Wednesday Jun 26

EXCERPT FROM Rents: How Marketing Causes Inequality • By Gerrit De Geest: Want to Fix Inequality, Don’t Forget About Rents, and We’re Not Talking about Housing

Work ethic may explain some of smaller income differences, but it can’t explain most of the larger ones. If your neighbor makes twenty times more than you, it
is unlikely she worked twenty times harder. She usually just captures more rents than you do. Rents are artificial profits made possible by market failures.

The idea that there can be such a thing as a “rent” is nothing new. Rents are much more widespread in the economy than generally believed. Most products and services you buy contain a rent; they are more expensive than they would have been in a perfectly transparent, competitive market. I have estimated that, on average, $35 of every $100 you spend goes to rents.

How exactly do rents increase income inequality? In two ways. First, fast-food cooks do not receive any rents, but they may pay rents whenever they buy something with their yearly income of $19,000. If rents are 35 percent of the economy, that means that, statistically, $6,650 of their $19,000 yearly income goes to rents. This $19,000 has a true purchasing power of only $12,350. That is indeed how much the same goods and services would have cost in an economy without rents. Thus, rents impoverish those who pay rents but don’t receive rents.

Second, rents enrich those who receive the rents. Who are they? Well, the people with offices in those prestigious buildings. For the largest part, it is the business owners (including stockholders), the people who work for them and to whom some rents are leaked (such as pricing consultants and corporate officers), and the owners of land and other natural resources.

Why did income inequality increase since the 1970s? Because the total amount of rents in the economy increased. In 1970, about $20 out of every $100 that people spent went to rents. By 2010, that amount had increased to $35 out of every $100.

There are two reasons why rents have increased. One is that society has become more complex, with more product types and product variants. This has made it easier for experts (like salespeople) to exploit asymmetric information. In addition, the complexity has made it easier to transform competitive markets into foggy, oligopolistic ones.

But the more fundamental reason is that the economy has become less competitive as marketing methods have become more sophisticated. Well-trained business economists are now simply better at creating market failures and at extracting rents out of them. And so far, their insights have been applied on a larger scale in the US than in Europe. This helps to explain why income inequality has grown faster in the US.

Building Political Consensus on How to Fight Income Inequality

Income inequality is a hot political topic. Unfortunately, there is no consensus on what to do about it.

The fundamental reason for this lack of consensus, in my view, is that policymakers focus on the wrong instrument—taxes. The lack of consensus can be attributed to different empirical estimates on the true costs of inequality and the true costs of tax distortions.

If rents are the real culprit, it may be possible to find common ground on how to fight income inequality. Indeed, rents cause not only inequality but they also distort the economy. Rents distort the economy even more than taxes. If politicians on the right are worried about taxes harming the economy, they should be worried even more about rents harming the economy.

Rents are also hard to defend from an ethical point of view. They are not the result of hard work, but the result of strategies such as exploiting information asymmetries (that is, not being honest), creating lock-in effects (using traps), using subtle cartels (cheating the game), or being over-rewarded by the legal system (picking up golden eggs that should not have been laid there by the government).

People are tired of the lack of ethics in the economy and the lack of fairness in the income distribution.

It is hard to reach consensus on increasing taxes and even harder to stop lobbyists from lobbying. My proposals are much easier to agree upon—they come down to more honesty and more competition. And many are much easier to realize—they are legal rules that can be implemented by courts without being blocked by political gridlock in Washington, DC.

Do We Need More Regulation or More Market?

The point that some legal rules do not “regulate” the market but rather make the market possible was made by Coase (1959) in a paper that discussed the Federal Communications Commission’s intervention on radio frequencies. Before 1927, no radio station could own a specific radio frequency. Stations with a stronger transmitter could simply blow away the signal of competitors. The Federal Radio Commission (the forerunner to the Federal Communications Commission, or FCC) stepped in and gave radio stations their own radio frequency. As a result, new entrants had to buy radio frequencies from existing stations, rather than taking someone’s frequency by blowing the station’s signal away. Commentators at that time considered this a prime illustration that government regulation was needed to bring order on a chaotic, failing market. Coase argued instead that the chaos couldn’t be called a market failure because there wasn’t even a market. Only after the FCC created (largely) transferable property rights could a market exist. And it worked well.

When is the law not regulation, but just the establishment of a market? Coase (1959) mentioned property rights. In another paper, he suggested rules that make contracts binding as another example (how can there be markets if the legal system does not enforce contracts?). We can easily extend this to rules that forbid fraud (how can markets be “free” when lying and cheating is permitted?) and rules that forbid cartels (how can there be price competition if competitors can fix prices?).

Our proposals essentially of that nature. They forbid forms of fraud, cartels, and duress that are now falling through the cracks of the legal system. They make
sure that markets are transparent. They make sure that competitive auctions take place whenever mining and building rights are given away. And they reduce intellectual property protection—a government-installed system of monopoly rights. The only case where the government has to take over a job from the market is standardization. Standards are public goods with network externalities, which is why markets aren’t good at producing them.*

Competitive markets are formidable mechanisms to achieve both economic efficiency and income equality. All the government
has to do is write down the laws that make it happen.

Rent Economics

Although the economic literature on rents started in 1817 with David Ricardo, it is still under-researched today. Economic analysis of law is traditionally based on only three pillars: incentive analysis, risk analysis, and transaction cost analysis. To evaluate a legal rule, economists look at its incentive effects, its risk allocation, and its transaction costs (a broad category that includes enforcement costs). That’s it.

Why isn’t rent analysis a fourth pillar? A first reason is that, so far, rents have been considered economically harmless. Rents are believed to affect, at most, who gets the economic pie, but not how large the pie is. I have shown that this is incorrect. Rents distort the economy even more than poorly designed taxes.

A second reason why rents have largely been ignored is that, even if rents increased income inequality, taxes were believed to be the best instrument to fix these distributive distortions. This does not hold when inequality is caused by rents. Legal rules are the best instrument in that case because they can fix the market failures that cause the rents in the first place.

A final reason why rents have largely been ignored by economists so far is that rents were believed to be small. Rents were seen, at most, as temporary problems because whenever rents appear, there are market forces that make them disappear. Rents are 35 percent of the national income. Not exactly a minor problem.

This has major implications for the cost-benefit analysis of legal rules. Inequality costs should become a part of the equation when we design legal rules that affect rents. The result will usually be that the law will have to be more aggressive against market failures—even more aggressive than it should be on pure market efficiency grounds.

Here is another way of looking at it. Go back to the 1950s, when pollution costs were disregarded by policymakers. Take a time machine up to the present, when we realize that pollution has a cost. As a result, we now add pollution costs to the equation when we discuss legal changes, and we fight pollution more aggressively. By the same token, if we realize that income inequality is a serious problem that should largely be addressed in the legal system, we should add those costs to the equation and fight market failures more aggressively.

The lack of interest in rents may be similar to the lack of interest in transaction costs before the 1960s. Transaction costs are, in a sense, also temporary: whenever they arise, there are market forces at work that make them decrease. If drafting a contract takes one hundred hours, there is room for innovators to sell model contracts. If finding a certain piece of information takes one hundred hours, there is room for an innovative app that does the same in a few minutes.

For transaction costs, just as for rents, there are forces at work that make them smaller over time. But at the same time, there are forces at work that create new sources. The result is that, at any given moment, transaction costs may be significant, just like rents.

But until today, economists have underestimated the impact of rents. It is time to correct this mistake. It is time to take rents seriously.

Gerrit De Geest is the Charles F. Nagel Professor of International and Comparative Law at Washington University School of Law in St. Louis, where he teaches contracts, antitrust law, law and economics, and seminars on consumer contracts, and served as the director of the Center on Law, Innovation & Economic Growth.. This excerpt is from his book, Rents: How Marketing Causes Inequality available from Beccaria Books.

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