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5. Capitalization and Rent
The subject of “rent” is one of the most confused in the entire economic literature. We must, therefore, reiterate the meaning of rent as set forth above. We are using “rent” to mean the unit price of the services of any good. It is important to banish any preconceptions that apply the concept of rent to land only. Perhaps the best guide is to keep in mind the well-known practice of “renting out.” Rent, then, is the same as hire: it is the sale and purchase of the unit services of any good.22 It therefore applies as well to prices of labor services (called “wages”) as it does to land or to any other factor. The rent concept applies to all goods, whether durable or nondurable. In the case of a completely nondurable good, which vanishes fully when first used, its “unit” of service is simply identical in size with the “whole” good itself. In regard to a durable good, of course, the rent concept is more interesting, since the price of the unit service is distinguishable from the price of the “good as a whole.” So far, in this work, we have been assuming that no durable producers’ goods are ever bought outright, that only their unit services are exchanged on the market. Therefore, our entire discussion of pricing has dealt with rental pricing. It is obvious that the rents are the fundamental prices. The marginal utility analysis has taught us that men value goods in units and not as wholes; the unit price (or “rent”) is, then, the fundamental price on the market.
In chapter 4 we analyzed rental pricing and the price of the “good as a whole” for durable consumers’ goods. The principle is precisely the same for producers’ goods. The rental value of the unit service is the basic one, the one ultimately determined on the market by individual utility scales. The price of the “whole good,” also known as the capital value of the good, is equal to the sum of the expected future rents discounted by what we then vaguely called a time-preference factor and which we now know is the rate of interest. The capital value, or price of the good as a whole, then, is completely dependent on the rental prices of the good, its physical durability, and the rate of interest.23 Obviously, the concept of “capital value” of a good has meaning only when that good is durable and does not vanish instantly upon use. If it did vanish, then there would only be pure rent, without separate valuations for the good as a whole. When we use the term “good as a whole,” we are not referring to the aggregate supply of the whole good in the economy. We are referring, e.g., not to the total supply of housing of a certain type, but to one house, which can be rented out over a period of time. We are dealing with units of “whole goods,” and these units, being durable, are necessarily larger than their constituent unit services, which can be rented out over a period of time.
The principle of the determination of “capital values,” i.e., prices of “whole goods,” is known as capitalization, or the capitalizing of rents. This principle applies to all goods, not simply capital goods, and we must not be misled by similarity of terminology. Thus, capitalization applies to durable consumers’ goods, such as houses, TV sets, etc. It also applies to all factors of production, including basic land. The rental price, or rent, of a factor of production is equal, as we have seen, to its discounted marginal value product. The capital value of a “whole factor” will be equal to the sum of its future rents, or the sum of its DMVPs.24 This capital value will be the price for which the “whole good” will exchange on the market. It is at this capital value that a unit of a “whole good” such as a house, a piano, a machine, an acre of land, etc., will sell on the market. There is clearly no sense to capitalization if there is no market, or price, for the “whole good.” The capital value is the appraised value set by the market on the basis of rents, durability, and the interest rate.
The process of capitalization can encompass many units of a “whole good,” as well as one unit. Let us consider the example of chapter 4, section 7, and generalize from it to apply, not only to houses, but to all durable producers’ goods. The good is a 10-year good; expected future rents are 10 gold ounces per year (determined by consumer utilities for consumers’ goods, or by MVPs for producers’ goods). The rate of interest is 10 percent per annum. The present capital value of this good is 59.4 gold ounces. But this “whole good” is itself a unit of a larger supply; one of many houses, machines, plants, etc. At any rate, since all units of a good have equal value, the capital value of two such houses, or two such machines, etc., added together equals precisely twice the amount of one, or 118.8 ounces. Since we are adding rents or DMVPs in money terms, we may keep adding them to determine capital values of larger aggregates of durable goods. As a matter of fact, in adding capital values, we do not need to confine ourselves to the same good. All we need do is to add the capital values in whatever bundle of durable goods we are interested in appraising. Thus, suppose a firm, Jones Construction Company, wishes to sell all its assets on the market. These assets, necessarily durable, consist of the following:
- 3 machines. Each machine has a capital value (based on the sum of the DMVPs) of 10 ounces. Therefore, total capital value is 30 ounces.
- 1 building, with a capital value of 40 ounces.
- 4 acres of land. Each acre has a capital value of 10 ounces. Total is40 ounces.
- Total capital value of these assets: 110 ounces.
But we must always remember, in adding capital values, that these are relevant only in so far as they are expressed in market price or potential market price. Many writers have fallen into the trap of assuming that they can, in a similar way, add up the entire capital value of the nation or world and arrive at a meaningful figure. Estimates of National Capital or World Capital, however, are completely meaningless. The world, or country, cannot sell all its capital on the market. Therefore, such statistical exercises are pointless. They are without possible reference to the very goal of capitalization: correct estimation of potential market price.
As we have indicated, capitalization applies to all factors of production, or rather, to all factors where there are markets for the whole goods that embody them. We may call these markets capital markets. They are the markets for exchange of ownership, total or partial, of durable producers’ goods. Let us take the case of capital goods. The rent of a capital good is equal to its DMVP. The capitalized value of the capital good is the sum of the future DMVPs, or the discounted sum of the future MVPs. This is the present value of the good, and this is what the good will sell for on the capital market.
The process of capitalization, because it permeates all sectors of the economy, and because it is flexible enough to include different types of assets—such as the total capital assets of a firm—is a very important one in the economy. Prices of shares of the ownership of this capital will be set at their proportionate fraction of the total capital value of the assets. In this way, given the MVPs, durability, and the rate of interest, all the prices on the capital market are determined, and these will be the prices in the ERE. This is the way in which the prices of individual capital goods (machines, buildings, etc.) will be set on the market, and this is the way in which these values will be summed up to set the price of a bundle of capital assets, similar and dissimilar. Share prices on the stock market will be set according to the proportion that they bear to the capitalized value of the firm's total assets.
We have stated that all factors that can be bought and sold as “whole goods” on the market are capitalized. This includes capital goods, ground land, and durable consumers’ goods. It is clear that capital goods and durable consumers’ goods can be and are capitalized. But what of ground land? How can this be capitalized?
We have seen in detail above that the ultimate earnings of factors go to the owners of labor and of ground land and, as interest, to capitalists. If land can be capitalized, does this not mean that land and capital goods are “really the same thing” after all? The answer to the latter question is No.25 It is still emphatically true that the earnings of basic land factors are ultimate and irreducible, as are labor earnings, while capital goods have to be constantly produced and reproduced, and therefore their earnings are always reducible to the earnings of ground land, labor, and time.
Basic land can be capitalized for one simple reason: it can be bought and sold “as a whole” on the market. (This cannot be done for labor, except under a system of slavery, which, of course, cannot occur on the purely free market.) Since this can be and is being done, the problem arises how the prices in these exchanges are determined. These prices are the capital values of ground land.
A major characteristic of land as compared to capital goods is that its series of future rents is generally infinite, since, whether as basic soil or site, it is physically indestructible. In the ERE, the series of future rents will, of course, always be the same. The very fact that any land is ever bought and sold, by the way, is a demonstration of the universality of time preference. If there were no time preference for the present, then an infinite series of future rents could never be capitalized. A piece of land would have to have an infinite present price and therefore could never be sold. The fact that lands do have prices is an indication that there is always a time preference and that future rents are discounted to reduce to a present value.
As in the case of any other good, the capital value of land is equal to the sum of its discounted future rents. For example, it can be demonstrated mathematically that if we have a constant rent expected to be earned in perpetuity, the capital value of the asset will equal the annual rent divided by the rate of interest.26 Now it is obvious that on such land, the investor annually obtains the market rate of interest. If, in other words, annual rents will be 50, and the rate of interest is 5 percent, the asset will sell for 50/.05, or 1,000. The investor who purchases the asset for 1,000 ounces will earn 50 ounces a year from it, or 5 percent, the market rate of interest.
Ground land, then, is “capitalized” just as are capital goods, shares in capital-owning firms, and durable consumers’ goods. All these owners will tend to receive the same rate of interest return, and all will receive the same rate of return in the ERE. In short, all owned assets will be capitalized. In the ERE, of course, the capital values of all assets will remain constant; they will also be equal to the discounted sum of the MVPs of their unit rents.
Above, we saw that a key distinction between land and capital goods is that the owners of the former sell future goods for present money, whereas the owners of the latter advance present money, buy future goods, and later sell their product when it is less distantly future. This is still true. But then we must ask the question: How does the landowner come to own this land? The answer is (excepting his or his ancestors’ finding unused land and putting it to use) that he must have bought it from someone else. If he did so, then, in the ERE, he must have bought it at its capitalized value. If he buys the piece of land at a price of 1,000 ounces, and receives 50 ounces per annum in rent, then he earns interest, and only interest. He sells future goods (land service) in the production process, but he too first bought the whole land with money. Therefore, he too is a “capitalist-investor” earning interest.
“Pure rent,” i.e., rent that is not simply a return on previous investment and is therefore not capitalized, seems, therefore, to be earned only by those who have found unused land themselves (or inherited it from the finders). But even they do not earn pure rent. Suppose that a man finds land, unowned and worth zero, and then fences it, etc., until it is now able to yield a perpetual rental of 50 ounces per annum. Could we not say that he earns pure rent, since he did not buy the land, capitalized, from someone else? But this would overlook one of the most important features of economic life: implicit earnings. Even if this man did not buy the land, the land is now worth a certain capital value, the one it could obtain on the market. This capital value is, say, 1,000. Therefore, the man could sell the land for 1,000 at any time. His forgone opportunity cost of owning the land and renting out its services is sale of the land for 1,000 ounces. It is true that he earns 50 ounces per year, but this is only at the sacrifice of not selling the whole land for 1,000 ounces. His land, therefore, is really as much capitalized as land that has been bought on the market.
We must therefore conclude that no one receives pure rent except laborers in the form of wages, that the only incomes in the productive ERE economy are wages (the term for the prices and incomes of labor factors) and interest. But there is still a crucial distinction between land and capital goods. For we see that a fundamental, irreducible element is the capital value of land. The capital value of capital goods still reduces to wages and the capital value of land. In a changing economy, there is another source of income: increases in the capital value of ground land. T y p ical was the man who found unused land and then sold its services. Originally, the capital value of the land was zero; it was worthless. Now the land has become valuable because it earns rents. As a result, the capital value has risen to 1,000 ounces. His income, or gain, consisted of the rise of 1,000 ounces in capital value. This, of course, cannot take place in the ERE. In the ERE, all capital values must remain constant; here, we see that a source of monetary gain is a rise in the capital value of land, a rise resulting from increases in expected rental yields of land.27 If the economy becomes an ERE after this particular change from zero to 1,000, then this income was a “one-shot” affair, rather than a continuing and recurring item. The capital value of the land rose from zero to 1,000, and the owner can reap this income at any time. However, after this has been reaped once, it is never reaped again. If he sells the land for 1,000, the next buyer receives no gain from the increase in capital value; he receives only market interest. Only interest and wages accrue continuously. As long as the ERE continues, there will be no further gains or losses in capital value.28
- 22. This concept of rent is based on the original contribution of Frank A. Fetter. Cf. Fetter, Economic Principles, pp. 143–70. Fetter's conception has, unfortunately, had little influence on economic thought. It is not only in accord with common usage; it provides a unifying principle, enabling a coherent explanation of the price determination of unit services and of the whole goods that embody them. Without the rental-price concept, it is difficult to distinguish between the pricing of unit services and of whole goods.
Fetter used the rental concept to apply only to the services of durable goods, but it is clear that it can be extended to cover cases of nondurable goods where the unit service is the whole good.
- 23. See chapter 4 above. On capitalization, see Fetter, Economic Principles, pp. 262–84, 308–13; and Böhm-Bawerk, Positive Theory of Capital, pp. 339–57.
- 24. It is often more convenient to define rent as equal to the MVP, rather than the DMVP. In that case, the capital value of the whole factor is equal to the discounted sum of its future rents.
- 25. Fetter's main error in capital theory was his belief that capitalization meant the scrapping of any distinction between capital goods and land.
- 26. Cf. Boulding, Economic Analysis, pp. 711–12.
- 27. In the long run, increases in the capital value of capital goods are unimportant, since they resolve into increases in wages and increases in the capital value of ground land.
- 28. The problem of gains from changes in capital values will be treated further below.