A Bit on Rent Seeking

Cherry BlossomsThis is a continuation of two previous posts: Is Competition Always Good, and Competition in Free Markets.

Prabhudesai referred to JEE (Joint Entrance Exam) in a comment and wrote, “An examination that has too much of competition resulting to very high cost of producing one engineer. For a poor country like India it is a massive blow.”

Is that type of competition good? That is socially wasteful competition. It belongs to a broad class of activities that are technically known as “rent seeking.”

One of the principal ways of obtaining wealth is by earning a profit. Profits are the difference between the cost of producing something and the price obtained from its sale. Profits indicate that wealth has been created and value delivered. Rent seeking occurs when one attempts to obtain some wealth without actually creating wealth. 

Here’s an example. Suppose a firm as a monopolist in some particular market could earn a profit of $10 million but the same firm would earn only $2 million in a competitive market, then as a monopolist it gets a rent of $8 million. Therefore to get that $8 million rent, it would lobby the government to grant the firm monopoly rights to the market. That is rent seeking. But rent-seeking is not free; the firm has to pay lobbyists and they have to pay the politicians and  bureaucrats. Those activities don’t create wealth; they consume wealth. The lobbyists could have been producing some goods and services instead. 

Anyway, the firm can never get all the $8 million in rent. Rent seeking costs money. But even if it has to spend, say, $5 million in lobbying, it still ends up collecting $3 million in net rent.

But wait there’s more: it is not the only firm that is interested in rent seeking. There are, let’s say, half a dozen other firms which also want to monopolize the market. If on average they spend $2 each, seeking the $8 million rent, they end up on aggregate spending $12 million to seek the $8 million rent. It’s a total waste.

The competitive exams like JEE are a form of rent seeking, as mentioned before. Suppose as 4-year IIT diploma can be obtained at a private cost of $40k but the full cost of the training is $100k. Therefore getting into an IIT is the same as obtaining a rent of $60k. Suppose spending $5k in coaching classes improves a student’s chances of getting into an IIT from 2% to 10%, the expected benefit (10 percent of $60k) is greater than the cost ($5k). So it is rational for a student to spend real resources on coaching classes. But all the rent is dissipated eventually when too many people compete. If 1 million students each spend $5k (for an aggregate of $5 billion) and the total rent is only $1 billion, more than the total rent is dissipated in rent seeking.

In the next bit, I will explore why this happens in a distorted market. In a free market this would not happen.

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