LECTURE WEEK 3:ECONOMIC RETURNS

OUTLINE OF LECTURE WEEK 3: Ricardian rent theory Classical rent theory Urban rent theory

Ricardian land rent

Ricardo introduced the crucial concepts in the theory of land rent: 1. Land varies in its natural endowment or advantage for the user. 2. Land of a given level of natural endowment or advantage is fixed in supply. 3. The land market is governed by competition among land users. 4. Land rent is determined by the differences in natural endowment or advantage of land. 5. Land has single use ( grow corn)

Ricardian land rent

The supply of land at each location fixed perfectly price inelastic. The demand for a particular site quite sensitive, or elastic, with respect to price. Numerous competitive sites, or substitutes, exist at adjoining locations Determining Rent : Land must be priced at each site so that its occupant is charged for the value of whatever locational advantages exist at that site. Understanding these advantages and how consumers evaluate them is the key to understanding the usage pattern of land and housing prices.

Ricardian land rent

This is a theory of compensating differentials. Only demand considerations determine the relative value of land or housing at different locations. The supply of land does play a role, but only in setting the overall level of prices. The first theory of land rent by David Ricardo in his 1821 Ricardos focus was on agricultural land. Useful to study it as a steppingstone to the modern theory of urban land rent

Ricardian land rent

The markets for land and housing: completely productdifferentiated. Each product sold in the market (every flat or location) unique. Urban land a completely differentiated product. Difficult to speak about the supply of land or demand for sites at any particular location

Ricardian land rent

Imposition of taxes on land will neither increase rents nor alter the use of land Price of land is high because the price of corn is high and not vice versa So price of land is high because the price ( housing) is high, and not vice versa ( refer diagram 1 ) So Ricardian argued that price of land and housing is wholly demand determined, so

Ricardian land rent

Diagram 1 explanation: Vertical axis represent rent and horizontal axis represent quantity of land Vertical line SS indicate that supply of land is fixed at OS Demand for corn is represent DD, at equilibrium the rent paid at OR 2 conclusion can be derived from this:

Ricardian land rent

a) rent of land is solely demand determined, since supply is fixed, variations in rents can only occur through shifts in the demand curve DD, so the rent of land is HIGH because the price of corn is high and not vice versa b) taxes levied on rents will not alter either the rent paid or the quantity of land supply

Ricardian land rent

Supply of land is irrelevant, but supply of land is under control of the planning authorities and can be changed So Ricardian argument is based on assumption that the supply of land is fixed and unchangeable. An increase in the amount of land allowed by the planning system to be used for housing can therefore result in the price of land & housing

Agricultural and land rent

Ricardos fundamental insight was that agricultural land is not all of the same level of fertility. There is a fixed supply of land of the best fertility, called No. 1 land. Land with a somewhat lower level of fertility called No. 2 land, fixed in supply too. Land with even lower levels of fertility (No. 3, No. 4, etc.) also fixed in supply

Agricultural and land rent

Assume that with equal employment of capital and labor, No. 1, No. 2, and No. 3 land would yield a net produce of 100, 90, and 80 units of corn per acre. The country under consideration young and has a small population. A sufficient amount of No. 1 land exists to feed the entire population, with some No. 1 land left over. The land rent is zero. The most fertile land is a free good: supply exceeds demand, even at a price of zero.

Agricultural and land rent

Say rent for No. 1 land is not zero but some positive number. Only some of the land earns this rent. Some of the land is left vacant, and the vacant land earns 0 rent. Owners of vacant land are willing to rent out their land for less than the assumed positive rent rather than earning nothing. The competitive bidding process will continue until rent is down to zero.

Agricultural and land rent

As Ricardo put it, when, in the progress of society, land of the second degree of fertility is taken into cultivation, rent immediately commences on that of the first quality, and the amount of that rent will depend on the difference in the quality of these two portions of land.

Agricultural and land rent

Land rent exists because land varies in fertility and land of a given fertility level is fixed in quantity Further, progress of society will bring No. 3 land into cultivation: Rent for No.3 land = 0. (each acre produces 80 units) Rent for No.2 land = 10. (each acre produces 90 units) Rent for No. 1 land = 20. (each acre produces 100 units)

Agricultural and land rent

No. 2 land remains a free good, commanding a zero rent, if not all of it is in use. But now all no. 1 land is in use. If it remains a free good, all farmers would try to acquire no. 1 land, and none would be interested in working on no. 2 land. The demand for no. 1 land exceeds the supply.

Agricultural and land rent

This situation persists so long as farmer could earn more working on no. 1 land than no. 2 land. No. 2 land produces 90 units of corn per acre and is a free good. Equilibrium reached only if the rent for no. 1 land exceeds the rent for no. 2 land just by 10 units of corn: the advantage of no. 1 land over no. 2 land.

Agricultural and land rent

Competition among farmers generates the result. A farmer who is cultivating No. 3 land would pay up to 20 units of corn to occupy No. 1 land. The farmer who actually occupies No. 1 land must pay 20 units or lose his lease.

Neoclassical rent theory

Assumption : a) Land had alternative uses like any other factor of production b) land supply is not fixed c) each piece of land had an opportunity costthe rent that could be obtained in the most profitable alternative use ( rent of land enter into cost of production )

Neoclassical rent theory

Refer diagram 2 : The neoclassical approach is represented by diagram 2.2. Horizontal and vertical axis represent quantity of land and rent. Total supply of land is OS. Land now is assumed to be two uses, growing potatoes and corn Demand for potatoes is PP

Neoclassical rent theory

So the amount of land used for potatoes is indicated along the horizontal axis from left to right, starting from O. The remaining land can be used for growing corn, so the demand for corn is indicated in the reverse direction along the horizontal axis from right to left, starting at S. Demand for corn is CC Equilibrium in the land mkt is determined at ss and dd intersect

Neoclassical rent theory

Rent is OR, OX is used for growing potatoes and XS for growing corn This diagram explanation is contrary to ricardian theory, suppose there is an increase in the demand for potatoes, with no change in the demand for corn, demand for land for potatoes will shift to P1P1, increased in demand for potatoes cause reduction in usage of land for corn, from SX to SX1 ( diagram 2.3)

Neoclassical rent theory

Rent paid for all land increased from OR to OR1 . Less corn is supplied to the market and now rent price already increased, therefore the price of corn will also rise, therefore the increase in the rent of land is not caused by the rise in corn price but vice versa. So the Ricardian theory can be incorrect if land has alternative uses and can be shifted from one use to another

Neoclassical rent theory

Conclusion: rent of land for particular use is not solely determined by the demand for the product, land taxes can affect the use of land. Land with higher taxes will result shift in the use of land from the higher to the lower taxed use with the tax being passed on in the form of a higher price for the product of the land taxed at the higher rate

Planning controls and rent theory

Ricardian theory seem to be more relevant if planning control is allowed ( if each piece of land can be regarded as having a single use which is allowed by the planning system) Refer diagram 4 ( 2.4-handout): Supply of land is OS. OX is allowed for housing and XS is allowed for agricultural. Demand for housing is HH and demand for agricultural is downward sloping from right to left

Planning controls and rent theory

Planning system separates the markets and different rents are charged in each market, RH and RA rent for housing and agricultural respectively. Supply is fixed by the planning system and price of rent is determined by the demand Thus the price of housing land is high because the price of housing is high and not vice versa

Planning controls and rent theory

The argument that supply of land can be changed does not affect the price of land can be explain using diagram 5 ( 2.5- handout) Initially land supply is fix at OX and demand for housing is HH. The pricing of housing land is OR. Let assume demand for housing shifts, demand will cause the price of land to rise and vice-versa. So price of land is demand determined

Planning controls and rent theory

Now suppose supply of land increased and planning authorities give permission for a number of new housing development. So supply of land for housing increased by XX, new rent at OR, this new price is reached by increasing the supply and demand is given. But in true, supply and demand determined the price. We could say also that shifts in demand will

Planning controls and rent theory

affect house price and land prices more quickly than shift in supply. A fall in interest rates is likely to result in house price being higher within few months, on the other hand an increase in supply of land for housing may take years to affect prices, especially large development of the site will be phased over many years. So increase in supply unlikely affect price of housing in short-term

Planning controls and rent theory

If the land and property market were efficient then announcement of an increased in land supply would result in house buyers and builders immediately lowering their prices in anticipation, but property market is not an efficient.

Planning controls and rent theory

Example where Ricardian and Neoclassical both are agree ( diagram 2.6 ): Land area OS. DD demand for industry. Amount of land use for industrial is OI. Price for industry use is OP1. HH demand for housing. Amount of land available for housing is IS, price of land use for housing is SPH Both market appears representing Ricardian Model

Planning controls and rent theory

Assume demand for housing and housing land increases, demand shifted to H1H1, price of housing land is higher than industrial land, so now more profitable to develop industrial land for residential use, new equilibrium at E. This situation best represent neo-classical model

Urban Land Theory

As in agricultural land, a fundamental characteristics of urban housing and land markets is that housing and land are more expensive at better locations and cheaper at less advantageous sites. This holds whether we consider natural locational amenities, such as lakes or an ocean, or manmade locational advantages, such as distance to employment or cultural centers.

Urban Land Theory

To study how rent and locational advantage interact, we begin with a model of a very simple city, originally due to German geographer J.H. von Thunen in his 1826 classic Isolated State, the modern version of which appeared in W. Alonsos Location and Land use in 1964.

Urban Land Theory

In this city, commuting or access to place of employment is the only locational advantage that is considered. The city is monocentric. It has only one employment center. Commuting to this center gives rise to what is called (Ricardian) location rent.

Urban Land Theory

Assume that the density of development is fixed. This absence of any factor substitution may seem unrealistic, but we will be determining density in the following

Urban Land Theory

Households are identical, and the number of workers (commuters) per household is fixed. Household income (y) can be spent on commuting, housing, and nonhousing consumption (x) Employment is at a single center, called the Central Business District (CBD), to which households commute along a direct line from their place of residence. Commuting costs k dollars annually per km. The location of a household refers to its linear distance (d) from the employment center.

Urban Land Theory

Housing has fixed and uniform characteristics at all locations. Housing rent is an annual amount R(d), which varies by location (commuting distance d) Housing is provided by combining a fixed amount of land per unit of housing (acres, q) together with a fixed amount of housing capital (materials and labor) that costs C (no factor substitution) to construct. Residential density, i.e. number of households per acre is 1/q

Urban Land Theory

Housing at any location is occupied by households who offer the highest rent; land is allocated to that use yielding the greatest rent. Consider two locations: d1 and d2. Suppose kd1 + R(d1) < kd2 + R(d2) . The household, say household A, who occupies location d1 spends less on commuting and rent altogether than the household, say household B, who occupies location d2. Can this situation be equilibrium?

Urban Land Theory

Seeing this difference in commuting and housing expenditure, household B would want to move to location d1. To compete for the lease at location d1, household B can offer to pay a little bit more than what household A currently pays. So long as (1) remains, the process of this competitive bidding continues. In equilibruim we must have kd1 + R(d1) = kd2 + R(d2)

Urban Land Theory

R(d1) R(d2) = kd2 kd1. Think about d1 < d2, so that location d1 is a more desirable location. It costs less to commute from this site to jobs than what it costs to commute from location d2. The savings in commuting cost must be just offset by the higher rent. When the housing market is in equilibrium, increased rents as one moves towards the CBD must exactly offset the lowered commuting costs.

Urban Land Theory

Since the quality and density of housing is assumed fixed across locations, the only variation possible among housing units is commuting distance. If housing rents do not exactly offset commuting costs, then consumers who live at farther locations would seek to move to closer ones. They do so by offering greater housing rent than current occupants. Since housing is rented to the highest bidder, rents at the closer locations would rise, while those at farther sites would fall

Urban Land Theory

When rents exactly offset commuting costs, households would no longer have an incentive to move. The market is then said to be in a equilibrium. Mobility aims to increase welfare is not possible when the housing market is in equilibrium

Urban Land Theory

Let the farthest location in the city be b and write R(b) = . For any d b, R(d) = R(b) + k (b d) = + k (b d) This is the bid rent function: the maximum rent that households would be willing to bid for each location d in city.

Urban Land Theory

Suppose rents in all locations in city, except for one, say location d1, follow the above equation. How much households would be willing to pay to occupy housing in this location d1 ? If at location d1 , R(d1 ) < + k (b d1 ) all households in the city would like to move to just this location.

Urban Land Theory

The households expenditure on rent and commuting is less than the corresponding sum at all other locations in the city The process of competitive bidding must raise the rent to just the level R(d1 ) = + k (b d1 ) The amount is the maximum households would be willing to bid for housing at each location d in the city

Urban Land Theory

In many cities throughout the world, land beyond the edge of development is used for agriculture. In this case, it earns some rural rent per acre (ra). In other situations, land is simply held vacant with little or no meaningful rural rent

Urban Land Theory

land owners seek the highest income from their land, just as housing is rented to those making the highest offer. As long as urban housing yields a rent for a site that exceeds that which the owner can receive from farming, land will be rented to urban households.

Urban Land Theory

At the edge of the city (b) , then, urban landlords can rent land for its agricultural value (opportunity cost) of ra per acre. With fixed density, a lot for each housing unit can be rented for raq The (annualized) cost for putting up a housing unit at the edge of a city has two components: the land rent raq

Urban Land Theory

the structure rent, which is the annualized cost of constructing a unit c = iC, where i is the interest rate This structure rent could be measured by the annual mortgage payment necessary to cover the cost of constructing the unit. If property development is perfectly competitive where firms earn zero profit, R(b) = = raq + c

Urban Land Theory

R(d) = raq + c + k (b d) Housing rents at any location will equal the sum of construction cost the opportunity cost of land plus the difference between commuting costs at the urban edge and those at the location in question.

Urban Land Theory

Moving from the edge of the city, rents must rise as commuting costs decrease. To the extent that households maintain the same housing and commuting expenditure : R(d) + commuting exp. = raq + c + k (b d) + kd = raq + c + kb Equilibrium housing rent at any interior site absorbs the savings in commuting that result by moving in from the farthest location currently developed in the city

Urban Land Theory

Only with these rents will households be willing to live at any location within the city There are three components to housing rent: 1. the rent necessary to convert a lot from farm land into urban land (raq) 2. the rent on the structure that sits on the site 3. the location rent resulting from saved commuting costs, k (b d)

Urban Land Theory

Both the agricultural rent and the structure rent are constant across locations. The slope of the housing rent function with respect to distance, k, is due to the location rent. Rents fall away from the city center (per km) by exactly the amount of additional commuting incurred by each household. This slope is known as the rent gradient in urban economics

Urban Land Theory

Those components of housing rent that involves location and agricultural land are often combined into a hypothetical rent for just urban land r (d) . Urban land rent can be thought of as a residual: the land rent that is left after subtracting the rent for the housing structure from the total rent.

Urban Land Theory

Housing rent is measured per housing unit, while land rent will be measured as rent per acre (unit of land). To convert housing rent R(d) into land rent, r (d),subtract the structure rent and then divide by land per unit (q), r (d) = ra + k (b d)/q This is the same as multiplying housing-minusstructure rent by residential density (1/q)

Urban Land Theory

Urban land rent has two components. 1. The first is the rent (per acre) for its alternative use (agricultural) 2. the second is the savings in commuting costs per acre that result when housing is placed on the land

Urban Land Theory

At a density of 1/q, there are that many households per acre, each of which is saving k (b d) in commuting The gradient for land rent with respect to distance has a slope of k/q. The rent per acre of land falls by the increased total commuting of all who live in the 1/q units built on the land

Urban Land Theory

How do housing rent and urban rent vary across cities or within one city over time? When the edge of the city (b) is farther from the center and involves a greater commute, housing and land rent at all interior locations is higher since at these locations, there is a greater savings in commuting cost.

Urban Land Theory

When commuting is more costly (per km), interior housing and land rents will be higher relative to edge rents because the commuting cost savings at interior locations are higher When urban land has a more productive alternative use (higher ra), urban housing and land rents will also be greater, because this land rent component of housing rent is higher

Urban Land Theory

When the density of urban housing is greater, the gradient for urban land rents will become steeper, with higher rents at the city center relative to those near the edge. The slope of the land rent gradient is k/q. If the amount of land used per housing unit, q, decreases, then the land rent gradient becomes steeper