Rent Seeking

Jeff Bezos recently told employees that Amazon will die one day, but it was all their jobs to make sure it takes as long as possible for that day to arrive. History will tell you that every business will lose relevance over time and management needs to actively make attempts to keep the business alive. The important question we need to ask though is how are businesses going about this goal.

In order to understand rent seeking, it is important to understand the concept of ‘Economic Rents’. We aren’t talking about the money that invariably comes due on the 1st of every month and eviction looms unless this debt is paid. We are talking about economic rents which is the amount of profit a business earns over normal profit. Let me explain this using an example.

Let us assume I am an individual of Mexican descent and I just moved to a rather large town called Wild Wild West. I am craving tacos and I don’t want to make them at home. I realize there are no Mexican restaurants in town and I’d have to drive 30 minutes to Fair City for some restaurant tacos. I see an opportunity and decide to open up a Mexican restaurant. The restaurant is an instant hit and local customers can’t get enough. Another Mexican in town realizes how much money I am making with my monopoly and decides he wants in on the action. He buys a food truck and starts selling tacos out of it. Turns out his food is equally good and my business is suddenly cut in half but I am still pretty profitable. More people see the opportunity and more Mexican joints pop up further denting my earnings. I am now really contemplating if I should keep my business open at all but if I were to shut down my restaurant, I’d have to get a cashier job at a fast food restaurant (this is known as my opportunity cost) and my restaurant still makes a little more than I’d make as a cashier so I keep the place open. However, now there are enough Mexican restaurants in town and not worth anyone else’s opportunity cost to open a new Mexican joint. Now lets talk about the economic phenomena taking place in this story.

When I opened up my restaurant, I had monopoly. This allowed me to earn higher than normal profits. I have an advantage since I am the only Mexican place in town. I can overcharge for tacos and people will pay since they don’t want to drive all the way across town. I am therefore making what economists call ‘Economic Rents’ (Higher than ‘Normal’ profits). Now as another place opens up, my ability to overcharge for tacos is seriously impacted. If I try to overcharge, they might go to my competition. I can still overcharge if my food and service are worth it but as more places open, these advantages fade and suddenly, I can only charge what everyone else is charging and hope that my food and service brings people in. The profits have now ‘normalized’. When profits normalize, there is no more incentive for more people to jump into the mix because the opportunity is not lucrative enough.

Now you might say that there are often places right close to each other that sell the same type of food but one is more expensive than the other, and I’d say great point. This is called differentiation and it allows you to earn economic rents even when there is competition. My restaurant has a great ambiance, free chips and salsa and phenomenal service and all this comes at a price premium but most of my customers don’t mind paying extra for the perks. The food truck down the street serves takeout customers who are price sensitive and just need a quick bite. We’ve managed to make peace by splitting the market into two distinctive segments. This is a perfectly legal way of creating economic rents. We are both happy – I get the fewer customers from whom I profit more per plate of food served while the food truck sells a lot more food with a smaller per plate profit and we both might make good money from doing so.

But I want more money and need to find a way to make that happen. I have a few options here –

  1. I can buy the food truck: Great idea and a real possibility in this scenario but doesn’t work for large businesses. The government doesn’t allow this because it creates a monopoly and gives a business too much consolidation of pricing power to squeeze customers for cash.
  2. I drop my prices to attract the food truck customers: I might succeed doing this for a short time but I have a lot more overhead since I have to pay rent, cooks, waitstaff, dishwashers etc. I am going to start making serious losses for a while but if that puts the food truck out of business, it might be worth it because after the truck is gone, I can start jacking up the price again. I still run the risk of the truck coming right back as soon as I start increasing prices because the truck doesn’t cost much to set up (entry barriers are quite low).
  3. I can Talk to the truck owner and we both agree to overcharge customers: This is know as collusion, specifically, price fixing and is highly illegal. We could both go to jail for doing this so I decide not to do this.
  4. I can lobby to the mayor of Wild Wild West: The mayor of Wild Wild West is a regular customer at my restaurant. The next time the mayor is at my restaurant, I ask him if his campaign needs help in the coming elections and he says that is always the case. I tell him how I think food trucks are unhygienic and that people get sick from eating there. As an affluent citizen of the city, I would be willing to make a donation to his campaign if we could ban food trucks from the city since they are such a health hazard once the mayor gets elected. The mayor agrees to push the cause and I hand him a big check for his campaign. The mayor is elected and in a few months, food trucks are banned from the city. Now anyone wanting to serve Mexican food will have to invest a lot more money as they will need to pay rent and staff. I’ve created an entry barrier of a higher investment requirement discouraging competition. While I’m at it, I’ve also convinced the mayor to make 1 year leases mandatory for all restaurant rentals. This means that any aspiring restaurateur is now going to have to risk being stuck in a lease and with a bad business for 1 year if they open a restaurant and it doesn’t do well. So I’ve also created an exit barrier further discouraging competition. Mean while, the price of a taco in Wild Wild West has never been higher. People wanting Mexican food are forking over $10 for a taco because they don’t want to drive 30 minutes to Fair City and I couldn’t be happier.

The last move is known as Rent Seeking. Lobbying is the most popular form of rent seeking. While every business needs to fend off competition. A lot of businesses (especially ones with influence) try to change the rules of the game once they’ve succeeded so that no-one else can enter or compete allowing them unfair advantages and ability to generate higher than normal profits. There are a few byproducts of this behavior that are detrimental to customers and in some cases, humanity.

  1. Unfair Pricing – In the above example, is $10 for a single taco fair? Absolutely not but it is the new reality thanks to the mayor we all voted for. One of the major bipartisan problems right now is drug pricing and it is a direct result of big pharma rent seeking over the years. Pharma companies have spent so much effort fixing the rules in their favor that life saving medication is now priced at levels where normal people are priced out of the market (Think pharma bro Martin Shkreli). People are actually stretching insulin doses so it would last longer risking their lives in the process while drug companies rake in economic rents on each dose of insulin.
  2. Blatant disregard for customers – Have you ever called your cable company and felt that you were mistreated as a customer. Maybe it has happened with your cell phone provider? So much consolidation has been allowed to happen in these industries that customers sometimes have no other option than to stay with their providers which means the providers have no incentive to treat their customers with respect because there is little to no risk of defection.
  3. Lack of innovation – This is likely the largest, most detrimental impact of rent seeking. Since competitive advantages are obtained in an unfair manner, there is no reason to develop innovations that will help you win in the marketplace. In my restaurant example, there is no need for me to bring a new dish to the menu since there is nowhere better diners can go. I don’t even need to adequately staff the restaurant or buy good quality produce. If I am a pharmaceutical company, there is no need for me to develop new drugs since the old ones are making enough money for me to care and that could mean that when diseases evolve to become resistant to the old medication (they always do), we won’t have anything to combat them.

Just about every industry out there indulges in rent seeking behavior. Big Pharma, Telecommunications and Petroleum are the biggest ones. The irony of the world we live in is that a political candidate projects anti rent seeking sentiment will not have the campaign contributions needed to publicize their campaign and hence will never get elected. On the other hand, candidates that take money from super PACs will have the publicity to get elected but then be a puppet controlled by his corporate master. They will invariably write legislation that will then contribute to corporate gluttony.

While rent seeking is usually a tacit process, the most recent example of Amazon openly asking for tax subsidies to bring the prospect of jobs and taxes for states has been a blatant example of rent seeking behavior. It is not difficult to see how paying lower taxes puts more money and hence more power in the pocket of one of the world’s largest companies helping it prevent competition which they already have very little of. I say kudos to the people of New York for thwarting this blatant rent seeking attack from Amazon on their city and state. I live in Seattle and know first had what a business like Amazon moving in can do to a city. The below house is currently listed for $1.5 million in Seattle. It is 1060 Sq. Ft., was built in 1907 and looks as if it hasn’t been touched since. There is no doubt it will need to be rebuilt from the ground up. You can imagine what Amazon would do to a place like New York.

1060 Sq. Ft. West Seattle home listed for $1.5 million

A burning topic lately has also been the wealth gap and you can imagine how rent seeking adds fuel to this fire too. A business is doing well so then they seek rents by donating to political campaigns turning the laws more favorable for them making them richer while making every customer out there poorer. It is no coincidence that the wealth gap is increasing. It is a monster of our own making and if humanity is to survive for another thousand years, we need to make a change.

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