................................................................= $ 90,000

Total shareholder's equity (A+B+C)......................................= $ 150.000

Unlike in stock dividend, stock split does not involve transfer of funds from retained earnings to paid-in capital and common stock accounts.

Stock splits do not change the proportionate ownership of the company. Therefore, stock splits has no economic value to the investors or shareholders. When the number of shares held by shareholders increases, because of stock splits, the market price of the stock should decrease proportionately to remain the total value of common stock unchanged.

Concept Of Stock Dividend And Its Value To Investors

A stock dividend refers to the dividend paid to existing stockholders in the form of additional shares of common stock. Unlike cash dividends it does not result into the cash outflows. The purpose of stock dividend is to conserve cash in the firm, so that it can be used in new projects. It involves simple book keeping transfer from retained earnings to the capital stock account. The stock dividend does not affect the equity position of stockholders; rather it represents a recapitalization of a company which takes place in the form of transfer of certain amount from firm's retained earnings to capital stock account.

Example,

Suppose a firm has following total shareholder's equity account before a 20 percent stock dividend announcement:

A. Common stock (100,000 shares of $ 10 par) .........= $ 1,000,000

B. Additional paid in capital.............................................= $ 200,000

C. Retained earnings........................................................= $ 1,800,000

Total shareholder's equity(A+B+C)..............................= $ 3,000,000

If the firm announces 20% stock dividends, the firm has to issue additional 20,000 shares in common stock. To illustrate the effect of stock dividend on total shareholder's equity accounts, let us assume that current market price of the stock is $ 40. So, amount of stock dividend will be $ 800,000 (i.e. $40 x 20,000 shares). The total amount of dividend is transferred to common stock account and additional paid-in capital from retained earnings. Since par value of common stock is $ 10 a total of $ 200,000 (i.e. $10 x 20,000 shares) is transferred to common stock account and rest $ 600,000 (i.e $ 30 x 20,000 shares) is added to paid-in capital. Thus, the total amount of shareholder's equity remains the same. total shareholder's equity account after 20% stock dividend appears as follows:

A. Common stock( 120,000 Shares of $ 10 par)...............= $1,200,000

B. Additional paid-in capital.................................................= $ 800,000

C. Retained earnings.............................................................= $ 1,000,000

Total shareholder's equity (A+B+C)..................................= $ 3,000,000

Stock dividend generally has no economic significance as it only results into change in capitalization keeping total equity position constant. Stock dividend simply results into an increase in outstanding shares of common stock. In the above example, with a 20% stock dividend, there is an increase in outstanding shares of common stock from 100,000 shares to 120,000 shares.

Factors Affecting Dividend Policy Of A Firm

A firm's dividend policy is influenced by the large numbers of factors. Some factors affect the amount of dividend and some factors affect types of dividend. The following are the some major factors which influence the dividend policy of the firm.

1. Legal requirements

There is no legal compulsion on the part of a company to distribute dividend. However, there certain conditions imposed by law regarding the way dividend is distributed. Basically there are three rules relating to dividend payments. They are the net profit rule, the capital impairment rule and insolvency rule.

2. Firm's liquidity position

Dividend payout is also affected by firm's liquidity position. In spite of sufficient retained earnings, the firm may not be able to pay cash dividend if the earnings are not held in cash.

3. Repayment need

A firm uses several forms of debt financing to meet its investment needs. These debt must be repaid at the maturity. If the firm has to retain its profits for the purpose of repaying debt, the dividend payment capacity reduces.

4. Expected rate of return

If a firm has relatively higher expected rate of return on the new investment, the firm prefers to retain the earnings for reinvestment rather than distributing cash dividend.

5. Stability of earning

If a firm has relatively stable earnings, it is more likely to pay relatively larger dividend than a firm with relatively fluctuating earnings.

6. Desire of control

When the needs for additional financing arise, the management of the firm may not prefer to issue additional common stock because of the fear of dilution in control on management. Therefore, a firm prefers to retain more earnings to satisfy additional financing need which reduces dividend payment capacity.

7. Access to the capital market

If a firm has easy access to capital markets in raising additional financing, it does not require more retained earnings. So a firm's dividend payment capacity becomes high.

8. Shareholder's individual tax situation

For a closely held company, stockholders prefer relatively lower cash dividend because of higher tax to be paid on dividend income. The stockholders in higher personal tax bracket prefer capital gain rather than dividend gains.

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