You are reading Economic Forces, a free weekly newsletter on economics, especially price theory, without the politics. Economic Forces arrives weekly in the inboxes of over 6,000 subscribers. You can support our newsletter by sharing this free post or becoming a paid subscriber:

Subscribe now

Imagine that you and I are both endowed with land at birth. I have more land than you. In fact, I have “too much” land in the sense that I cannot use all of the land I have productively given the constraints of my time, ability, and resources. You not only have less land than me, but you have the time, ability, and resources to use more land than you own.

There are potential gains from trade here. On the one hand, I could sell you some of my land. However, there are many potential impediments. You might not have the resources to purchase my land. It is possible that I could extend credit to you with the land as collateral, but there are information problems. You might have a better idea of whether you intend to pay me back or not. And while I can reclaim the quantity of land that I sold to you, the quality of the land might have changed.

At the same time, you might be skeptical of purchasing some fraction of my land. I have more knowledge of the quality of the land than you do. Although you might know the average quality of my land, I might choose to sell you the fraction of my land that has the lowest value.

Now, you might be thinking, “sure, there are information problems, but a lot of these could be sorted out through contracting.” And that is correct. However, it is important to note that what type of contract we agree to is also a choice. The contract doesn’t have to be a contract to purchase.

So-many-decisions GIFs - Get the best GIF on GIPHY

A lot of other arrangements are possible. I could simply hire you to work on my land in your spare time for a given wage. Alternatively, I could rent the land to you at a fixed rate. But I could also agree to simply allow you to work the land and keep some fraction of the output for yourself and give me the remaining fraction.

For some time, economists argued that this sharing contract was inefficient. The argument was that the incentives of sharecropping were similar to the incentives created by a tax. Suppose you only get to keep 80 percent of the output from working the land and you have to give me the remaining 20 percent. The marginal cost of working the land doesn’t change, but the marginal revenue you generate is 20 percent less than it would be if you owned the land. As a result, you will tend to work less and produce less than you would if you owned the land yourself. This is inefficient.

That is a nice story, but in economics the question that is to be answered is “inefficient relative to what?” In this case, the answer is that it is inefficient relative to you owning and working the land yourself. But suppose that I am not willing to sell you the land. This means that we have to consider the wage and rent alternatives.

Consider first a wage contract. One argument might be that if I pay you the market wage, you will produce the same amount as you would if you owned the land yourself. This comes from the familiar result that if I am a profit-maximizer, I will pay you a wage equal to your marginal revenue product. If you owned the land and worked it yourself, the opportunity cost of working the land is the market wage that you could earn by doing something else. Thus, you would continue working as long as the marginal revenue product was greater than or equal to your market wage. The wage contract seems to replicate the outcome from your ownership of the land.

But this ignores key factors. Not all workers are the same. Some have higher productivity than others. Some are more likely to shirk than others. Since I don’t have time to work the land myself, I probably also do not have time to monitor your effort. In theory, although I wouldn’t have time to monitor your effort, I could monitor your output. However, there are a wide variety of factors that could influence output beyond your effort, such as bad weather. Alternatively, I could pay some sort of monitoring cost, like hiring a manager or installing cameras to make sure you were not shirking.

yellowstone gifs | Explore Tumblr Posts and Blogs | Tumpik

Think about this monitoring cost. This cost drives a wedge between the price that I pay to have someone work the land and what you receive to work the land. That wedge sounds a lot like a tax and results in an inefficient allocation relative to the competitive benchmark. In this way, it is similar to the share contract.

Okay, you might say, the share contract is inefficient and the wage contract is inefficient. It must be the case that the rent contract is the solution.

Not so fast.

Think about the rent contract. If you are paying me a fixed amount of rent, it is true that you will have no incentive to shirk since shirking would affect your payoff and not mine. But consider this. There are two costs associated with working the land. There is the costs associated with planting and growing and harvesting. There are also costs in terms of the depletion of nutrients in the soil. Since you do not own the land, you are unlikely to take into account the marginal cost of depletion of the land. You will therefore tend to produce too much in the sense that you are extracting too many nutrients from the soil.

At the same time, if the rental contract does not stipulate that the land owner is required to provide maintenance, I will have no incentive to provide maintenance over the duration of the contract. As such, the land will not be properly maintained. This is, yet again, another inefficiency since the value of a little maintenance almost certainly exceeds the marginal cost.

With each possible contract there are inefficiencies (foregone gains from trade). The choice of the contract by the contracting parties will therefore tend to be the contract that minimizes the degree of inefficiency. For example, if the primary cost is monitoring or policing effort and/or output, then the rent contract minimizes inefficiencies because the worker has no incentive to shirk when renting. On the other hand, if the primary cost is in maintaining and policing the quality of the land, then sharing contract or a wage contract might be preferable. In reality, it is unlikely that there will be one primary cost. Nonetheless, the decision about what contract to choose will depend on the costs and the corresponding inefficiencies.

In short, the fundamental point here is one that was emphasized by the late Yoram Barzel (to whom Brian offered a tribute last week). Critiques of things like share contracts rely on comparisons between the share contract and the benchmark competitive model. But there is always another margin that one could be thinking about. The choice of the type of contract to use is a relevant margin of analysis. Thus, the share contract itself was a choice. It is therefore important to consider the relative alternative contracts. There is always another margin to the consider.

Economic Forces

There is Always Another Margin