Saturday 3 July 2010

Ricardo's Law Of Rent in action

NB, if you are familiar with this topic, then please skip straight to points 6 and 7, that's where it gets interesting.

1. Ricardo's Law Of Rent is actually blindingly obvious if you think about it, and is just another way of saying that what you pay for is the location. Ignoring aesthetic considerations, the extra amount you will pay for exclusive possession of a particular bit of land or building (Plot A) compared to what you would pay for Plot B is the additional income you can generate by trading from Plot A rather than Plot B.

2. If this were not true, then all newsagents in town centres would be stupendously wealthy compared to newsagents operating elsewhere. The reason they are not is because the rent for a shop in a town centre is five or ten times as high as 'anywhere else', so what the newsagent is left over with is pretty much the same wherever his shop is.

3. Of course, most people commute to work, so residential rents or house prices are very closely correlated to what salaries are like within easy commuting distance. This is a question of time, not distance, so if a new motorway or railway line is opened or a faster train service is brought in, rents and house prices where the new station is or near the motorway junctions increase, as happened with the new Javelin service between London and Kent.

4. Remember also that we have free movement of people within the UK, so to the extent that people are prepared to move for economic reasons, we would expect people to gravitate to areas where the difference between net incomes and rents (or mortgage repayments) is highest, so these differences are quickly competed away by 'the markets' and net incomes after actual or notional housing costs are pretty flat across the whole of the UK - even The Daily Mail points this out.

5. OK, so rents (or their capitalised equivalent, the price for land and buildings) are merely the total income generated in an area minus the bare minimum that people expect to actually live on - and yes I accept that living standards tend to rise continually, but they only rise by a small part of the overall growth in the economy, and the rest of the benefit of that growth just drives rents and house prices every higher.

6. Henry George applied Ricardo's Law Of Rent and concluded that over the long run, rents would take up an ever larger share of the economy. So rather bizarrely, as we move away from what you normally think of as a land-based economy (farming) into more profitable or productive things, rents go up rather than down. Simple maths and logic would also lead to this conclusion, of course. But is it borne out in practice?

What can't speak can't lie. From the BBC:

In the Office for National Statistics (ONS) report on the state of the nation... Over the same period [1970 to 2007] housing, fuel and water had replaced food and non-alcoholic drinks as the biggest household expenditure.

7. Now, if housing is now the biggest item of expenditure (which it clearly is, about one third of people's net incomes) and has got more expensive over the last forty years, we'd expect younger people to be living in smaller houses and/or buying a house (and getting married, settling down and having children) later in life. In a related article the BBC reports:

The traditional nuclear family is in decline in Britain as more people chose to live alone or as couples without children, data suggests.[this might be because fewer young people 'settle down' or because older people are surviving their partners for longer]. The number of people living in family homes with children fell from 52% in 1961 to 36% in 2009, the ONS says. In their Social Trends 40 report, official statisticians say 28% of homes are single person households, while 29% contain childless couples. This is up from 11% and 26% respectively on 1961.

The proportion of people living in lone parent households has also increased over the past half century, jumping from 3% in 1961 to 12% in 2009 [blame the welfare system for that, separate issue]. The Office for National Statistics said the most common type of household was the couple family household, but that there had been a "decline" in the proportion of households containing a "traditional" family unit....

The ONS also said women were having babies later. The proportion of babies born to women under 25 in England and Wales was 47% in 1971. This had dropped to 25% in 2008. And fewer people are getting married, with 143,000 first marriages in England and Wales happening in 2007, compared with 340,000 in 1971...


Anonymous said...

"living standards tend to rise continually, but they only rise by a small part of the overall growth in the economy, and the rest of the benefit of that growth just drives rents and house prices every higher"

In other words, most of the notional increase in GDP is accounted for by (house price) inflation. And "real GDP growth" is lower than notional.

House price inflation is caused by

a) Demand exceeding supply


b) Nasty rent-seeking landlords trying to screw the workers

Mark Wadsworth said...

AC, it's neither a) nor b), and I've never gone in for landlord-bashing.

The total rental value of the land in any economy is quite simply a function of how well the economy is doing. If we were simply to abandon (quantitative) planning restrictions and build more roads, more harbours and railways stations, more factories, more houses in the right place etc, then clearly the economy would grow a lot, and hence the total rental value of land would grow even more.

So NIMBY-ism is a battle between landowners - those who have planning permission don't want landowners who don't have planning permission to get it. NIMBYs want a larger share of a smaller pie.

If all landowners (acting collectively) wanted to maximise their total income, the first thing they'd do is get rid of planning restrictions. (The fact that this would be A Good Thing overall is a separate issue).

It's the same as the thought experiment that the 26 letters of the alphabet and the ten digits would be auctioned off to the highest bidders to hold as eternal copyright, with the state collecting the royalties on behalf of the owners.

The more the economy grows, the more people will need to use those letters and digits and the more royalties the copyright owners can rake in, despite them not making the slightest contribution towards that growth (in fact, they are depressing economic activity by charging for the use of those letters).

Mark Wadsworth said...

... or if you want me to return to a) "Demand exceeding supply", supply of physical land in the UK is fixed more or less for all time. The economy grows and the population grows at the same time as the cost of other necessities falls (relative to wages), so demand for land grows disproportionately.

James Higham said...

Remember also that we have free movement of people within the UK, so to the extent that people are prepared to move for economic reasons

I'm not. My continued existence depends at this point on what deals have been cut on this particular property I'm in. If I step outside that, three or four interdependent agreements are breached and lost.

It is simply not cost effective for me to move and besides, there are aesthetic/emotional reasons to remain where one is - a person will fight tooth and nail to be shifted out.

Mark Wadsworth said...

JH, sure, that's why I caveated that with "to the extent that".

But similarly, since returning to England 17 years ago, I have lived in five different houses or flats (some owned, some rented) all within a four mile radius, without any major hiccups to studying, work or family life; it's about as dramatic as changing your bank account or internet supplier or something (and a lot less stressful than getting divorced or changing jobs).

Unknown said...

Hi Mark

The problem is how too persuade the people who are benefiting right now to jump off the gravy train.

Who benefits now?

- Basically anyone who bought property in good areas years ago (pre 2000) and is mortgage free or can easily afford their mortgage.

What would happen under LVT?

- Less productive people/businesses would have to move to less desirable areas
- Government could lower production taxes like VAT and payroll taxes.
- Production gets a larger slice of the economy vs the FIRE economy (Finance, Insurance, Real Estate)
- The country is more productive (Hooray!)

However what it doesn't address is who gets the extra profits from the extra production.

So what good does it do if all production was done by machines (an extreme example to highlight my point) and the people who owned the machines kept the profits while everyone else ate cat food?

Mark Wadsworth said...

A, it's far fewer people who benefit than you think. It's not much use sitting on a big paper profit if you have to remortgage to help your kids pay a deposit etc.

"what good does it do if all production was done by machines (an extreme example to highlight my point) and the people who owned the machines kept the profits while everyone else ate cat food?"

That would never happen:
1. Despite centuries of innovation, the split of profits between return on capital and wages is fairly constant.
2. To whom would the machine owners sell all their stuff to make all their profits?

neil craig said...

Demand is exceeding supply but only because the "planning" system prevents supply. If nothing else the fact that technology has improved makes it relatively to build higher & to build arcologies. Thus even if land prices were going up in real terms there could be more gomes per acre.

I have previously shown how house prices are 4 times what they could be so instead of 33% of income they could be 8% leaving us with an average 25% increase in standard of living. The extra spin offs in increased national spending feeding through to higher growth & not having to pay the "planner's" salaries would be enormous.

And Mark has described the follow through advantages of people being able to have families.

Mark Wadsworth said...

NC, sure, if we liberalised planning laws, then land values 'at the margin' (i.e. where a farmer gets planning for houses or a factory or a power station on fields next to the conurbation) would be negligible.

This would be A Good Thing in and of itself. But the total returns to land ownership would still increase disproportionately.

neil craig said...

Mark I don't think they would if the supply was not restricted as it is. As industries take less ground area (everything from intensive farming to making computer programmes less land intensivem & less dependent on particular locations, than Victorian industries like shipbuilding) & better personal transport making out of town shopping & living easier the per capita need for land drops. This is similar to Julian Simon's proof that raw materials prices fall as technology improves.

Someday, though not yet, seasteding & orbital settlements will add to the land available.

Mark Wadsworth said...

NC, let's imagine two countries that are physically and geographically very similar:

Country A is totally NIMBY and only allows subsistence farming in hand built houses that must be spaced a mile apart.

Country B is more like Hong Kong or Manhattan, and you can built as much and as high as you like.

In which country would the total rental value of the land be higher?

Anonymous said...

Rental values for land will clearly be higher as the economy grows. However, it does not follow that rent will represent an ever-increasing proportion of the economy. The whole theory rests on the assumption that each unit of production requires a fixed quantity of land, and that quantity will only change as economic efficiency improves. That isn't true because land can be sustituted by other inputs. For example, if land is too expensive, it can be partially substituted with capital e.g. by building a high rise building instead of single storey, or by increasing the amount of automation. Or it can be partially substituted by labour, e.g. by using more labour to farm more intensively.

Land is actually no different from any other fixed asset. It is bought with money and therefore acts as a store of value. Its value depends on supply and demand like any other asset. And although the quantity of land in the economy is (mostly) fixed, the supply of land is not fixed (in economic terms), because it depends on people's desire or willingness to sell it.

In actual fact, over the last couple of centuries, the proportion of output devoted to wages has increased enormously.

"Over the same period [1970 to 2007] housing, fuel and water had replaced food and non-alcoholic drinks as the biggest household expenditure." - indeed - because the demand for housing has risen massively due to social changes (which you have mentioned) and immigration, while supply has remained artifically restricted by planning; and world fuel prices and water prices have both risen due to demand going up faster than supply. Food and drink, on the other hand, have become cheaper to produce due to improved production efficiency.

To suggest that the decline in the nuclear family (more divorce, more single parents, longer lifespans, better education etc etc) is caused by increases in land values, is questionable. Surely it is the other way around.