Rents and Rent seeking

The conditions under which Schumpeterian rents,

contingent rents for learning, and monitoring rents
are likely to be value enhancing in developing
countries
Rents and rent seeking
Rent definition:
In economic terms, Rents can be defined as excess incomes which, in
simplistic models, should not exist in efficient markets. More precisely, a
person gets a rent if he or she earns an income higher than the minimum that
person would have accepted, the minimum being usually defined as the
income in his or her next-best opportunity and while some rents are indeed
inefficient and growth retarding, other rents play an important role in growth
and development. This view that some rents are efficient, challenges the
conventional rule of the thumb perception of the liberal market that removal
of institutions and rights which protect rents is always desirable as a way of
moving towards a greater efficiency and economic performance. (Khan 2000,
p.21)
Political economy tells us that political variables and, in particular, the
distribution of political power can determine which individuals or groups are
likely to win distributive contests and a more general approach to rentseeking can incorporate political and institutional variables to explain, first,
how much effort is actually extended in rent-seeking and, second, the types
of rights and rents which are created as a result a view (Lecture ppt-Suzuki).

Types of rents:

Schumpeterian rents

Schumpeterian rents emerge due to innovation and information generation

which involves new technology, new institutional arrangements and or use of
the existing information which is not a costless exercise. In such,
Schumpeterian rent serves to ensure that efficiency and growth are sustained
by creating incentives to necessitate optimization of scarce resources. These
rents play a role in cases of new innovation and also in situations where there
is generation of new market information as discussed below.
Schumpeterian rents for innovators
Innovations usually lead into generation of new products and means of
production and according to Marx (1979 pgs 429-438), innovations can be
both technical and institutional. An innovating firm will experience and
generate rents if it has cost or quality advantage over its competitors if the
innovation is not copied or the window of time between the time it is
generated is sufficient enough to allow the firm optimize the benefits. In
cases where the innovation can be easily copied, scarcity can be artificially
protected through issuance of patents.
According to figure 1.1 below, in a simplistic way, the innovating firm is able
to produce an identical product at lower cost while also in reality this may be
a situation where the firm produces a better quality product. From the market
view, there is a discontinuity where the now there are two levels of marginal
costs, the old upper one and the innovators lower one.
Due to the innovation factor, the firm can now produce an output OQ 2 at a
lower marginal cost OP2 whereas the rest of the market demand is OQ 1 at the
price OP1. Since the market price of the product is higher than the marginal
cost of the innovating firm, this makes the innovating firm enjoy a producer
surplus P1ADP2 which in essence is the Schumpeterian rent.

Notional deadweight welfare loss

P1

Marginal cost

Schumpeterian rent
C

P2

D
Demand

Q2

Q1

Q3

Quantity

Diagram 1.1 Schumpeterian Rents

In this arrangement, the innovator can choose to offer the product in the
market at a lower price a situation which can lead to the competitors making
loses as the innovator enjoys high profits and more so if he has a large
market share. The price cutting will put pressure on the competitors to
innovate or else suffer being pushed out of the market. This scenario sets the
consumer on the other end to enjoy the low product prices. In the event that
all firms innovate, the price will drop to OP 2 and consequently the quantity
purchased increases to OQ3 hence the consumers will not only benefit from
the rent but also on the additional consumer surplus ABCD (Notional
deadweight welfare loss which existed prior to innovation)
If the other firms dont fully imitate due to either inability to learn or the
existence of patent protection, it follows that the Schumpeterian rent will not
reduce the social benefit below any attainable level and therefore this will not
be associated with efficiency. In the case where the imitation is prevented by
the law, the net social benefit in the static sense is lower due to the
Schumpeterian rent by the amount ABCD and its associated with Static
inefficiency. In the worst case scenario where an innovation is instantly
copied devoid of legal protection, the innovating spirit will be dampened and
therefore institutional protection is necessary to encourage innovation. On
the other hand, if imitation takes too long, the persistence of the Notional

Welfare Deadweight loss outweighs the benefit from additional innovation

which the protection calls for and the net social loss is high.
In certain levels of protection, Schumpeterian rent may become like
monopoly rents and innovation rates may decline to bare minimal since the
innovating firm lose the incentives for further innovations therefore the
protection would need be optimised to ensure great social benefits else the
Schumpeterian rents would be associated with both static inefficiencies and
sub-optimal growth rates. Its therefore evident that in industries where
innovation is risky, or if the entrepreneurs are risk-averse, longer protection
periods may be necessary. The figure 1.2 below shows the relationship
between the net social cost/benefit and the duration of protection, in some
cases the protection can be misused to maintain profitability of the
innovating firm without innovation leading to monopoly other than
Schumpeterian rents. The optimal protection of the society is at point
P*where the net social benefit is optimised.

Net social cost/benefit over time

Sum of net social benefits over time due to faster innovations

Sum of net social cost over time due to the persistence o

Period of rent protection

Fig. 1.2 Dynamic net social benefits with Schumpeterian (and learning) rents
A firm in a given industry which has advantage in research can speed up in it
in such a way that the competitors wishing to innovate risk losing their R&D
as sunk cost and thus scaring them out of the game and consequently the
insider will enjoy the rents for a prolonged time making the rents have
monopoly rents characteristics (Dasgupta and Stiglitz 1988; Stiglitz 1996:
139-152)

Information rents as a variant of Schumpeterian rents

The same understanding under which Schumpeterian rents operate by,

also is applicable to the incentives required to generate and use all
types of information and those who have the information either about
the market situation will earn higher returns (rents) with respect to the
past situation. These rents are very necessary for making the markets
work efficiently.
In developing countries, asymmetric information is pervasive and so
are the information rents a situation propagated by weak institutions
for information dissemination and regulation which lead to
monopolization of the information and therefore higher rents than in
advanced countries. This situation will be damaging if there is no
freedom to access the information and therefore inefficiency on the
other hand if the information is accessed instantly, the generators of
the information wont benefit.

b). Rents for Learning

In developing countries, productivity growth is not boosted by innovation but
rather by learning so companies do increase the social benefits by adopting
and adapting technologies under use in the developed countries. As in the
case of innovation, only firms which learn faster reduce their marginal costs
and therefore benefit from the accruing rents. The learning process is a risky
one and the risk averse companies or industry stands a better position to
exploit this rents.
In developing countries, the firms would rather engage in known technologies
and enjoy minimal profits than venturing in the risky innovation process and
thus why its important for the subsidies to be availed so as to accelerate
technological learning.
Unlike Schumpeterian rents, rents for learning are created ex ante by a policy
rather than ex post as a result of innovation. These rents allow that firm in
the learning sector to have ample time to catch up.
From the figure 1.3 below;
There are two Marginal cost curves, one for a developing country DCE and for
a developed country ABQ. Despite the characteristic low wages in the
developing countries, the costs are still high due to the poor technological
capabilities associated with such countries and its majorly because learning
technology takes time.

Price
E
C
Learning effect
Marginal cost with foreign technology
D
Rent for learning/ conditional
F subsidy
P
Q
P
B
A
0

Q1

Q2

Quantity

Figure 1.3 Conditional subsidies as rents for learning.

Considering a situation where the government offers the industry a subsidy
AD per unit of output, with a cap on the total subsidy offered set at ABCD
which serves as a rent for the firms since its an income above their next best
and would involve selling their produce in the world markets. In effect the
subsidy lowers the marginal cost of the domestic production over part of the
range giving an effective domestic cost curve along ABCE and a domestic
production of OQ1 of the product. Such a subsidy is inefficient since it allows
production in a sector where the actual cost of production is higher than the
price of output with a social cost implicated by PFCD
According to Khan (2000 pgs 49&50), the subsidy given if based on time
restriction or a credible conditionality for export growth may be justified over
time if these requirements are met. In this case, the subsidy will create
incentives for learning-by-doing. For successful subsidy effects, the marginal
costs should be able to go the international level or even lower since the
industry has a lower labour cost advantage. In this situation the subsidy
ABCD is no longer necessary and domestic production can increase to OQ 2
and thence the industry is able to capture producer surplus APQ.
In this case, benefit of learning becomes the discounted value of the stream
of future producer surpluses APQ and any other positive externalities and the
social cost over time is the discounted value of the stream of temporally
costs of PFCD plus the social cost of transferring ABCD to this sector in the
form of temporary disincentive effects elsewhere in the economy provided
that the costs do not have to be sustained for long. In the event that the
learning gains are large and the net social benefit with time is positive, it
implies that learning subsidy is dynamically efficient.

As diagram 1.2 displays, the sum of net social benefits due to accelerated
learning by learning rents is also likely to manifest that curve. In case the
protection period is short, there will be very low benefits in terms of future
producer surpluses, as domestic entrepreneurs would have insufficient time
to learn, but if the time is too long, it can result in to waste as infants in the
industry know they will never have to grow up and the learning can actually
slow down.
For the learning rents to produce results, the state should be able to make
decisions rapidly to correct the situation in case the recipients fail to perform.
As it was with Schumpeterian rents, the learning rents have a likelihood of
not generating growth. To monitor performance, it may be necessary to
subject the domestic firms to international competition over a pre-set time
frame. The success of this system depends solely on the ability of the state to
enforce the allocation and withdrawal of subsidies which depends on the
political context in which the policy is conducted.
Since the social desirability of rents for learning depends crucially on the
efficiency of the state in managing these rents, the optimal technology
trajectory of a country is dependent on the state it has.

Monitoring rents and financial institutions

The study of these rents has opened up new tools for investigating the role of
financial institutions in developing countries I that rents of financial
institutions may be efficient if the induce efficient monitoring of credit
portfolios.
In the past the rents caused financial repression, and
consequently caused allocative inefficiency, since the governments held
down interests for savers to facilitate industrial borrowers but this system
created dead welfare losses by creating a gap between demand and supply
price of credit as it is in monopolies which create a gap between price and
the marginal cost Hellman et al. 1997.
Financial rents under some conditions may be useful but they suffer the
problem of asymmetrical information which can lead to market breakdown
(Stiglitz and Weis 1981). Bad borrowers who are willing to take high interest
since they are not intending to repay, do drive away good borrowers and this
calls for financial institutions to be able to monitor these types of borrowers
else they risk going bankrupt. This is because only at high rates only bad
borrowers are willing to borrow causing the bank get returns less than the
nominal interest rates.
Considering the diagram 1.4 below, it shows that the banks expected returns,
r, are not the same as the nominal interests, i , charged to borrowers. After
the critical interest i*, the expected returns start to drop due to the high risks
of bad borrowers attracted at these rates which is a adverse selection
problem.

In the diagram below, i* is below the market clearing and thus there is an
excess demand for funds. At i*, the bank is willing to lend at L S while the
demand is for LD of loans, the excess demand is dealt by monitoring of the
bank aiming at separating the good and bad borrowers and so allocate credit
to the good borrowers only.
D,S

LD

LS
D
i*

Nominal interest rate i

Expected return r

i*

Nominal interest rate i

According to Stiglitz and Weiss argument, information problems can lead to

credit rationing by the banks whereas Hellmanet al. (199 7), argued that in
developing countries where the banking sector is weak, the government
regulations which create rents for banks can increase their incentives to
monitor their portfolios better.

r0

rd

rL

Interest rates

Rent which contributes to the fran

Fig 1.5. financial sector loans as incentives for monitoring

Loanable funds

According to Hellman et al. 1997, in the figure above, the gap between the
regulated deposit rd, and the market lending rate rL, is the source of the rent
for banks.
According to Hellman et al. the financial restraint model is important since
it challenges that the non-rent competitive equilibrium in the financial market
is possible and efficient. This model assumes that the bank ownership
structures earned the rents and that they provided incentive to monitor their
portfolios. These rents in public sector banks wont provide incentives for
monitoring unless we assume that the managers are able to appropriate a
large part of these rents.
Another related problem is that if the bank doest face risk for bankruptcy, the
incentive to monitor can be significantly diluted and hence losing the
franchise value. The social cost of bankruptcy increases of the banks are
large since they wont be allowed by the government to do so and therefore
the government will bail them out.

Also worth noting is the fact that the difference between the efficient and
inefficient bank based lending often was more about the effective power of
banks to monitor and discipline borrowers than the incentives they had.
In as much as the financial restraint model assumes that the banks have the
information and therefore stand a better position to monitor, on the contrary
the government is usually closely involved in the operation of the financial
sector, regulates the size and ownership of banks and hence determine the
effectiveness of rents as management incentives. This therefore implies that,
even though the banking system has the power to monitor, this is dependent
on the states ability to enforce and implement policy decisions because its
technical capacity and political ability to overcome resistance and enforce
decisions on both the banks and borrowers is a critical variable. The efficiency
of financial allocation can be highly reduced if the state has other political
objectives.

Financial sector rents not only cause good economic performance through
creating monitoring incentives but also by;

Financial institutions creating rents for onward transfer to the emerging

capitalists engaged in primitive accumulation as well as political clients
of the state from the intermediate classes to maintain political stability.
Despite the vulnerability of the process based on delicate political
compromises, it was for a long time successful in the East Asian
countries.
Using state control over interests and political transfers to
simultaneously create learning rents for industries by keeping
borrowing rates low which consequently leading to improved economic
performance.

Stock Markets
According to Musgtaq Khan, bank allocation declining efficiency could not be
blamed on the declining capital allocation especially in the 1990s but rather
that stock markets could generate information rents for stock holders or
investors in certain countries if the decision to do so was good. This period is
characterised by growth of stock market information rents relative to the
long-term state-created bank-based rents in the financial sector. Stock
market information rents in the real sense are able to perform a useful role in
capital allocation.
One of the undoing of the stock market information is that they only tell what
companys prospects are but not what actually are. (Stiglitz 1996: 92-96).
Making money in the stock market requires good sociological understanding
of what the market thinks is better and its not a good analysis of the basics.

Stock market sentiments can affect capital allocation regardless of changes in

fundamentals. In advanced countries, mangers have been forced to pay high
dividends even when that was not the projected company interests since
dividends were viewed as indicators of management performance.
There is great need to regulate stock markets and international capital flows,
such that valuations do not move greatly out of line with underlying
fundamentals.

Reference:
i.

ii.

Rents, Rent-seeking and Economic Growth , Theory and Evidence in

Asia Edited by Mushtaq H. Khan and Jomo K. Sundaram Cambridge
University Press.
Suzuki .Y. 2015 Theories of Institutions ppt.

References:
BOOKS
Japan's Financial Slump: Collapse of the Monitoring System Under
Institutional and Transition Failures - Author: Yasushi Suzuki 2011

An increasing role for competition in the regulation of banks

A report by darryl biggar and alberto heimler 2005
The international competition network antitrust enforcement in
regulated sectors
PDF link:
http://www.internationalcompetitionnetwork.org/uploads/library/doc38
2.pdf