Thursday, 11 June 2015

Economic Myths: Profit maximisation

Exhibit A: from Wikipedia:

In economics, profit maximization is the short run or long run process by which a firm determines the price and output level that returns the greatest profit.

Which is of course not a myth at all. By trial and error and on the basis of very incomplete information, this is what businesses do - they tweak price and/or output levels.

Clearly, there is a sliding scale between perfect competition, where the market sets the price and all you can do is vary output levels; and a monopoly or cartel situation, where you can choose the best price/output combination to maximise profits.

It appears that the UK land bankers home builders have discovered that their profit maximising output level is somewhere in the region of 120,000 - 150,000 new residential units per year; they know that their own inputs (skilled labour, building materials) are price-insensitive, so an increase in demand for those means that their costs would go up disproportionately and profits would go down. Fair enough.

Exhibit 2: So why do all the Faux Libertarian twats in the City AM believe that if we "liberalise planning laws" that they will suddenly increase output? Why would they?

Which is why the six largest home builders own enough land with planning or outline planning for eight years' supply. If the government gave them planning permission for another million units or another ten million units, this would not change their profit-maximising level of output by a single unit.

(Of course, the whole notion that increasing supply of housing in high demand/high price areas would reduce house prices overall is nonsense anyway - there is simply no evidence for it or else house/land prices in large cities would be lower than in the countryside and they would be giving away apartments on Manhattan for free.

And don't give me "Spanish and Irish ghost estates", those were not built in areas of high demand/high prices and are thus irrelevant. They might as well have built them in the middle of the Australian outback for all the difference they make.)


Dinero said...

Also, studying the policies of property developers is not practically a good guide to the economics of land prices as property developers sell out of a position once the houses are built on the land and so their policies aren't designed to include capturing the future increase in the local land values that result from their development. For a policy that does include the application of the concept of
More homes = higher home prices , succesfully , thus demonstating the concept, see the Western States of the USA "planned communities" where developers actually have created rising house prices by taking an area with no houses and building many houses in one area.

Sean Vosper said...

Great article.

Here's some other housing related stuff:

Mark Wadsworth said...

Din, fair point, but that is why it is advantageous for "home builders" to drip feed homes onto the market so that they can sell each new phase for a slightly higher price.

SV, thanks, I'll have a read later on.

A K Haart said...

In other words it's a cartel?

Mark Wadsworth said...

AKH, yes of course.

Getting planning is hampered by barriers to entry. You need a team of lawyers, 'friendly' councillors, you have to offer to rebuild a roundabout, build a new playground etc.

If you can muster all this at a huge cost, you need planning for hundreds of homes to ensure you still make a profit.

If you only are only applying for planning for a small development they will either turn you down, or by the time you have 'bought' planning permission the project is no longer viable.

So you end up with a handful of large 'players' who can

a) restrict new construction down to the profit maximising level
b) control all the land pipeline, and therefore

c) who actually make more profit from inflated land values than from actually building.

Logan Boettcher said...

You're absolutely right Mark because land is a monopoly good and is therefore subject to the analysis that we give to monopoly suppliers, not the competitive suppliers analysis. The problem is that people don't see land as a monopoly good because they assume monopoly means a single seller of a good and they see tens of thousands of landowners, so it must not be a monopoly good. But the necessary trait of a monopoly good is that its supply does not increase in response to a higher price. It will only release an increased supply up to the point of maximum profit and no more, whereas in a market of competitive suppliers, the reason to increase supply is to cut into the maximum profits that would be necessarily be enjoyed by a monopolist. Land banking developers do the same thing by looking at the future revenue to be gained by selling land with buildings at a higher price later and deciding if the present value of that profit is larger than the profit to be made by building and selling a home at its current price. It’s in their profit-maximizing interest to control supply based on profit differentials between the present and the future, and they know that their profit can’t be undercut by other builders since those builders cannot increase the supply of land to take advantage of the profits to be had.

In the National Review article referenced by Mr. Vosper, the article authors say this about how capitalism is 'supposed' to work: "The market economy should have natural mechanisms to limit inequality. If housing is very expensive in coastal California, more firms should build houses. If Mickey Mouse toys and Barbie dolls are profitable, more companies should produce those toys. If some professions make more than others, people should move into the higher-paying professions." I hate to break it to the authors, but housing is more expensive in coastal California because its land is getting more expensive, but more companies can't come in and produce or import more coastal California locations like they can Mickey Mouse toys and Barbie dolls (though I would just say toys and dolls since intellectual property restricts the supply of Mickey Mouse toys and Barbie dolls). If this is “how capitalism is supposed to work,” than the land market must exist outside of the normal rules of capitalism and thus the normal prescription that would work for toys and dolls, increasing supply to lower prices, simply cannot work for land because land won’t increase in supply.

It’s like saying a horse could float in a lake if it could just turn into a duck, but since a horse cannot turn into a duck, it can never float in a lake. Likewise, if the land market acted like the toy market than it could increase supply to bring down prices, but since the land market cannot increase its supply, it can’t possibly be like the toy market.

Anonymous said...

Just suppose there was no such thing as planning permission - you just bought land and built on it. This would cut out the power of the land bankers, indeed some of the banked land might become valueless. The blockage you describe seems to be a consequence of a tight planning system rather than a necessary consequence of house building. Are you suggesting no entrepreneurs would enter the market?

Indeed, if cheap housing were available all round London then Mayfair might still be expensive but Southwark, Enfield and Bromley might well become affordable. Equally pigs might fly, the present situation suits politicians, bankers and incumbents, only when the young wake up and put the electoral boot in will things change.

Mark Wadsworth said...

SV, first article was good but it wouldn't accept my comment. Second article pretty weak on housing but correct on the other two issues.

LB, but that is key to Faux Libertarianism and Home-Owner-Ism, pretending that "land" is just another kind of "capital" and thus subject to normal rules of capitalism.

R, we don't need to "suppose" though, do we?

For most of English history there were little or no planning laws, and did this lead to greater equality or higher levels of owner-occupation? Did it Hell as like.

And what is with "cheap housing round London"?

That's why London is so big, they keep adding on another concentric layer which is a little bit cheaper (further out) but the people who move there then add to agglomeration effects so prices go up again, but more in the centre than round the outside.

More to the point, imagine they demolished all buildings in the whole of London apart from a couple of dozen in the centre. What would they be worth? Not much - of course - because now they are just a little village in the countryside.

Random said...
The mad monk continues..

Bayard said...

"This would cut out the power of the land bankers, indeed some of the banked land might become valueless."

Er, no, planning restrictions push down the cost of agricultural land, not increase the cost of building land. If you removed all planning restrictions, all the agricultural land round London would become building land and be worth whatever building land in that location is currently worth. In the short term the land bankers would be no worse off, but in the long term they would be as they would no longer be able to buy agricultural land and sell building land.

We can see a similar effect with restrictive covenants on existing houses. A restrictive covenant on one house has absolutely no effect on the price of the next house in the street, but if that covenant is lifted, the price of the house it once applied to will increase. All planning restrictions are, are a type of general restrictive covenant applied to certain types of land.

Robin Smith said...

All good stuff jolly good show.

Don't forget the builders don't make any money. The Real Estate Investment Trusts have taken all the planning gain long before the housing is built. They buy up the soon to be granted sites from a fuckwit who got lucky for say 50. And sell the piece of paper later with planning for say 200. It all happens within a few months. Having spent a million in marketing costs to convince the local planners who ate also as stupid as hell.

What do I mean by 50? Call it millions for a site of 2000 houses.

George Carty said...

"For most of English history there were little or no planning laws, and did this lead to greater equality or higher levels of owner-occupation? Did it Hell as like."

You can only "sprawl your way to affordability" if you have mass car ownership, which England didn't have before the current restrictive planning laws were imposed.

Bayard said...

GC, instead, it had railways, which were just as effective as cars and predated restrictive planning laws.

George Carty said...

While railways do help to some extent (which may be why houses built in the 1930s -- the last ones before the T&CPA 1947 -- are especially prized in today's Britain), they are still nowhere near as effective as automobility at opening up land for development. In places like Texas where there are no Green Belts, developers don't need to bid against each other for land because they can just buy land that is on the market anywhere (because its owner died or just decided to get out of the farming business).

Railway networks only open up narrow ribbons of land following the lines, meaning that it is still far too easy for landowners to extract rent (in fact that was crucial to the operation of early passenger railways, in that they used the rents to subsidize the fares). Government subsidies for trains all end up in the pockets of the owners of sites served by the railways.

Japan is an interesting case -- from what I've read (please correct me if I'm wrong) much of the land area in Japanese cities is still owned by the rail companies to this day, and its value was prevented from rising by the government forcing trains to make an operating profit (which meant that the rail companies had to develop their land at high density to get a high enough ridership).