Supporting Material is available for this work. For more information, follow the link from
the Table of Contents to "Accessing Supporting Material".
Table of Contents
ON THE THEORY OF RENT
AND THE DYNAMICS OF PROFITABILITY
Jeff W. Trailer, Ph.D.
The Califomia State University, Chico
College of Business
Chico, CA 95929-0031
Office: 530-898-6570
jtrailer@ csuchico.edu
ON THE THEORY OF RENT
AND THE DYNAMICS OF PROFITABILITY
Abstract
For virtually all firms, successfully setting performance targets has proven difficult, likely
due to the inherent structure of their environment’s competitive dynamics; multi-loop, nonlinear
feedback systems. This seems especially true for firms competing with a low cost strategy, in
commodity markets, because the mechanics of profitability seem simple but are actually counter-
intuitive. This paper presents a dynamic Low Cost Strategy model that explicitly models the
competitive dynamics peculiar to commodity markets (energy, agriculture, ...etc) to investigate the
dynamic causes of rent-type profit. This paper shows that a simple system dynamic model is able to
confirm, and make explicit, the abstract propositions of Adam Smith, David Ricardo, J ohn Stuart
Mill, and Vilfredo Pareto in regard to Rent-type profit.
For virtually all firms, successfully setting performance targets has proven difficult, likely
due to the inherent structure of their environment’s competitive dynamics; multi-loop, nonlinear
feedback systems. This seems especially true for firms competing with a low cost strategy, in
commodity markets, because the mechanics of profitability seem simple but are actually counter-
intuitive. A low cost strategy simulation model would help managers to investigate and better
understand the dynamic causes of rent-type profit. This paper reviews the mechanics of economic
rent and then presents a system dynamics model able to make explicit the abstract propositions of
Adam Smith, David Ricardo, John Stuart Mill, and Vilfredo Pareto.
STRATEGY AND THE MECHANICS OF PROFITABILITY
The field of strategy has employed the theory of rent as a basis for arguing policies and
behavior that will produce retums in excess of the “ordinary profit” rate. That is, by delineating the
causal structure of profitability, one can deduce the actions necessary to formulate an effective
strategy for the fim. Our ability to dictate the proper course of action is limited, then, by the extent
to which we understand the causal and dynamic structure of profits. Thus, rent, as one component
of profits, is integral to our understanding of strategy formulation.
The theory of rent offers a means of clarifying the consequences of the behavior of the firm
given knowledge of the firm’s competitive environment structure. For example, rent has been used
to explain how firms can generate retums above the ordinary rate through simultaneous competition
and cooperation (Lado, Boyd and Hanlon, 1997), how unique resources create sustainable
competitive advantage (Peteraf, 1993), how investment in specialized assets favor vertical
integration (Klein, Crawford and Alchian, 1978), why firms diversify in response to excess capacity
of factors that are subject to market failure (Montgomery and Wemerfelt, 1988), and how
managerial skills and expertise create sustainable competitive advantage (Castanias and Helfat,
1991).
Of rent theory, Mill states,“ It is one of the cardinal doctrines of political economy; and until
it was understood, no consistent explanation could be given of many of the more complicated.
industrial phenomena” (Mill, 1902; 520). The potential contributions to the understanding of
market forces and the strategic behavior of the firm are likewise profound, and worthy of
explication and extension. Ironically, the rent theory was created and developed in economics so
that it could be eliminated from further discussion on the creation of value, and the determination of
price. Because it is argued not to have an effect on these issues, the theory has, and continues to be
debated (Winch, 1992). These debates have led to numerous re- definitions of the term to suit the
analytical needs of various academic fields. What is needed is a means of formalizing the abstract
reasoning of the last 200 years, to make explicit the causal nature of profit, and to demonstrate that
the mechanics hold across time. The purpose of this paper is to investigate how System Dynamics
modeling may provide the means to solve this problem.
The problem of inconsistency and ambiguity in the theory of rent
The problem begins with the premise that economic rent is not equal to profit. In explaining
why this is so, researchers employ different definitions of rent. Differences in these definitions are
understandable given the long, dynamic history of the development of the topic (see Bye, 1940; and
Keiper, Kumow, Clark and Segal, 1961). However, a variety of definitions are all being used at
once in the field of strategy. Examples of rent theory cited in strategy research include Ricardian
rent (Montgomery and Wemerfelt, 1988), economic rent (Lado, Boyd and Hanlon, 1997),
monopoly rents, opportunity cost rent (Peteraf, 1993), managerial rents, (Castanias and Helfat,
1991), organizational rent (Amit and Schoemaker, 1993), Pareto and Marshall rent, entrepreneurial
rent (Rumelt, 1987), systematic rent, temporary rent, quasi rent (Schoemaker, 1990), and
appropriable quasi rent (Klein, Crawford & Alchian, 1978).
As noted by Marshall (1901: 410), “This doctrine (the rent theory) is however difficult, and
easily misunderstood.” This inherent difficulty of applying the rent theory is aggravated, I believe,
by our inconsistency and this creates ambiguity. Camerer and Fahey (1990) argue that the field of
strategy would benefit from a more deductive logic approach to theory development. Accordingly,
when our theoretical premises are not precise, it is impossible to draw any rigorously logical
conclusion (Pareto, 1897). Popper (1959, 1983) is more specific, and argues that the fundamental
basis of science is the ability to falsify a premise of a theory. Thus, a theory that is ambiguous is of
litle value, as it may not be refuted by the evidence. The purpose of this paper is to provide a
definition of the rent theory that is specific to the field of strategy, in a rigorous, explicit manner.
By specific to the field of strategy I mean that the definition will focus on explaining the
performance of the firm, and will be tied explicitly to Porter’s (1980, 1985) generic competitive
strategies. By explicit, I mean that a system dynamics model is developed: the major premises
necessary to apply the argument are incorporated explicitly in a dynamic, non-linear model. In this
manner, the rent theory can be refuted or updated by rejecting and modifying individual premises
(in the model), consistent with Popper (1989).
This project begins with a formal description of a strategy- oriented theory of rent. To
provide a basis for arguing this definition of rent, the historical definitions will be quoted to
illustrate consistency or inconsistency with the theory prescribed. This theory of strategic rent
encompasses the mechanics of the classical (1770-1870) economic definition of the rent concept, as
well as the neoclassical period (1870-1935). Next, the specific major premises of the rent theory
are presented, and a generic System Dynamics model is presented to make explicit the theoretical
mechanics alluded to by Smith, Ricardo, Mill and Pareto. The analysis ends with a discussion of
the causal structure of rent, competitive advantage and retums in excess of the “ordinary” profit
rate. Managerial implications are discussed. In summary, the mechanics of profitability is
described in three components: “ordinary” profit, monopolistic, and rent. Each is regulated by
unique mules.
A STRATEGY-ORIENTED THEORY OF RENT
Strategic rent is that component of profit appropriated by owners of an input resource, when
a resource is employed with advantage in the production of a commodity. Whether the resource is
permanent, as in the case of land rent, or temporary, as in the case of capital rent, or intangible, as
in the case of knowledge rent, each is regulated by the same principle: it is the return to that
portion of productive inputs which are superior to the inputs of the producer with no advantage.
This principle explains the profit- mechanics of the low- cost competitive strategy. Profit from
differentiation is explained by an entirely different causal mechanism. Thus, strategic rent theory is
intended to clarify the link between altematives available to the manager, competitive advantage
and the performance of the firm.
This definition of strategic rent is a synthesis of classical and neoclassical propositions of
the rent theory as developed by Smith (1776), Ricardo (1821), Mill (1871), Pareto (1897), and
Marshall (1901). A review of their definitions illustrates the fundamental arguments preserved in
the strategy- oriented theory of rent.
Smith's “Rent.”
Adam Smith (1776) states that rent is equal to the surplus, or profit in excess of the
“ordinary profit” rate, received by the farmer and paid to the landlord:
“Rent, considered as the price paid for the use of land, is naturally the highest which the
tenant can afford to pay in the actual circumstances of the land. In adjusting the terms of the lease,
the landlord endeavors to leave himno greater share of the produce than what is sufficient to keep
up the stock from which he furnishes the seed, pays the labor, and purchases and maintains the
cattle and other instruments of husbandry, together with the ordinary profits of farming stock in the
neighborhood. This is evidently the smallest share with which the tenant can content himself
without being a loser, and the landlord seldom means to leave him any more (Smith, 1776: 144).”
The farmer cannot appropriate a larger share of the profit because it is assumed the landlord
can switch the lease to substitute farmers with no additional cost. As a consequence, the highest
rent to be charged is set by the substitutes available to the farmers competing for the use of the
famland. If “ordinary” profit is a required minimum payment necessary to compensate the farmer
for his or her opportunity cost of labor, then it may be treated as a cost, similar to wages, and it
follows that:
“Rent, itis to be observed, therefore, enters into the composition of the price of commodities
ina different way fromthe wages and (ordinary) profit. High or low wages and profit, are the
causes of high or low price; high or lowrent is the effect of it. It is because high or low wages and.
profit must be paid, in order to bring a particular commodity to market, that its price is high or low.
But it is because its price is high or low; a great deal more, or very little more, or no more, than
what is sufficient to pay those wages and profit, that it affords a high rent, or a low rent, or no rent
at all (Smith, 1776, 145-6).”
Itis important to note the use of the term “commodities” in the description above. If the
output is not a commodity, then the output has been differentiated and some control over price
exists. If any level of control exists, then price is not caused by wages and ordinary profit, a
violation of the definition above. Consequently, rent applies only when the resource in question, in
this case farmland, is used in the production of a commodity. This indicates an argument can be
made that rent does not explain excess retums due to differentiation of the product. This argument
will be developed further and made explicit below.
The assumption of a commodity output in determining rent is illustrated further when Smith
(1776) explains why changes in the obstacles to production affect price:
“The lowest price at which coals can be sold for any considerable time, is, like that of all
other commodities, the price which is barely sufficient to replace, together with its ordinary profits,
the stock which must be employed in bringing them to market (Smith, 1776: 167).”
On these issues, the formulation of the strategic rent is consistent with Smith (1776).
Ricardo’s “Land Rent.”
Ricardo (1821) argued that Smith’s definition, while essentially correct, was not rigorous
enough. He felt that the vague definition allowed inappropriate conclusions to be drawn, and set
about defining the rent theory in a manner that would be difficult to misinterpret. It is likely due to
the clarity and rigor of Ricardo’s definition that the theory of rent is more often attributed to him
rather than Smith, or other early developers of the theory (for a review of the history of the rent
theory see Buchanan, 1929).
Ricardo (1821) emphasized four major points: rent of land is attributable to the
indestructible power of the soil, rent is not equal to profit, land is heterogeneous in quality, and rent
does not determine price.
Ricardo was opposed to the attribution of rent to aspects of land other than (what he
believed to be) the indestructible power of the soil: “ ...whenever I speak of the rent of land, I wish
to be understood as speaking of that compensation which is paid to the owner of land for use of its
original and indestructible powers (Ricardo, 1821: 34).” This emphasis is essentially driven by the
argument that all other attributes deplete over time, and the cost of replacement must be deducted
from the rent.
In emphasizing that rent was not equal to profit, Ricardo recognizes that the causal structure
of rent and ordinary profit are entirely different: “ ..-the laws that regulate the progress of rent are
widely different from those which regulate the progress of (ordinary) profits, and seldom operate in
the same direction (Ricardo, 1821: 34). Consequently, he argues that it is necessary to distinguish
between the two in order to understand and predict the dynamic impact of extemal events on the
financial performance of farms.
To clarify the difference between rent and ordinary profit, Ricardo argues that rent is caused
by differences in the productivity of farmland: “Itis only, then, because land is not unlimited in
quantity and uniformin quality, and because, in the progress of population, land of an inferior
quality, or less advantageously situated, is called into cultivation, that rent is ever paid for the use
of it. When, in the progress of society, land of the second degree of fertility is taken into cultivation,
rent immediately commences on that of the first quality, and the amount of that rent will depend on
the difference in the quality of these two portions of land.
When land of the third quality is taken into cultivation, rent immediately commences on the
second, and it is regulated as before by the difference in their productive powers (Ricardo, 1821:
35).” Because rent is argued to be a function of the differences in the productiveness of the land,
Ricardo’s theory of rent is often labeled “differential rent’ or “efficiency rent.” (Figure 1).
Figure 1
Rent: One Component of Profitability
Ricardian type rent
Market Price
Average cost
/ possibilities curve
ae Cost trend
Pi
Demand
Qa Qs QA
Market Quantity
This notion of differences between firms (farms) is a deliberate violation of the traditional
“purely” efficient market assumption (Chamberlin, 1962), but is entirely consistent with the
resource- based view of the firm (Bamey, 1991; Wemerfelt, 1984). That is, competitive advantage
is attributable to ex ante and ex post market failure caused by differences in resources employed by
the various producers (Chi, 1994). However, efficiency rent applies only to producers of a
commodity. Thus, land rent explains the producer surplus resulting from a low cost competitive
advantage. That is, the output is undifferentiated so any excess retums are attributable to
differences in production costs between firms.
The efficiency rent assumption of a commodity output is reflected in Ricardo’s argument
that the “marginal producer,” or least efficiently produced unit, sets the price (exchangeable value)
and consequently establishes the benchmark for all other producers to measure their efficiency
rents:
“The exchangeable value of all commodities, whether they be manufactured, or the produce
of the mines, or the produce of the land, is always regulated not by the less quantity of labour that
will suffice for their production under circumstances highly favorable, and exclusively enjoyed by
those who have peculiar facilities of production; but by the greater quantity of labor necessarily
bestowed on their production by those who have no such facilities; by those who continue to
produce them under the most unfavorable circumstances; meaning -- by the most unfavorable
circumstances, the most unfavorable under which the quantity of produce required renders it
necessary to carry on the production (Ricardo, 1821: 37).”
Further, the commodity output premise is essential to the argument that rent does not cause,
or determine price: “ Raw material enters into the composition of most commodities, but the value
of that raw material, as well as com, is regulated by the productiveness of the portion of capital last
employed on the land and paying no rent; and therefore rent is not a component part of the price of
commodities (Ricardo, 1821: 41).”
Thus, the major premise of the differential rent theory is: when the sum of all costs to
produce a commodity by firm “ A” are less than the sum of the costs of the least efficient producer,
firm “B,” firm A will posses a low cost competitive advantage and eam rent equal to the difference
between costs of these two firms: “Without multiplying instances, I hope enough has been said to
show whatever diminishes the inequality in the produce obtained from successive portions of capital
employed on the same or on new land tends to lower rent; and that whatever increases that
inequality, necessarily produces an opposite effect, and tends to raise it (Ricardo, 1821: 44).” This
is consistent with the resource- based view arguments on the sustainability of a competitive
advantage: when an advantage can he transferred between firms on equivalent cost terms, or
imitated by rivals, the advantage diminishes and is ultimately eliminated.
Without multiplying instances, I hope enough has been said to show that the strategic rent
definition described above is consistent with Ricardo’s “efficiency rent” basis for determining the
unique performance of the firm.
Mill's “Rent”
John Stuart Mill's (1871) theory of rent is based on the efficiency rent argument of Smith
and Ricardo: “Any land yields just as much more than the ordinary profits of stock, as it yields
more than what is returned by the worst land in cultivation (Mill, 1871; 425).”
Mill, like Ricardo, was concemed with clearly defining the logic of the rent theory, but
unlike Ricardo, Mill believed that definitions could be too specific and consequently lose their
general utility: “We must never forget that the truths of political economy are truths only in the
rough: they have the certainty, but not the precision, of exact science (Mill, 1871; 428).”
Mill recognized that efficiency rent can be applied to any inputs to the production of a
commodity, not just to land. In the following, Mill discusses efficiency rent appropriated from a
cost advantage driven by a patent, or trade secret:
“Cases of extra profit analogous to rent, are more frequent in the transactions of industry
than is sometimes supposed. Take the case, for example, of a patent, or exclusive privilege for the
use of a process by which cost of production is lessened. If the value of the product continues to be
regulated by what it costs to those who are obliged to persist in the old process, the patentee will
make an extra profit equal to the advantage which his process possesses over theirs. This extra
profit is essentially similar to rent; and sometimes even assumes the form of it; the patentee
allowing to other producers the use of his privilege, in consideration of an annual payment (Mill,
1871; 476).”
In this case the efficiency rent is temporary, lasting only as long as the patent protection or
until the patent no longer provides a “cost of production” advantage. However temporary the nature
of the effect, the mechanics of efficiency rent are unaffected.
In another example, Mill applies efficiency rent to intangibles, such as knowledge: “The
extra gains which any producer or dealer obtains through superior talents for business, or superior
business arrangements, are very much ofa similar kind (Mill, 1871; 476).” This is consistent with
the knowledge-based view, and helps clarify the causal link between differences in business
knowledge and superior performance of the firm (Grant, 1996).
Ultimately, Mill argues that any resource or capability may be exploited in a manner
explained by efficiency rent if used to achieve a production advantage: “...any difference in favor
of a certain producers, or in favor of production in certain circumstances, being the source of a
gain, which, though not called rent unless paid periodically by one person to another, is governed
by laws entirely the same with it (Mill, 1871; 477).”
As a final note, one premise of rent is that cost is reduced relative to at least one other
producer of the commodity. Mill discusses this issue in general: “ Rent is the extra return made to
agricultural capital when employed with peculiar advantage; the exact equivalent of what those
advantages enable the producers to economize in the cost of production: the value and price of the
produce being regulated by the cost of production to those producers who have no advantages; by
the return to that portion of agricultural capital, the circumstances of which are the least favorable
(Mill, 1871: 691).”
The definition of strategic rent is designed to reflect the efficiency rent proposed by Ricardo,
but with the broader, all encompassing application of differential rent to any advantages enabling
the producer to economize on the cost of production, proposed by Mill.
Marshall's “Quasi-rent”
In the field of strategy, the justification for broad application of efficiency rent is typically
attributed to Alfred Marshall, rather than Mill. Marshall’s (1901) treatment of rent is more concise
than Mill, but is essentially the same. Marshall’s rent is based on efficiency advantage, consistent
with Smith Ricardo- Mill. Marshall’s noteworthy distinction was to separate “true” land rent, from
“quasi-rent’ which could be safely applied to any advantages enabling the producer to economize
on the cost of production. In this way, Marshall absolved us from violating Ricardo’s strict rules of
land rent:
“The net incomes derived from appliances for production already made, may be called their
quasi-rents partly because we shall find that, when we are considering periods of time too short to
enable the supply of such appliances to respond to a change in the demand for them, the stock of
them has to be regarded as temporarily fixed. For the time they hold nearly the same relation to the
Price of the things which they take part in producing, as is held by land, or any other free gift of
nature, of which the stock is permanently fixed; and whose net income is a true rent (Marshall,
1901: 408).”
Consistent with Mill, Marshall (1901) encourages the application of efficiency rent to all
aspects of production, including intangible resources: “ Appliances for production are of many
different kinds: they include not only land, factories and machines, but also business ability and.
manual skill (Marshall, 1901: 409).”
The definition of strategic rent is designed to be consistent with the general, wide
applicability of Marshall’s quasi-rent. Unlike Marshall, strategic rent does not assume a distinction
between resources that are temporary and fixed. Strategic rent assumes that no resources are
permanently fixed; even soil is not indestructible. The assumption is that certain resources may be
continuously repaired, maintained, or developed. Consequently, with proper planning rent
generating resources may last indefinitely, approximating a permanently fixed advantage.
However, the mechanics of strategic rent are unaffected by the life span of the cost advantage.
Pareto’s “Rent”
Vilfredo Pareto (1897) is often cited in the Strategy literature as justification for defining
rent as a type of opportunity cost/profit, rather than an efficiency rent. That is, rent is described as
an economic value representing the difference between the employment of a resource in its first best
and next best, altemative use. The attribution to Pareto of rent as opportunity cost is incorrect, for
two reasons: 1. Pareto’s theory of rent is based on efficiency rent, and 2. Rent defined as
opportunity cost requires the employment of efficiency rent to calculate the basis of the cost; a
logical contradiction.
Pareto’s distinction in the rent theory is primarily: 1. Recognizing that the rent exists even
when the farmer owns the farmland. 2. That all producers may eam a rent, and 3. That rent affects
price, indirectly.
Strategic rent is based on Pareto’s argument that the amount of rent that would be
appropriated by the landlord, is appropriated by the entrepreneur when the entrepreneur owns the
land he or she farms. This translates into surplus eamings explained exactly by the efficiency rent
theory, even though no rent is actually paid (it is intemalized):
“We have, for example, two plots of ground the first of which, with an expenditure of 100,
produces 6 wheat, the second, 5; the price of wheat is 20 francs. The first plot has a rent of 20, the
second of zero. In an organization where there is an owner (of the farm land), an entrepreneur (the
farmer), and a consumer, the consumer pays 220 for 11 of wheat; of this amount 20 goes to the
landowner as rent, 200 francs are expenses. The cost of production, for the entrepreneur, is equal
to the selling price, it is 20.
If there is only a single person who is landowner, entrepreneur, and consumer, this quantity
of 11 wheat is produced with an expense of 200, and each unit costs 18.18. The cost of production
is no longer the same as before (Pareto, 1897: 249).”
Thus, resources that provide a low cost advantage produce rents, but rents that are never
paid out. The rent is intemalized as profit above the normal rate. Such rent can only accme to the
firm if the resource can be acquired or developed with low cost advantage, ex ante market failure.
Further, the advantage must be protected ex post. Such acquisition, development and protection of
advantages is the intended result of the strategy process: hence “strategic” rent.
Pareto (1897) took a strong position against the assumption that the worst resources brought
into production of the commodity would eam zero rent, as proposed by Smith- Ricardo- Mill:
“there can be a rent for all the landowners (Pareto, 1897: 248).” The strategic rent theory
supports this view, with the following conditions. The marginal producer may eam positive rent
when bamiers to entry exist (Demsetz, 1989). Altematively, the marginal producer may eam a loss
when exit barriers exist. Also, positive intra- marginal rent may be eamed by the least efficient
producer; the least efficient farmland eams positive rent on all its acres except the very last (worst)
acre, which eams zero rent. In any case, there exist forces toward zero rent on the margin.
The final point is that Pareto believed that rent affected price. His general argument was
that one effect cannot be separated from the totality of economic activity. All transactions are
linked in a causal chain that cannot be completely isolated. The effect on price takes place in an
indirect manner, via mobility between industry segments. Regardless, it would be another 60 years
before Jay Forrester would create the field of System Dynamics (Forrester, 1961), a field that could
rationalize Pareto’s conviction.
A “Strategic” Rent Theory
The following are major premises of a “Strategy-based” theory of rent:
Ra =Sxa- Oxa- Cxa
Where:
And,
Rxa is the rent earned by Firm (x) fromsales of commodity (A),
when Rx > 0.
Sx is the total revenues, or sales, for firm (x) of commodity (A).
Ox. is the “ordinary” profit required for Firm (x):
This is the minimum earnings necessary to compensate the owners’ for
“abstinence, risk, and management effort’ (Foreman, 1919). This may be
approximated by finding the firms cost of capital in accordance with the
Capital Asset Pricing Model (CAPM).
Cx, is the cost for firn{x) to produce commodity (A).
Sa =(Pa)* (Vxa)
Where:
Pa =Cma
Py is the price of commodity (A).
Vx. is the volune of firm(x) units sold of commodity (A).
Cw is the unit cost of commodity (A) on the margin; the cost of the last
Commodity (A) unit produced to fill the market demand, using the least
And,
efficient resource{s).
Rxa = 2[Cxi -Cua] = 2[Cxi -Pal
Where:
Cx; is the cost to produce unit (i) of commodity (A), by firm (x).
The Rent theory assumes the premises of a perfectly efficient market (Cohen and Cyert,
1965), with the following exceptions and additions:
Premise 1.
Premise 2.
Premise 3.
Premise 3a.
Premise 3b.
Premise 4.
Premise 5.
Heterogeneity of producer costs, across firms: The sum of all costs to produce a
commodity are not equivalent across firms in the same market.
The rent generating resource is limited in quantity: scarce.
The output of the resource (ex: farmland) is a commodity (ex: com, wheat, etc): all
producers must accept the same price for their output.
Producers sell their output in the same market.
Producers sell their output in the same time-frame.
The last portion of the output necessary to fill the market is produced by the least
efficient resources, and the cost structure achieved by these resources sets the price
for the output of all producers of the commodity.
Constant or increasing retums to scale are not possible for all output possibilities in
production of the commodity. That is, no firm faces a constantly downward sloping
long-run average cost curve.
Given the above, the following System Dynamics model is presented to make explicit these
assumptions, in the dynamic context alluded to by Smith, Ricardo, Mill and Pareto.
The Rent Generic-M odel
In general, management is expected to be susceptible to problems with decision making
when the decisions are embedded in multi-loop nonlinear feedback systems, because the human.
mind is not structured in a manner that accommodates such complexity (Forrester, 1971). Rent-
type profit, as described by Smith, Ricardo, Mill and Pareto, is especially associated with such
complex systems, and so Ricardo (correctly it seems) points out the counter- intuitive behavior of
rent versus ordinary profits. System dynamic models are a means of effectively overcoming such
problems of complexity (Sterman, 2000). Thus, to more effectively investigate the impacts of the
interaction of competitive dynamics, non-linear demand, and the counter: intuitive mechanics of
rent- type profitability, we built a dynamic simulation. The model is a system of nonlinear
differential equations describing:
(i) multiple competitors that all must take the same price for their output
(ii) non-linear demand, conforming to the Pareto distribution of wealth
(iii) heterogenous cost structures; across competing firms
(iv) non-linear cost structure, reflecting the interaction of fixed and variable costs.
(v) an auction-type commodity market
(vi) price as a result of aggregate supply decisions, and non-linear demand
(vii) price level ultimately determined by the least efficient resources necessary to fill the
market.
The variables and their interactions are based on existing theories (Smith Ricardo- Mill-
Pareto), summarized in this paper, and my own field studies (see figure below).
Cost per unit fo!
Martha
Production decision
by Martha
Production decision
by Muncie Cost per unit for
Muncie
—
Cost per unit for
Sterling
Production decisio AC, Booman rent per
¥ by Stove unit for Sterling
Exit decision by . ;
Steve ‘conomic rent per
Production unit for “ty
level for Stevd Increase
Decreast Cost per unit
Units produced And table for Steve
Production productio!
conversion facts
Electricity Price:
Consumption 4
Delay h Production as a percent
Auction rate of potential demand
KWH ed Income distribution
available table
Conversion factor ™
Market potential Population
Average _ ew demand. 42
Consumption
Economic rent per
unit for Martha
Production decision
by Sterling
Economic rent per
unit for Muncie
Modeling the Competitors
The model simulates the performance of four competing firms, in an auction market. The
example here is a market for electricity; sold in kilowatt hours. Each firm is represented by a
generic structure, which is customized through parameterization to reflect production cost
heterogeneity across competitors.
Three of the firms, with the lowest cost structure, are modeled in a simplified form. This is
because these firms are assumed to be operating at their point of maximum efficient scale, and thus
have no incentive to expand or contract production as long as rent is eamed. It is important to note
that this is a deliberate simplification of this industry segment’s growth, and the interested reader is
encouraged to review Ford's (1997) more comprehensive discussion and model of electric power
industry growth dynamics.
The following model variables are described using “Martha's” firm as a generic example of
all three firms having the low cost advantage (Martha's, Muncie’s & Sterling’):
Economic rent per unit for Martha: Calculated as Price less the Cost per unit for Martha.
Cost per unit for Martha: Constant at $0.05 per KWH.
Production decision for Martha: Calculated as IF THEN ELSE(Economic rent per unit for
Martha>0, 600000 , 0 ). The argument here is that the firm is operating at maximum scale
efficiency, and there are no barriers to exit if rent falls below zero.
The fourth firm in this market (Steve's) is the least cost- efficient, and therefore is expected
to dynamically influence the market price. Thus, this firm is modeled in greater detail:
Econonic rent per unit for Steve Calculated as Price less the Cost per unit for Steve. In this case,
a cost table was created to reflect a non-linear cost distribution associated with altemative
combinations of fixed and variable costs associated with different production levels.
Specifically, rent for Steve is: Price-Cost per unit table for Steve(Current
production/10000). The cost per unit table (see figure below) is designed with a generic
scale of 1 to 100. Thus, the lookup for Current Production is divided by 10000 to scale the
actual production levels to the table.
Graph Lookup - Cost per unit table for Steve
Export
=
i Output vn
os
Dmnt
|
|
lel Yenin:
loos
|
Import Vals_| —xmin:|1 rhx-65.49—y=0.3074 Mmax|100 =| Reset Scaling
OK | ClearPoints | Clear AllPoints | CurrRet| _ClearReference | Ref>Cur| Cancel |
Production decision by Steve Calculated as IF THEN ELSE(Economic rent per unit for Steve <0,
-1,1). The assumption here is that Steve will react when rent drops below zero, or rises to
zero.
Production level for Steve Calculated as Increase-Decrease. The desired effect here is to capture
gradual changes in production level, over time.
Decrease, Calculated as IF THEN ELSE(Production decision by Steve< 0 :AND: Production level
for Steve > 10000 , 1000, 0). The desired effect here is that Steve will cease production
only if rent falls below zero and his production falls below his minimum efficient plat scale;
of 10,000 units (KWH) per month. Otherwise production will decline 1,000 units per
month, every month rent is less than zero. The strategy is that by decreasing the supply to
the market, the price is expected to be bid upward. Reducing production is also expected to
reduce losses, since rent is less than zero. However, as the production level falls, the firm’s
costs are expected to rise due to the change in the proportion of fixed to variable expenses.
Increase: Calculated as IF THEN ELSE(Production decision by Steve>0 :AND: Production level
for Steve < 999000, Production decision by Steve*Economic rent per unit for Steve* 100000,
0). The desired effect here is that Steve will increase production levels in proportion to the
positive rent eamed. For example, if Steve eamed 100% rent- type profit, he would target a
100,000 unit (KWH) per month increase in production.
Current production: Calculated as Production level for Steve/Production conversion factor. The
desired effect is to create a dimensionless variable that reflects the current production level.
This is necessary to execute the lookup table for Steve's costs.
Production conversion factor: Is a constant, dimensioned as KWH, to convert Current Production
into a dimensionless variable.
Exit decision by Steve Calculated as IF THEN ELSE(Production decision by Steve<0 :AND:
Current production < 11000, 0 , Current production * Production decision by Steve). The
desired effect is that Steve will cease production if rent falls below zero and production falls
below the minimum efficient plant scale; 10,000 units (K WH) per month.
Modeling the Competitors’ Auction (Commodity) Market
The model simulates an auction market. The entire output of the competitors is sold at
whatever price the market will pay. In this example, the auction is for electrical power; sold in
kilowatt hours, for a particular month.
Units produced. Calculated as Production decision by Muncie+Production decision by
Sterling+Production decision by Martha+Exit decision by Steve. This is the sum of all
production brought to market.
Electricity: Calculated as Supply-Consumption. In this model, the example is electrical power sold
in units of Kilowatt Hours. The values are not assumed to be “true to scale,” and are just for
purpose of illustrating the system dynamics.
Supply: Calculated as DELAY 1(Units produced, Delay). The desired effect is to model a delay for
availability on the market. In this case, the example is Kilowatt Hours (KWH) electricity
co-generation, and so the delay is not necessarily realistic, but is included because of the
desire to provide a generic model that has a good basic structure to represent any commodity
market. However, because power is actually sold by month in futures contracts, it is
realistic to sell your power today for delivery in one or more months. Thus, in reality there
does exist a delay between the purchase of the contract and delivery to the market, for those
firms that buy and sell forward.
Delay: Calculated as 1 month.
Consumption: Calculated as Auction rate*Electricity. The desired effect is to account for the total
amount of the commodity (KWH) auctioned, on average.
Auction rate Constant at 100%. That is, 100% of the supply (electricity) available is auctioned off
at the market price.
KW level available. Calculated as Electricity/Conversion factor. The desired effect is to create a
dimensionless variable that reflects the current KWH level.
Conversion factor: Is a constant, dimensioned as KWH to convert KWH level available into a
dimensionless variable.
Market potential demand: Calculated as Population*Average Consumption. This is the measure of
total aggregate consumption, if price were zero.
Population: Calculated as 1,000,000+STEP(100000, 30 ). The assumption is that this market has
one million consumers. In month 30, population grows to 1.1 million. The step at month 30
is to investigate the impact of a change in population on price and profitability.
Average consunption: Calculated as 1+STEP(0.1, 60 ). The assumption is that each consumer
would like to consume 1 KWH per month. In month 60, consumption changes to 1.1 KWH
permonth. The step at month 60 is to investigate the impact of a change in average
consumption on price and profitability.
Price. Calculated as Income distribution table(Production as a percent of potential demand). The
assumption here is that the market price is determined by budget available to the individuals
that would consume the product. As price is a rationing mechanism, the price will be bid
upward until the budget of the poorest individuals prevents them from bidding higher.
When enough individuals have dropped out, supply will equal demand, the auction hammer
will fall, and the price is set.
Production as a percent of potential demand: Calculated as KWH level available/Market potential
demand. The assumption here is that a “price” is only imposed on goods and services that
are “scarce” (otherwise, these would be free; like air). The proportion of total potential
demand reflects the products scarcity.
Income distribution table: Calculated as the frequency distribution specified by Pareto (1897:
p285). Pareto concluded that this distribution was essentially invariant to scale. Thus, a
generic distribution scale is developed here. The salient property of the distribution is that
80% of the wealth is located in 20% of the population. This distribution’s non-linear shape
(see figure below) is critical in correctly mapping demand. The input is the percent of the
population that can be supplied by the market. The output is the price that is within the
budget of the poorest consumer in the top percent- distribution of the population.
Graph Lookup - Income distribution table
\ Output
o |:
0.001 09
0.004 08
0.014 OF
0.034 0.6
10.094 05
0.194 04
0.33 03
0.58 0.2
0.91 0.1
1 Oo ea |
New
| | |
Import Vals | xmin:|0 z)e0.2416 —y=1.035 Xmax1 >| Reset Sealing
OK | ClearPoints | Clear AllPoints | CursFet| _ClearReference | Ret>Cur| Cancel |
Rent Dynamics: Rent is the result, not the cause, of price
I used the model to test whether Ricardo’s famous statement, “Rent is the result, not the
cause, of Price” (Ricardo, 1821) could be modeled in a dynamic manner. The model has not been
calibrated, and the model is very simple, but the answer at this point is yes. This will be discussed
by viewing the time series graphic results for Price, Rents eamed, production decisions, and
aggregate supply.
Two scenarios were simulated. Both simulated three identical “events,” which shocked the
system in manners that allowed observation of rent- type profit dynamics. The three events were
deregulation of the market, population growth, and an increase in average consumption.
In scenario 1, at time zero, 99% of the population was provided power (perhaps via price
subsidies and legal price discrimination dictated by regulatory agencies), but in month 1 the market
was deregulated and price was set by supply and demand.
In the scenario 2, the simulation begins month 1 with aggregate supply sufficient to meet
only Yof the total potential demand.
Within each of the two scenarios, two more “events” are created. In month 30, the
population grows 10%, and in month 60 the average consumption increases 10%.
Price (of 1 KWH ina given month).
Price
1
0.75
0.5
0.25
0
0 10 20 30 40 50 60 70 80 90 100
Time (Month)
Price : Scenario 1 99 percent of demand is supplied ———————————— Dm
Price : Scenario 2 50 percent of demand is supplied ————————————__ Dm
Price in Scenario 1 increases severely at first, then drops just as severely. The implication is
that deregulation caused the price to crash because supply was available for 99% of the market, and
this heavy supply auctioned off at a very low price. Each of the firms decides to withdraw from this
market (perhaps to sell to a different market), and the massive withdrawal creates a severe shortage
that causes price to spike. At this point, the market seems attractive, even to the most inefficient
firms, and we see price fall again as re-entry occurs. The price almost stabilizes when at month 30
the population grows 10% and we see a price increase. Price falls again until month 60 when
average consumption increases 10%. Price falls again, appearing to stabilize by month 100.
Price in Scenario 2 (begin at Yof demand) declines at first, and then stabilizes until month
30 when the population increases 10%. At this point the price jumps and then stabilizes at a higher
level. At month 60 the price rises and stabilizes again in reaction to the 10% increase in average
consumption.
The salient question at this point is why price behaves differently at the three “events,” even
though the competitive “system” is exactly the same for both scenarios. Again, the only difference
between these scenarios is the starting aggregate level of supply. To understand these dynamics, it
is necessary to first review the rent- type profits, as this motivates the decision making of the firms.
Rent Dynamics.
Economic rent per unit for Steve
0 10 20 30 40 50 60 70 80 90 100
Time (Month)
Economic rent per unit for Steve : Scenario 1 99 percent of demand is supplied Dmnl
Economic rent per unit for Steve : Scenario 2 50 percent of demand is supplied Dmnl
In scenario 1, rent is negative initially because the market price is too low for Steve to eam
rent. As the market deregulates, and firms exit the market in search of profit elsewhere, supply
drops to zero and the price spikes as the wealthiest individuals bid up the price in hopes of capturing
any KWH available (this spike may seem unrealistic, but in actuality it is not. Several times during
the Summer energy shortages in Califomia, following their deregulation of electrical power, the free
market price spiked to $999.00 per KWH... and would have gone higher but that the software used
by the power market was not designed to allow more digits!). At this high price, all firms reenter
the market and eam high rent (see figure below for the rent- type profit of the competitors). Three of
the four competitors enter the market at full production capacity, but Steve enters at his minimum
efficient plant scale (MEPS). Steve's cost at MEPS is 30 cents per KWH, which is high compared
to the next most costly competitor, Sterling, at 7 cents per KWH. Thus, Steve's production pushes
supply higher and the price drops quickly toward 30 cents. With rent low now, Steve expands
production, but more slowly so as not to over supply the market; push price below his cost. He will
continue to expand output as long as rent is positive (note: at zero rent Steve is still eaming his cost
of capital, or ordinary profit requirement). Thus, we see a trend to zero rent, by month 29. At this
point the price is 10.8 cents, and Steve’s cost is 10.8 cents. Thus, we have replicated the
proposition of Ricardo; that price is determined by, not the most efficient resources, but the worst
resources able to meet the market price, if the rents of the remaining competitors are both positive
(because their costs were designed to be lower than steve’s) and consstently higher than Steve's
(because all producers sell at the same price, and their costs were not allowed to vary).
Economic rent per unit for Sterling Economic rent per unit for Muncie
o 0 2 3 4 50 6 70 60 99 100 o wm 20 3 40 50 6 70 8 99 100
Time (Month) Time (Month)
Economic rent per unit for Sterling : Scenario 1 99 percent of demand is suppliddhn! Economic rent per unit for Muncie : Scenario 199 percent of demand is suppliBtinn!
Economic rent per unit for Sterling : Scenario 2 50 percent of demand is suppliashn! Economic rent per unit for Muncie : Scenario 2 50 percent of demand is suppliBtinn!
Economic rent per unit for Martha
a ee eee
o 10 2 30 40 50 60 70 80 90 100
Time (Month)
Economic rent per unit for Martha : Scenario 1 99 percent of demand is dippiied
Economic rent per unit for Martha : Scenario 2 50 percent of demand is sippiied
Indeed the data for Steve’s competitors show that each competitor experienced the same
rent- type profit dynamic, and consistently eamed a greater rent than Steve. Thus, each of the
competitors was affected by Steve's decisions on expanding output. As Steve expanded output his
cost per unit fell, allowing him to expand further in a positive feedback loop. This growth was
ultimately limited by decreasing retums to cost improvements, and decreasing prices due to the
greater aggregate supply to the market. As a consequence, all the competition felt the blow to their
own rent- type profits as Steve was able to expand and push the market price lower.
Atmonth 30, the population grew 10% and it can be seen that this sudden increase in
demand had a positive effect on profitability, however this joy was brief as Steve took advantage of
the higher rent in expanding output more rapidly, thereby driving the market price back down.
Atmonth 60, average consumption increased 10% and the dynamic impact on profits was
the same as was the case for population growth. This would be expected, to the extent that these are
just two altemative events that cause the same effect; an increase in aggregate demand.
In scenario 2, the market is initially supplied at 50% of potential demand, and the
profitability dynamic is quite different from scenario 1, in all three events. First, because the supply
of KWH is scarce, compared to scenario 1, the price is initially higher when the market is
deregulated. Thus, deregulation does not result in a free market price that is much different from
the regulated price. Accordingly, the competitors all initially eam positive rents and so they all
remain in the market. The price falls at bit, as all the competitors immediately change production
levels to maximum efficient scales. At this point price does not change until the event at month 30,
and rent is positive for all of Steve's competitors. The salient question is, why? One of the
producers, the least efficient, should be eaming zero rent and setting the price for the others. This is
not the case. As Pareto suggested, all competitors are eaming positive rent! The answer is that
bamiers to entry prevent Steve (and all others) from selling in the market. The bamier, in this case is
the price. The price is never high enough to justify Steve's entry (price must be at least 30 cents for
Steve to breakeven at MEPS). Steve never enters the market, the existing competitors are already
operating at their maximum efficient scale, and supply is scarce enough to prevent price from
falling to cost. Thus, all firms in the market eam a positive rent. When the next two events occur,
demand increases, and price rises accordingly. Price never falls because no fim is willing to
expand their output (see figure below for the production levels of each firm).
Current production
400,000
300,000
200,000
100,000
0
0 10 20 30 40 50 60 #70 80 90 100
Time (Month)
Current production : Scenario 1 99 percent of demand is supplied —————— Dmnl
Current production : Scenario 2 50 percent of demand is supplied —-————— Dmnl
Because rent- type profit is based on efficiency relative to the unit on the margin of cost
efficiency, and because Steve's firm was designed to be the least efficient producer,
Production decision by Sterling
Production decision by Muncie
60,000
45,000
30,000
15,000
0
304080
‘Time (Month)
70 80 90 100
Production decision by Sterling : Scenario 1 99 percent of demand is suggvéd/Month
Production decision by Sterling : Scenario 2 50 percent of demand is sugvéd/Month
405060
‘Time (Month)
70
Production decision by Muncie : Scenario 1 99 percent of demand is subilxiMonth
Production decision by Muncie : Scenario 2 50 percent of demand is suMikxiMonth
Production decision by Martha
800,000
600,000
400,000
200,000
0
o 10 20 30
40° 50 «60
‘Time (Month)
70 80 90 100
Production decision by Martha : Scenario 1 99 percent of demank W Hiypotinth.
Production decision by Martha : Scenario 2.50 percent of deman W Hypptinth.
Itis important to note that rent- type profit cannot set the price in this model. Price is
determined only by the aggregate supply, given the distribution of wealth in the population, the size
of the population, and the average consumption rate of the population. Thus, this model is
consistent with the declaration of Ricardo, that rent is the result of price, not the cause. Pareto,
however, is also correct, in that there exists a causal chain of economic activity that ultimate
includes both rent and price. This model offers a simple system of economic activity that explicitly
links rent to price, in the sense that rent causes decisions on production, that cause changes in
aggregate supply, that cause changes in price. System dynamics can now show that these great
thinkers were correct, in a manner that no other field could demonstrate.
As a matter of economic policy, it is interesting to mention the results of the two scenarios
on production as a percent of potential demand. It can be seen that a greater proportion of the
population can be served when there exists low barriers to entry. Further, the price for all
consumers is lower when the greater proportion of the population is served. Thus, social welfare is
maximized when Steve was able to enter and compete. The point here is that Steve might have
entered the market in scenario 2 if he had “good” reason to believe that positive rent targets could
ultimately be achieved. To the extent that management has the ability to draw sound conclusions on
profitability, social welfare may be maximized. System Dynamics models, such as the one
presented here, are hopefully a step in the direction of facilitating a greater understanding of the
dynamic mechanics of rent- type profitability.
Production as a percent of potential demand
om A ee eer
0.5
0.25
0 10 20 30 40 50 60 70 80 90 100
Time (Month)
Production as a percent of potential demand : Scenario 1 99 percent of demand isumilied
Production as a percent of potential demand : Scenario 2 50 percent of demand is3upplied
KWH level available
2M
15M
1M
500,000
0
0 10 20 30 40 50 60 #70 80 90 100
Time (Month)
KWH level available : Scenario 1 99 percent of demand is supplied ————— Dmnl
KWH level available : Scenario 2 50 percent of demand is supplied ————— Dmnl
Discussion & Managerial Implications
The implications of the rent theory are numerous, and the discussion that follows can only
be considered one small portion of what is, perhaps, a field itself. There are three implications that
are particularly important to the competitive strategy dynamics field at this time. The rent theory
explains: 1. the profitable co- existence of low-cost strategy firms; 2. why successfully reducing
production costs may produce no improvement in performance, and 3. why a change in demand
may have no effect on performance.
On the co-existence of profitable low-cost strategy firms. Low cost advantage is often
described as only possible for one firm per market; only one firm may possess the lowest cost
structure. Accordingly, the touted strategy is to become the low cost leader. The system dynamic
view of rent theory predicts, and the model results show, that this is incorrect. All the producers
with a cost structure lower than the marginal producer will be profitable. Thus, the strategy is to
maximize the cost differential, relative to the producer on the margin, over time.
The difference may seem subtle, but the effect on strategy and performance are substantial.
If we pursue a strategy of lowcost leadership, our performance may decline even though we are
completely successful in accomplishing the strategic goal. Consider the hypothetical case where a
new process technology is adopted by all producers of a commodity. The cost savings are realized
by all the firms, but the impact is greater on the least efficient fims. The net effect is an
elimination of major cost advantages enjoyed by a few firms. One fim integrates the new
technology more effectively than the others, and becomes the leader in efficiency. However,
hypothetically the production cost differential between this firm and the least efficient fim may be
smaller than was the case before the diffusion of the technology. Thus, in spite of their success in
achieving low cost leadership, the performance of the firm will fall! Contrast this with a strategy of
maximizing the differential in production cost relative to the marginal producer. In this case,
successful implementation of the new technology is driven by increasing the production cost
differential relative to the marginal producer, not the lowest cost producer. Successful achievement
of this strategic goal will result in improved performance. Further, performance will improve
regardless of whether or not the firm becomes the low cost leader!
Reducing production costs may produce no improvement in performance. The system
dynamic view of rent theory explains why success in reducing production costs is not necessarily
rewarded with increased profitability. This occurs in two fundamental scenarios: 1. the firm is the
marginal producer, and 2. the marginal producer is a competitor who is reducing production costs
with a relatively faster rate of success.
In the first scenario, process improvements may successfully reduce costs but competitive
pricing pressure will cause the price to fall to the new level of least productive cost efficiency.
Consequently, the firm continues to breakeven until it surpasses the cost efficiency of one firm in
the market. If the competitors improve at the same rate, the marginal producer will never realize
profitability, even though it is consistently able to achieve cost reductions. Thus, the strategy is to
improve at a faster rate than at least one of the competitors.
In the second scenario, the marginal producer is a competitor who is reducing production
costs with a relatively faster rate of success. Thus, while the strategy of cost reduction is successful,
performance declines because the cost differential relative to the marginal producer is smaller. If
the trend continues, the firm will ultimately become the producer on the margin and will only
breakeven (eam only ordinary profit) as the price falls to their cost. Thus the strategy is not to
reduce cost, but to maximize the cost differential relative to the least efficient producer, or to create
a positive differential.
Change in demand may have no effect on performance. The rent theory explains when
increasing or decreasing demand will not have significant effects on profitability. The impact on
profitability is depends largely on the trend of the average cost curves for all producers in the
market. There are two basic profiles: the average cost curves increase at an increasing rate, and 2.
the average cost curves increase at a decreasing rate.
Changes in demand will have a strong effect on performance when the average cost curves,
across firms, increase at an increasing rate. In this case, it is assumed that additional demand
requires increasingly inferior resources to be employed in order to meet the additional demand.
Electricity generation is an example. During the summer months, peak demand for electricity can
cause traditional sources of supply, such as hydroelectric, to be insufficient. The price rises to the
point where relatively inferior resources, such as diesel, wind and solar powered generators can
profitably supply electricity. The inferiority of altemative generation sources benefits the efficient
generators in the form of higher profit margins.
Conversely, changes in demand will have a minor effect on performance when the average
cost curves, across firms, increase at a decreasing rate. In this case, additional demand requires
only slightly inferior resources to be employed in order to meet the additional demand. An example
is IBM-PC compatible computer sales in the 1980's. The open- architecture design of the IBM-PC
allowed multiple producers to assemble a commodity- like product, allowing competition to drive
price quickly down toward cost. As price fell, a greater number of individuals were able to afford
the PC, and demand increased. To meet demand, IBM-PC clone assembler entrepreneurs were
entering the market by operating out of their garage or bam. At this point, increases in demand did
not cause increasingly inferior resources to be employed in meeting demand and prices could
continue to follow reductions in costs associated with realization of scale economies in component
parts. Thus, in spite of tremendous demand, prices did not rise, and profit margins were not high.
Conclusion
The mechanics of profitability are fundamentally composed of three independent profit
structures: ordinary profit, rent and monopolistic profit. Ordinary profit is the amount of earings
necessary to compensate the owner(s) for abstinence, indemnity for risk, and remuneration for the
labor and skill required to oversee the business (Foreman, 1919; Mill, 1871). This is the minimum
amount of eamings required to justify the investment in the business. The Capital A sset Pricing
Model (CAPM), as the contemporary basis for approximating ordinary profit in terms of the firm's
cost of capital, dictates that the cost of capital is a function of the risk free rate, the retum for the
market, and the Beta or coefficient of systematic risk for the firm. Of these factors, only the Beta
may be influenced by the firm. Thus, the strategy is to increase the present value of future eamings
by reducing the cost of capital through a minimization of Beta risk. Such a strategy is likely to
involve decreasing the firm’ s sensitivity to macro environment effects on sales by lowering
operating leverage via reduction in the proportion of fixed to variable expenses.
Eamings in excess of the ordinary rate of profit occur only when the market fails; when
entry barriers exist or there are differences between firms in their cost structure, or in their output.
That is, in the absence of entry bamiers, the firm must have a competitive advantage, low cost or
differentiation (Porter, 1980). Rent mechanics explain eamings in excess of the ordinary rate of
profit when output is homogenous and input costs are heterogeneous across firms. Rent type profit
is a function of cost advantage relative to the least efficient firm in the market. Consequently, rent
explains profits eamed via Porter’ s (1980) generic low cost advantage. In contrast, the
monopolistic profit mechanics explain eamings in excess of the ordinary rate of profit resulting
from heterogeneity in firms’ output. Profitability in this case is a function of creating and exploiting
an inelastic demand curve produced via Porter's (1980) generic differentiation advantage.
Given that each type of profitability is driven by different variables, strategy formulation
requires the separation and understanding of the functional structure of each to enable the deduction
of specific goals and actions to control, and thus, maximize the performance of the fim.
Asa final note, I believe Marshall (1901; 410) demonstrated proper caution and foresight
when he stated, “This doctrine (the rent theory) is however difficult, and easily misunderstood.
Further study is required before it can be safely applied to complex issues.”
References
Amit, R. and P. J. H. Schoemaker (1993). Strategic Assets and Organizational Rent, Strategic
Management Journal, 14: 33-46.
Bamey, J.B. (1991). Firm Resources and Sustained Competitive Advantage. Journal of
Managenent, 17, 1: 99-120.
Bennett, Stewart, G. (1991). The Quest for Value: a guide for senior managers. New Y ork, N.Y.
Harper Business.
Buchanan, Daniel H. (1929). The Historical Approach to Rent and Price Theory. Economica,
Volume IX (June): 123-155.
Bye, Carl R. (1940). Developments and Issues in the Theory of Rent. New Y ork: Columbia
University Press.
Camerer, Colin and Fahey, Liam (1990). The Regression Paradigm: A Critical Appraisal and
Suggested Directions. In Strategic Management Frontiers, Edited by John H. Grant.
London: JAI Press: 443-459.
Castanias, Richard P. and Helfat, Constance E. (1991). Managerial Resources and Rents. Journal
of Management, 17, 1: 155-171.
Chamberlin, Edward H. (1962). The Theory of Monopolistic Competition. 8th Edition. Harvard
University Press, Cambridge, Massachusetts.
Chi, T. (1994). Trading in Strategic Resources: Necessary Conditions Transaction Cost Problems,
and Choice of Exchange Structure. Strategic Management Journal, 15, 4: 271-290.
Cohen, Kalman]. and Cyert, Richard M. (1965). Theory of the Firm Resource Allocation ina
Market Economy. Prentice Hall, Inc. Englewood Cliffs, New Jersey.
Conner, K.R. (1991). An Historical Comparison of Resource- Based Theory and Five Schools of
Thought within Industrial Organization Economics: Do We Have a New Theory of the Firm.
Journal of Management. 17, 1: 121-154.
Demsetz, H. (1989). Efficiency, Competition and Policy. The Organization of Economic Activity,
Volume II. Blackwell, New Y ork.
Dierickx, I. And Cool, K. (1989). Asset Accumulation and Sustainability of Competitive
Advantage. Management Science, 35: 1504-1511.
Evans, Alan W. (1991). On Monopoly Rent. Land Economics, (Feb), 67, 1:1-14.
Evans, Alan W. (1993). On Monopoly Rent: Reply. Land Economics, (Feb), 69, 1:111-112.
Foldvary, Fred E. (1993). On Monopoly Rent: Comment. Land Economics, (Feb), 69, 1:108-110.
Ford, Andrew (1997). System Dynamics and the Electric Power Industry. System Dynamics
Review, 13, 1: 57-85.
Foreman, CJ. (1919). A Division Among Theorists in Their A nalysis of Profits. The Quarterly
Journal of Economics, 34, 1: 114-137.
Forrester, J. (1961) Industrial Dynamics. Cambridge, MA: Productivity Press.
Forrester, J. (1971). Counterintuitive Behavior of Social Systems, (R-21) Technology Review, Vol. 73,
No. 3, January: 52-68.
Foss, NJ. (1996). Research in Strategy, Economics and Michael Porter. Journal of Management
Studies, 33, 1: 1-24.
Grant, Robert M. (1996). Toward a Knowledge-Based Theory of the Fim. Strategic Management
Journal, 17 (Winter Special Issue): 109-122.
Grant, Robert M. (1998). Contemporary Strategy Analysis: Concepts, Techniques, Applications,
Blackwell, Cambridge, MA.
Hall, R. (1993). A Framework Linking Intangible Resources and Capabilities to Sustainable
Competitive Advantage. Strategic Management Journal, 14: 607-618.
Hill, Charles W. L. (1988). Differentiation versus Low Cost or Differentiation and Low Cost; A
Contingency Framework. Academy of Management Review, 13, 3: 401-412.
Ise, John. (1940). Monopoly Elements in Rent. American Economic Review, 30 (Mar):33-45.
Keiper, Joseph S. Kumow, Emest. Clark, Clifford D. and Segal, Harvey H. (1961). Theory and
Measurement of Rent. Philadelphia: Chilton Company.
Klein, 0., R. Crawford and A. Alchian (1978). ‘Vertical integration, appropriable rents, and the
competitive contracting process’, Journal of Lawand Economics, 11: 297-326.
Lado, Augustine A. Boyd, Nancy G. and Hanlon, Susan C. (1997). Competition, Cooperation, and
the search for Economic Rents: A Syncretic Model. Academy of Management Review, 22,
1: 110-141.
Lippman, S.A. and Rumelt, R.P. (1982). Uncertain Imitability: An Analysis of Interfirm
Differences in Efficiency Under Competition. Bell Journal of Economics, 13 (Autumn):
418-438.
Mahoney, J.T. (1995). The Management of Resources and the Resource of Management. Journal
of Business Research, 33: 91-101.
Mahoney, J.T. and Pandian, J.R. (1995). The Resource- Based View within the Conversation of
Strategic Management. Strategic Management Journal, 13, 5: 363-380.
Marshall, Alfred. 1901. Elements of Economics of Industry: Being the First Volume of Elements
of Economics, 3rd Edition. The MacMillan Co. New Y ork.
Mill, John Stuart. (1871). Principles of Political Economy with Some of Their Applications to
Social Philosophy. Reprinted in 1969 from the 7th Edition. New Y ork: Agustus M. Kelley.
Montgomery, Cynthia A. and Wemerfelt, Birger. (1988). Diversification, Ricardian rents, and
Tobin's g. RAND Journal of Economics, 19, 4 (Winter): 623-632.
Mosakowski, E. (1993). A Resource- Based Perspective on the Dynamic Strategy- Performance
Relationship: An Empirical Examination of the Focus and Differentiation Strategies in
Entrepreneurial Firms. Journal of Management, 19: 819-839.
Mosakowski, E. and McKelvey, B. (1997). Predicting Rent Generation in Competence- Based
Competition. In A. Heene and R. Sanchez (Eds.) Competence- Based Strategic
Management, Chichester: Wiley & Sons: 65-85.
Pareto, Vilfredo. (1897). Manual of Political Economy. Translated by Ann S. Schwier from the
French edition of 1927. Edited by Ann S. Schwier and Alfred N. Page. Reprinted in 1971.
New Y ork: Augustus M. Kelley.
Penrose, Edith T. (1959). The Theory of the Growth of the Firm. Reprinted in 1980. New Y ork:
M_E. Sharpe, Inc.
Peteraf, M. (1993). The comerstones of competitive advantage: A resource- based view, Strategic
Management Journal, 14, pp. 179-191.
Popper, Karl. R. (1959). The Logic of Scientific Discovery. Basic Books, New Y ork.
Popper, Karl. R. (1983). Realismand the Aimof Science, from the Postscript to The Logic of
Scientific Discovery, Edited by W.W. Bartley, III. Routledge, New Y ork.
Popper, Karl R. (1989). Conjectures and Refutations: The Growth of Scientific
Knowedge, 5th Edition. Reprinted 1992. New Y ork: Routledge.
Porter, M. 1980. Competitive Strategy: Techniques for Analyzing Industries and Competitors. The
Free Press. New Y ork.
Porter, M. 1985. Competitive Advantage. The Free Press. New Y ork.
Ricardo, David. (1821). The Principles of Political Economy and Taxation. 3rd Ed. Reprinted
1992. Charles E. Tuttle Co. Inc. Rutland, Vermont.
Rumelt, Richard P. (1984). Toward a Strategic Thoery of the Fim. In Competitive Strategic
Managenent. Edited by Robert Lamb. Englewood Cliffs, N.J: Prentice Hall: 556-570.
Rumelt, Richard P. (1987). Theory, Strategy and Entrepreneurship. Chapter 7 in The Competitive
Challenge. Edited by David J. Teece. Harper and Row, New Y ork: 137-158.
Schoemaker, Paul J.H. (1990). Strategy, Complexity and Economic Rent. Management Science,
36, 10 (Oct): 1178-1192.
Smith, Adam (1776). An Inquiry into the Nature and Causes of the Wealth of Nations. Reprinted
1937. New Y ork: Random House - Modem Library edition.
Spender, J.-C. (1994). Organizational Kowledge, Collective Practice and Penrose Rents.
International Business Review, 3: 353-367.
Sterman, J.D. 1989 “Modeling Managerial Behavior: Misperceptions of Feedback in a Dynamic
Decision Making Experiment.” Management Science, 35: 321-339.
Sterman, J.D. 2000 Business Dynamics: Systems Thinking and Modeling for a Complex World.
Chicago, IL: Irwin/McGraw Hill.
Teece, DJ. (1982). Towards an Economic Theory of the Multi- Product Fim. Journal of
Economic Behavior and Organization, 3 (March): 39-63.
Teece, DJ. Pisano, G. and Shuen, A. (1997). Dynamic Capabilities and Strategic Management.
Strategic Management Journal, 18: 509-533.
Tullock, G. (1990). The Costs of Special Privilege. In Perspectives on Positive Political Economy,
edited by J.E. Alt and K.A. Shepsle, Cambridge University Press, New Y ork.
Varian, Hal R. Microeconomic Analysis. 2"! Ed. New York: W.W. Norton & Company
Wemerfelt, B. (1984). A Resource- Based View of the Firm. Strategic Management Journal, 5,
2:171-180.
Wemerfelt, B. and Montgomery, C.A. (1988). Tobin's q and the Importance of Focus in Fim
Performance. American Economic Review, 78, 1: 246-250.
Winch, Donald (1992). Introduction to The Principles of Political Economy and Taxation. by
David Ricardo. Reprinted from the 3rd Edition of 1821. Charles E. Tuttle Co. Inc. Rutland,
Vermont.
Back to the Top
