## Wednesday, May 4, 2011

### Economics, Real Estate and the Supply of Land

As a general rule, economists relying on supply and demand curves without properly discussing the assumptions that sit underneath their graphs can be ignored.

Alan Evans' book Economics, Real Estate and the Supply of Land is an effort to refute Ricardian notions of land supply and rent, and offer an alternative neoclassical theory of land supply. The arguments in this book are taken by many who believe that reducing government involvement in town planning will decrease the price of housing. Evans’ reasoning is questionable to say the least, and supported by elaborate graphs with often biased assumptions and interpretations.

One of Evans’ aims is to refute the Ricardian proposition ‘that the price of land is high because the price of corn [read: houses] is high, and not vice versa’.

To do this he constructs a model economy with a fixed land supply where two agricultural uses compete for land – potatoes and corn. In the figure below we see his construction of this economy on the left, with demand for corn inverted so that the intersection of corn and potato demand determines the equilibrium share of land devoted to each crop, and the equilibrium rent of land at point A.

He then proceeds to add a demand shock to potatoes ‘for some reason’. The new blue line represents the new increased demand for potatoes which enables potato growers to bid up prices for land previously grown for corn and reduce the amount of land used to grow corn. He concludes with the following -

Now it is quite clear that the increase in the rent of land is not caused by the increase in the price of corn. Exactly the reverse is true. The price of corn has risen because the price of land has risen.
...
The rent for land is not solely determined by the demand for the product.

His conclusions are wrong.

First, it is still quite clear that at the new equilibrium the price of land for corn is still determined by the new higher price for corn. You could just as easily argue that every time a potato grower buys land from a corn grower he decreases the output of corn and the price of corn rises, thereby leading to an increase in the rents of land available for growing corn.

Second, he fails to notice that all he has done with the model is to demonstrate the inflation mechanism following an increase in money supply for one purpose. He increases total demand (potatoes plus corn) but shifts preferences towards potatoes so that corn demand is constant. The end result of his demand increase is to increase all prices in the model economy – potatoes, corn and rent.

Followers of Say would jump straight to this conclusion. You can’t simply increase total demand in the economy – demand is comprised of supply.

An actual demand shock, which models a change in preferences from corn to potatoes, is shown in the right hand side figure. You will notice that total demand remains constant and therefore the rents for this fixed quantity of land also remain constant.

So no, land rents do not determine prices. Prices determine rents.

Another example of poor reasoning is when Evans argues against a 100% land value tax. He argues that a tax of that nature would ‘freeze’ land development because there would be no incentive for a owner of agricultural land to sell his land to a developer for housing development, since he would not capture any of the value uplift. The rent achieved by the owner of the land will remain the same as when it is rented to the farmer – zero.

Yet in chapter 8 he argues that the value of land grows in anticipation of future higher value uses. In these cases, when the site is genuinely worth more as housing, the tax would be at a rate that reflects that higher value, and not the agricultural value. Therefore, the owner of the land will be facing a tax on the land value for housing while only receiving rents at agricultural values. As the city expands and the value of his land for housing surpasses the value for agriculture, he has a great incentive to sell or develop immediately to avoid losses.

Although I don’t support a 100% land value tax, I do support shifting the tax burden towards land and fixed rights to natural resources.

What we do learn from this book is that even the experts are prone to bias that affects their ability to apply objective logic and reason.

1. nice post :-)

Actually further to "As a general rule, economists relying on supply and demand curves without properly discussing the assumptions that sit underneath their graphs can be ignored."

as a science sort of fellow I find it hard to get the meaning of graphs where there is no scale on the axis as this can make something shallow look steep, or something curved look straight.

just something else I look for in economists work.

2. This comment has been removed by the author.

3. "What we do learn from this book is that even the experts are prone to bias that affects their ability to apply objective logic and reason."

especially if that bias positively effects their funding sources

4. Obakesan; there is millions of dollars of self-interest involved among a wide range of players, in maintaining "planning gain" and incumbency advantage. Who do YOU say is paying off some guy who is advocating for freer supply of land? Future first home buyers? Good on them if they are this clever and this well organised. But I don't THINK so. And are Uni professors likely to be more popular or less popular with faculty if they buck P.C. groupthink "green" ideology? It is noticeable that only OLD professors near the end of their careers ever speak out like Evans, or Morrill, or Anas, or Fischel, or Downs.

Cameron, Evans actually builds up a broad theoretical base in his book, according to the conditions under which each classical theory is or is not relevant. Evans says "The rent for land is not solely determined by the demand for the product", with which you disagree and say "total demand remains constant and therefore the rents for this fixed quantity of land also remain constant. So no, land rents do not determine prices. Prices determine rents".

But YOU are talking about the TOTAL supply of land, and Evans is talking about the supply of land for one particular purpose. The price of THAT land is NOT determined solely by the demand for THAT particular product, but the effect of competition for the supply of land from other users.

This is where all your arguments about vertical supply curves and "demand" being the only determinant of land prices, falls flat on its face. It fails to take into account TOTAL supply of land being competed for by multiple potential users of all types, and rents being set by "the strongest loser" - who should NOT be some household priced out of the urban land market, but some low value crop grower.

You say regarding taxes on land (I didn't intend to get involved in this, but you are insulting an economics writer of major stature in Alan W. Evans) ".....the value of land grows in anticipation of future higher value uses. In these cases, when the site is genuinely worth more as housing, the tax would be at a rate that reflects that higher value, and not the agricultural value. Therefore, the owner of the land will be facing a tax on the land value for housing while only receiving rents at agricultural values....."

But why WOULD the "value" of ANY land anywhere BE higher if it was being taxed at 100%?

By the way, I like the idea of "encouraging" fringe land owners to sell via some mechanism like this; that would actually go a long way to solving the price inflation effects we are ongoingly debating. Another way would be to zone broad swathes of rural land around the city "urban use ONLY", to destroy its value as farmland.

5. Obakesan; there is millions of dollars of self-interest involved among a wide range of players, in maintaining "planning gain" and incumbency advantage, in ANY SINGLE CITY. Who do YOU say is paying off some guy who is advocating for freer supply of land? Future first home buyers? Good on them if they are this clever and this well organised. But I don't THINK so. And are Uni professors likely to be more popular or less popular with faculty if they buck P.C. groupthink "green" ideology? It is noticeable that only OLD professors near the end of their careers ever speak out like Evans, or Morrill, or Anas, or Fischel, or Downs.

Cameron: Alan W. Evans actually builds up a broad theoretical base in his book, according to the conditions under which each classical theory is or is not relevant. You have cherry picked one step in his argument only.

Evans says "The rent for land is not solely determined by the demand for the product", with which you disagree and say "total demand remains constant and therefore the rents for this fixed quantity of land also remain constant. So no, land rents do not determine prices. Prices determine rents".

But YOU are talking about the TOTAL supply of land, and Evans is talking about the supply of land for one particular purpose. The price of THAT land is NOT determined solely by the demand for THAT particular product, but the effect of competition for the supply of land from other users.

This is where all your arguments about vertical supply curves and "demand" being the only determinant of land prices, falls flat on its face. It fails to take into account TOTAL supply of land being competed for by multiple potential users of all types, and rents being set by "the strongest loser" - who should NOT be some household priced out of the urban land market, but some low value crop grower.

You say regarding taxes on land (I didn't intend to get involved in this, but I have a great respect for Evans) ".....the value of land grows in anticipation of future higher value uses. In these cases, when the site is genuinely worth more as housing, the tax would be at a rate that reflects that higher value, and not the agricultural value. Therefore, the owner of the land will be facing a tax on the land value for housing while only receiving rents at agricultural values....."

But why WOULD the "value" of ANY land anywhere BE higher if it was being taxed at 100%?

By the way, I like the idea of "encouraging" fringe land owners to sell via some mechanism like this; that would actually go a long way to solving the price inflation effects we are ongoingly debating. Another way would be to zone broad swathes of rural land around the city "urban use ONLY", to destroy its value as farmland.

6. ?

Umm.. Don't developers usually lobby for freer zoning because it provides windfall gains to landowners whose development potential is restricted by planning?

According to your interpretation since lack of zoning forces land prices down no developer in their right mind would lobby for that? They would lobby for greater planning and zoning control. Doesn't sound much like the reality I see around me.

I'm not sure how you interpret Evans' model, but it is indeed a two sector economy with a fixed supply of land and the two agricultural products are designed to represent to competing land uses.

Clearly this example is not cherry picking. As you know in previous comments I have found many, many examples of flawed analysis in Evans' book.

I'm not sure if you realise but your above argument works against freer zoning. With planned zones there is no competing use for land - all land is designated with a single possible use. Thus the rent for that land can not be bid up by other users. Imagine if the residential zoning some inner city housing was removed to become a zone free area. Now various retail and commercial developers could bid up the price for that land, reducing residential supply and increasing residential rents in that area.

I can't take your argument seriously that land prices would be bid down to be set by the strongest loser. If that argument were to hold all land would have no value, as there is always somewhere a less valuable use to be the new 'strongest loser'.

I'm not sure you undertand the practical application of a 100% land tax. The value of the land to the owner will be zero. But you wouldn't pay 100% of zero. You would pay the equivalent annual payment that capitalised to the value in a without land tax scenario. So if a block of land is worth $100,000 without the tax, a 100% land tax would be$10,000 per year (assuming a 10% cap rate). In the market place the block of land would trade at $0 because of the$1,000 annual tax obligation.

So if the value of the block increases as the city expands to $200,000 in anticipation of future residential returns, the annual tax rises to$20,000. If the owner is only receiving $15,000 in rents from a farmer he is now making a$5,000/yr loss and there is a massive incentive for him to develop.

7. Testing, testing.

8. Testing, testing......

9. What "developers" lobby for, is for land banks that THEY own, to be rezoned. No land banker will ever lobby for the total abolition of growth restraints, merely for THEIR land bank to be zoned, and nobody else's. Classic rent-seeking behaviour.

IF growth restraints are abolished, it is "bye, bye" to the gouging capital gains that fringe land owners have been enabled to make. This is simply because anyone can now "leapfrog" the "holdout" land owners and buy SOME farmland someplace, that was for sale at farmland prices, not "zoned land racket" prices.

It actually does not take a LOT of land, cartographically speaking, to ensure a "supply" of raw land at which it will simply not "pay" anyone to indulge in land banking and "holding out" - because of the obvious cost of financing holdings for the length of time required to lock competitors out of the market. Compared to the existing built up area of a city, "30 years supply" is actually quite a slim ring around the perimeter.

You say:

".....Imagine if the residential zoning some inner city housing was removed to become a zone free area. Now various retail and commercial developers could bid up the price for that land, reducing residential supply and increasing residential rents in that area....."

Sure, no problem with that CONCEPT. That is a higher value use being allowed to displace a lower value use. But in a true free market in land, both commercial rents and residential rents would be kept low by the ability of BOTH to out-bid agricultural users for land at and beyond the fringe. The "rent curve" should slope up smoothly from "agricultural" rents at the fringe, with steadily increasing differential rents towards the centre and at nodes of local advantage. (But the slope is much flatter in a decentralised city - this is observable in the comparatively low land prices THROUGHOUT cities like Houston and Atlanta). If there were some significant "discontinuities" in rents between adjacent residential and commercial zones, that would indeed be a sign that the zoning plans need revisiting.

10. Testing, testing....I am having MAJOR problems with postings that delete the previous posting.

11. It is not that "land prices would be bid down to be set by the strongest loser", they are bid UP by everyone BUT the strongest loser. YES, when the world had a population of a few thousand, ALL land WOULD have had "no value". AIR currently has "no value". But you are obviously of the opinion that the world is "running out of land" - therefore, there has to be winners and losers in the competition for "scarce" land, and this rationing is conducted through "markets". There is currently a massive gap between the "return" available for the uses of land that use the greatest amounts, and the "return" for urban land.

At about 1950, about 1% of the earth's land was "urban" and about 33% was farmland, forestry, etc (and the other 66% was nature). At that time, the Gross Product of "urban" economies (on 1% of land) was about the SAME as the Gross Product of the rest - i.e. urban land was about 33 times as productive as rural land. Since 1950, this balance has swung massively further in favour of urban land. Urban production has increased fourfold, while its cover has increased to around 1.4% of the total, while rural land has remained very close to what it was - "nature" has lost ground in some parts of the world, but gained it in others, especially the USA. Not having to feed millions of horses and draught animals any more, plus more efficient use of rural land, has more than compensated for the extra numbers of humans needing feeding. Rural productivity has risen, and rural land prices have risen, but the gap between rural and urban land productivity has widened by a margin of about 3 times nevertheless, making urban land around 100 times as productive as rural. Therefore, there is an as-good-as-unlimited supply of "strongest loser" bidders for land for urban expansion.

I am intrigued by your description of how land taxes would be set by bureaucrats "playing land markets" in the absence of an actual land market. The former USSR could have learnt a lot from you - their lack of land markets and land price signals contributed vastly to the sheer inefficiency of their grand experiment. Do read Alain Bertaud's seminal study, "Cities Without Land Markets", if you are not already familiar with it.

12. Just as well I am saving all this work.

It is not that "land prices would be bid down to be set by the strongest loser", they are bid UP by everyone BUT the strongest loser. YES, when the world had a population of a few thousand, ALL land WOULD have had "no value". AIR currently has "no value". But you are obviously of the opinion that the world is "running out of land" - therefore, there has to be winners and losers in the competition for "scarce" land, and this rationing is conducted through "markets". There is currently a massive gap between the "return" available for the uses of land that use the greatest amounts, and the "return" for urban land.

At about 1950, about 1% of the earth's land was "urban" and about 33% was farmland, forestry, etc (and the other 66% was nature). At that time, the Gross Product of "urban" economies (on 1% of land) was about the SAME as the Gross Product of the rest - i.e. urban land was about 33 times as productive as rural land. Since 1950, this balance has swung massively further in favour of urban land. Urban production has increased fourfold, while its cover has increased to around 1.4% of the total, while rural land has remained very close to what it was - "nature" has lost ground in some parts of the world, but gained it in others, especially the USA. Not having to feed millions of horses and draught animals any more, plus more efficient use of rural land, has more than compensated for the extra numbers of humans needing feeding. Rural productivity has risen, and rural land prices have risen, but the gap between rural and urban land productivity has widened by a margin of about 3 times nevertheless, making urban land around 100 times as productive as rural. Therefore, there is an as-good-as-unlimited supply of "strongest loser" bidders for land for urban expansion.

I am intrigued by your description of how land taxes would be set by bureaucrats "playing land markets" in the absence of an actual land market. The former USSR could have learnt a lot from you - their lack of land markets and land price signals contributed vastly to the sheer inefficiency of their grand experiment. Do read Alain Bertaud's seminal study, "Cities Without Land Markets", if you are not already familiar with it.

- Wodehouselee

13. Where is the house found? Is the building among the factors that you at first bought the house? Exist landscape choices grow and not able to be duplicated in another area? Uninhabited land to improve is typically limited. Charisma Condos