From Crikey:
Local bike paths mean higher house prices
That is one housing stimulus package I would be happy to see implemented. From the comments section:
More accurate take on alternate headline –
Bikeways found to be desirable trait amongst urban home buyers.
Temporary shortage of bikeways elevates prices in areas with bike paths.
Once all areas have bike paths, price distortion will be nil.
Captain Planet
Wednesday, May 4, 2011
Demand shocks – the details
Many pundits claim that increasing population increases demand. In technical economic jargon it shifts the curve to the right. But what we rarely see is an exploration of the two types of demand shock and the different potential price impacts.
The first type, as mentioned above, shifts the downward sloping demand curve to the right. This means there are more people with the same willingness to pay.
The second type is a shift of the demand curve up upwards. This represents a willingness to pay more for the same goods from the same number of people.
It’s pretty clear from this distinction which of these factors is in play in Australian housing.
Let’s examine the first case. Consider an auction with 10 cars for sale and 50 bidders willing to pay $1000 for a car. You add another 50 people to the mix each also willing to pay $1000. If I’m not being clear enough, this is analogous to increasing population in the housing context.
When the auction is run with the original 50 bidders each car sells for $1,000. When the auction is run with 100 bidders, the 10 cars still sell for $1,000 each.
This is an extreme scenario but does demonstrate a very real point. Unless the new potential buyers are willing to pay more for the same items as the existing buyers, the price won’t rise. At most, a second price auction (the result of an English open auction with heterogeneous preferences) becomes closer to a first price sealed bid auction by the addition of another bidder willing to bid at a price between the second and first price (read up on some auction theory here).
As I said before, new buyers, even a small cohort of the total market, can influence the price level if they are willing to pay more than the existing buyers, since prices are set at the margins. Imagine our car auction once again, and we give 10 of our original 50 bidders and extra $500 to spend on the car. What is the new result? All cars sell for $1500 each to these 10 bidders. Even though they were just 20% of the original market of buyers, they dragged the price up 50%. In fact even if there were thousands of buyers willing and able to pay $1000 for those 10 cars, the ten people willing to pay $1500 would always win.
Prices are set at the margin by those with the highest willingness to pay.
This example, where the demand curve is shifted vertically to reflect an increased willingness to pay by the same number of buyers, is shown graphically in the right hand side graph above.
But, you say, the key problem here is that supply is being overlooked - in the simplified examples demand curves are horizontal and there is no supply response. But look at the graphs again. Not only is the demand curve a more acceptable shape, but supply does respond in both circumstances. In the first, where the demand profile of buyers shifts horizontally supply does respond enabling prices to remain at their equilibrium level.
However, when the demand curve shifts vertically, it doesn’t matter how much supply responds to price increases, it cannot be a mechanism to bring prices back down (except under extreme assumptions about the shape of demand and supply and the limits of peoples willingness to pay at the top and bottom of the market).
Of course, in the end this analysis is probably unecessary. The value of housing arises from the rents - its ability to generate revenue or provide a service. Since we haven’t seen rents outpace inflation significantly for any extended period in the past two decades, one must be quite certain that the cause of prices being much higher than a rational present value of future cash flows is pure demand side speculation.
The first type, as mentioned above, shifts the downward sloping demand curve to the right. This means there are more people with the same willingness to pay.
The second type is a shift of the demand curve up upwards. This represents a willingness to pay more for the same goods from the same number of people.
It’s pretty clear from this distinction which of these factors is in play in Australian housing.
When the auction is run with the original 50 bidders each car sells for $1,000. When the auction is run with 100 bidders, the 10 cars still sell for $1,000 each.
This is an extreme scenario but does demonstrate a very real point. Unless the new potential buyers are willing to pay more for the same items as the existing buyers, the price won’t rise. At most, a second price auction (the result of an English open auction with heterogeneous preferences) becomes closer to a first price sealed bid auction by the addition of another bidder willing to bid at a price between the second and first price (read up on some auction theory here).
As I said before, new buyers, even a small cohort of the total market, can influence the price level if they are willing to pay more than the existing buyers, since prices are set at the margins. Imagine our car auction once again, and we give 10 of our original 50 bidders and extra $500 to spend on the car. What is the new result? All cars sell for $1500 each to these 10 bidders. Even though they were just 20% of the original market of buyers, they dragged the price up 50%. In fact even if there were thousands of buyers willing and able to pay $1000 for those 10 cars, the ten people willing to pay $1500 would always win.
Prices are set at the margin by those with the highest willingness to pay.
This example, where the demand curve is shifted vertically to reflect an increased willingness to pay by the same number of buyers, is shown graphically in the right hand side graph above.
But, you say, the key problem here is that supply is being overlooked - in the simplified examples demand curves are horizontal and there is no supply response. But look at the graphs again. Not only is the demand curve a more acceptable shape, but supply does respond in both circumstances. In the first, where the demand profile of buyers shifts horizontally supply does respond enabling prices to remain at their equilibrium level.
However, when the demand curve shifts vertically, it doesn’t matter how much supply responds to price increases, it cannot be a mechanism to bring prices back down (except under extreme assumptions about the shape of demand and supply and the limits of peoples willingness to pay at the top and bottom of the market).
Of course, in the end this analysis is probably unecessary. The value of housing arises from the rents - its ability to generate revenue or provide a service. Since we haven’t seen rents outpace inflation significantly for any extended period in the past two decades, one must be quite certain that the cause of prices being much higher than a rational present value of future cash flows is pure demand side speculation.
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.
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.
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.
Thursday, April 28, 2011
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?
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?
Tuesday, April 26, 2011
Milk wars and Anti-Dumping
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
Sunday, April 17, 2011
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.
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.
Wednesday, April 13, 2011
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.
Tuesday, April 12, 2011
Risk homeostasis, Munich Taxi-cabs and the Nanny State
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.
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