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This post was previously published in earlier blog of this Investment Economics Foundation:
Adam Smith divided income into three types: profits, wages, and rents. The essential feature of profit is risk: capital is ventured in the hope of a return, and there may be a very great return, or little, or none. There is no guarantee of a profit in any enterprise, which is why businesses, both large and small, go bankrupt all the time -- unless, like Chrysler, they have enough political influence to get bailed out by the government. Profits ultimately represent the real growth of wealth in an economy, for the profits of one enterprise do not always come out of the profits for another. Say's Law is that supply creates demand, that a successful business adds to the productive capital of society, which increases the goods, and the profits, available for everyone. If the "profit motive" is rejected by governments because it is selfish or evil, and enterprises are conducted without concern for profitability, then what actually happens is that they will need to be subsidized, and the subsidies will have to come, if not out of profitable enterprises, then out of the stock of capital itself. This means that the economy will gradually consume itself, just as a starving person lives off their own tissues, until there is too little left to sustain life. That is what happened to the economies of the Soviet Union and Eastern Europe, and to countless, ill-advised Third World countries.
Wages, on the other hand, represent no risk, except that their source might (illegally) default or (legally) go bankrupt. Wages are a fee for a service, naturally discounted by the market mechanism for the absence of the kind of risk germane to profits. Market wages are otherwise proportional to productivity, and productivity is proportional to the capital investment in the person (education, honesty, diligence, etc.) and in the job (machinery, computers, etc.). Capital value in the person ("human capital") comes from natural endowments (talent, intelligence), upbringing (honesty, conscientiousness, reliability, etc.), and education (training and knowledge). Most of this belongs to people before they ever go to work, but employers may invest in workers further through on the job training or additional education. Labor intensive work means low skills, low productivity, low wages, and so a larger, less wealthy work force to produce a given amount of goods. Capital intensive work means higher skills, higher productivity, higher wages, and so a smaller, wealthier work force to produce a given amount of goods. People fear and hate being thrown out of work by mechanization and automation, but that is the only way that life gets better for most people. The labor that is not needed after productivity increases is then available to produce new kinds of products, further enriching life for everyone. The best example of this kind of shift is that for most of human history over 90% of the work force was necessary just to produce food (still 85% in Tanzania). By 1840, the United States for the first time had less than 90% of the population living in rural communities (of less than 2500 inhabitants). By 1880, the United States for the first time had less than 50% of the work force in agriculture. Now only about 1.6% of the work force is engaged in agriculture full time. No one thinks that the solution for unemployment is for people to go back into agriculture. The only real solution is for new products and new industries to arise. For this to happen, however, someone must risk some capital, with the hope of profit, in order to attempt to increase productivity or attempt to produce something new. Those attempts often fail, which is why profit involves risk. Also, some of them must fail, or many useless and uneconomic activities will continue to burden the economy (as in the Soviet Union, the U.S. Federal Government, etc.).
Rents are the easiest kind of income. A rent is money paid for the use of a capital asset, whether land, a building, an office, a car, a bicycle, or whatever someone might want but cannot or does not want to own. The owner who rents out his assets need only worry about (illegal) damage like vandalism, theft, etc. and about (inevitable) depreciation, where the capital value of the asset declines in time through ordinary use. Loaning money is a kind of renting, where the asset may depreciate through inflation and where there is considerable risk that the borrower may default or go bankrupt. The element of risk introduces an element of profit, but a careful lender can see to it that borrowers have the assents to cover any defaults: and the legal right to recover capital distinguishes renting from a straight investment for profit (where the whole capital can be lost without legal, moral, or any other recourse). Like banks in that respect, most renting enterprises mix rents with profits: they invest for profit by running a business where they collect rents.
Because rents are the easiest and most secure kind of income, it is natural for people to want income from rents rather than principally from profits or wages, and to want rents that involve the least risk and labor as enterprises. This motive is called "rent-seeking," and there is nothing wrong with it. Indeed, those who collect rents in an economy serve the valuable function of seeking to maintain and preserve capital assets [note]. It becomes wrong when rent-seeking means trying to collect rents off of capital that is not the rightful possession of the rent-seeker. This can be legally accomplished through the means that secure the rights of property in the first place: politics and the law. Through political influence people can be given ownership of things that are not their property, or should not be anyone's property. The theory of rent-seeking began with the economist Gordon Tullock.
A government that grants a monopoly in a certain enterprise cannot determine a market-clearing price and so is either going to victimize a company by not allowing a high enough price or is going to victimize the public by mandating or engineering prices that are too high: those prices then include "monopoly rents," the amount of money the company makes over the profits of a competitive market. The rent comes from the "ownership" of the monopoly market. Similarly, on the other side of the coin is labor law, which tends to vest workers with property rights in their own jobs. Since that is how feudalism worked ("livings," like property, were bestowed on people, and these consisted in collecting feudal rents), and it does contain the attraction of job security, there is a powerful historical and emotional pull to such rent-seeking, although it is contrary to the flexibility (albeit insecurity) for growth that the free market provides. The seduction is the thought that workers are better off with their monopoly rents and security, when in fact workers in general are far better off that the free market allowed the growth of wealth and erased the kind of peasant life (with security, apart from plagues, invasions, the droit de seigneur, etc.) that most people had under feudalism.
Source: http://www.friesian.com/rent.htm
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