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.

Faulty Reasoning

I’ve come across some fine examples of faulty reasoning lately in two key areas.

1. Analysing the economic importance of declining environmental quality, and
2. Assessing the impact of price drops in the Australian property market.

So let us take a closer look.

Pro-urban sprawl advocates (I didn’t really know there were so many until just recently) try to shrug off the claim of deterimental impacts on agricultural production from urban sprawl due to irreversibly land use changes. For example –

Suburban Development is not destroying farmland. Smart growth activists claim farmland is disappearing at dangerous rates and that government needs to protect farmland lest we lose the ability to feed ourselves. As growth expert Julian Simon wrote, this claim is "the most conclusively discredited environmental-political fraud of recent times." United States Department of Agriculture data show that from 1945 to 1992 cropland area remained constant at 24 percent of the United States. Though urban land uses increased, they now account for only 3 percent of the land area of the United States. Today, American farmers produce more food per acre than ever before. In fact, the number of acres used for crops peaked in 1930, but because of the ingenuity and innovation of American farmers, the United States continues to produce more food on less land. (here)

Why is this argument based on faulty reasoning?

Not pretty

Latest Econ Theory Keynes v Hayek rap video

Milk wars and Anti-Dumping

While there are many questionable assumptions in some economic theories, there are also many solid foundations to economic analysis. One of these was identified by Coles in its submission to the Senate inquiry into milk pricing (available in the Coles factsheet here).

The farm gate price dairy farmers receive is set by the world price because most Australian milk products are exported.


The first implication of this fact is that because prices are set by global markets, domestic buyers cannot buy at prices below the export market price - although they could perhaps be higher.

By following this logic Coles, or any other domestic dairy retailer, cannot exhibit bargaining power as a buyer from milk processors (or distributors). Dairy processors would simply sell all their products abroad, whereas the only alternative for retailers is to buy imported dairy products with associated freight costs.  Processors can then bargain the price up to the price of the retailers next best alternative of imported products. Thus, even though we are net exporters of dairy products we still pay a retail price for domestic dairy products very close to the retail price for imported dairy products.

And to provide further evidence against dairy industry claims, even if Coles did have market power, one must question why Coles would not already be getting milk for the lowest price anyone would be willing to produce for?

The sceptic in me might even go so far as to suggest that upsetting the political milk cart might have been a publicity strategy for Coles itself. News outlets have told the public that Coles is aggressively dropping prices for months now – all free of charge. You really can't buy publicity like that.

Of even greater concern than the media beat-up, and public perception of danger from falling milk prices, is that the law entrenches protection of local industries from international competitors through anti-dumping laws. As the Productivity Commission describes

Housing supply follow up – more evidence (UPDATED)

I promised to search around for some more evidence that local councils approve far more dwellings than are built. This would go some way to addressing the argument than planning is restrict, particularly zoning controls and approvals processes.

This report, by the Queensland Office of Economic and Statistical Reseach, adds to the previous evidence on a deevlopment approvals for subdivisions greatly exceeding the ability of the market to absorb the new land.  It outlines the number of development approvals for infill multiple unit dwellings in the pipeline at various stages of approval for South East Queensland.

The telling figure is that there are 48,152 approved new infill dwellings in SEQ, with another 29,014 at earlier stages of approval.  Remembering that there are also 30,566 approved subdividede housing blocks, we have a total approved supply in this region of 88,718 dwellings! Even at its recent peak population growth in SEQ was only 88,000 per year.  That makes about 2.5 years supply of dwellings already approved.

Other government reports which have compiled useful information on the potential housing supply available under current planning regimes.

This report notes the following

“...there appears to be a very low risk of the current broadhectare land not providing at least 15 years supply, particularly when the increased density and infill targets set by the SEQ Regional Plan are considered. Based on the SEQ Regional Plan assumptions for infill, then only 244,000 lots would be required over a fifteen year period”

Moreover it explains that the stock of approved lots represents 3.3 years supply.

We can take a look at a national level here and see that current planning schemes have the potential to yield 131,000 new homes per year for a decade from 2008! This excludes the increase in housing stock from developments with less than 10 dwellings.  In the abovelinked OESR report they state that smaller developments of 10 or fewer dwellings accounted for 69.5 per cent of projects at June 2010. This means the estimate of 131,000 new homes accounts for only 40% of the actual supply available under current planning schemes.

Even so, they sum up their analysis of land supply by stating that there was approximately 7–8 years supply of zoned broadhectare land in 2007.  

If this doesn't blow your mind...

I stumbled across this video on the web.  It's about growing organs... from scratch.  Absolutely amazing! 12 minutes very well spent.

Risk homeostasis, Munich Taxi-cabs and the Nanny State

There is an odd coexistence between two conflicting safety policies that may well be pursued by the same accident prevention agency. The first seeks to improve safety by alleviating the consequences of risky behaviour. It may take the form of seat belt installation and wearing, airbags, crashworthy vehicle design, or forgiving roads (collapsible lamp posts and barriers). This policy offers forgiveness for a moment of inattention or carelessness. The second policy seeks to improve safety by making the consequences of imprudent behaviour more severe and includes things such as speed bumps, narrow street passages, and fines for violations. Here, people are threatened into adopting a safe behaviour; a moment of inattention or carelessness may have a dire outcome. 

While these two policies seem logically contradictory, neither is likely to reduce the injury rate, because people adapt their behaviour to changes in environmental conditions. Both theory and data indicate that safety and lifestyle dependent health is unlikely to improve unless the amount of risk people are willing to take is reduced. (here - my emphasis) 

The above passage points out a common logical absurdity, and contains an important lesson for Australian’s with and overeager obsession of controlling personal choices through ‘nanny state’ regulations. More on the nanny state a little later. 

First, it is important to examine the hypothesis of risk homeostasis to properly understand the implication of the opening quote, since it claims that neither of the two contradictory policies aimed towards improving safety are effective. 

The essential argument of risk homeostasis is that humans have an inbuilt level or risk that they gravitate towards in response to their external environment. If we reduce the risk of an activity, people will compensate by finding other risky activities as a replacement, or undertaking the activity in a more extreme manner. For example, if we ban smoking tobacco, which doesn’t seem like such a remote possibility, do we really expect smokers to replace their habit with fruit snacks and yoga? Or might they compensate by increasing their alcohol consumption or perhaps smoking dope instead. 

Risk homeostasis is not to be confused with risk compensation, which suggests that individuals will behave less cautiously in situations where they feel "safer" or more protected, but that we don’t necessary return to a predetermined risk equilibrium point. 

Improving transport safety is an area where there is strong evidence risk compensation, and indeed of risk homeostasis. 

No evidence of supply-side constraints in approvals data

Possibly the central lesson of my previous post was that planning controls and development approvals by local councils are not a factor that limits the quantity of new homes constructed. Council behaviour in these areas could limit housing supply if councils began a system of quotas for approvals. But they don’t. They provide limitations on the location of new supply in their planning instruments, and they approve the quantity of homes demanded by the development industry - which is a reflection of the number of new home sales. Sales volumes of new homes and land determine the rate of supply of new dwellings. 

In my last post I provided no evidence for my assertion apart from logically examining the process of development in a hypothetical scenario.

So is there evidence that councils are limiting the supply of new dwelling through their planning controls and approvals processes?

No.

Let’s look at my home town of Brisbane. The following table shows the stock of approved house lots in Brisbane and surrounding local council areas that are yet to be developed (All data from here - Table 1. Excludes building units and retirement homes).



In Brisbane, where broadacre land is arguable more physically constrained, the stock of approved housing lots has remained relatively constant. And as you would expect, in the fringe areas, the stock of new house lots has grown far more rapidly than sales of lots or construction of housing. This indicates that councils approve far more housing lots than the market can absorb.

Yet it is this development approval that many claim is a hold-up to development.

In Brisbane, this reserve stock equates to about two years supply, while in surrounding areas there is between 3 and 10 years supply (Logan City and Somerset respectively) already approved. Of course, there are many thousands more lots that could be approved under existing planning schemes should demand arise.

Remember, this is just the stock of new land developments. If data were more readily available for unit developments there will no doubt be a similar story (in Brisbane attached homes are about 50% of new stock).

The clear message that comes from actual data on planning approvals is that they are not a constraint to supply. This might be one reason why these figures are never mentioned by ‘supply-siders’, even in the most detailed documents outlining supply side concerns in the housing market such as the 2003 Prime Ministers Taskforce on Home Ownership Report.

8 Economic Lessons on Planning and Housing Supply

The housing bubble debate often leads to claims that town planning controls and approvals processes are a contributing factor to the price boom. It is argued that such controls can constrain the rate of housing supply during periods of high demand, allowing prices to ratchet up. But there is no case for the argument that planning controls can influence the general price level of housing.

For those unfamiliar with property development, the following lessons may be of interest.