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Contents
1. The nature of real property 2. The functions of the real property market Activities 1 3. Efficiency in the market economy 4. Reasons for government intervention in the market economy 5. Efficiency in the real property market 5.1 Technical characteristics 5.2 Economic characteristics Activities 2 6. The pricing of land and land resources 6.1 Land as a whole 6.2 Commercial rent 6.3 Non-homogeneous land and economic rent 7. The dominance of stocks over flows 7.1 The relative size of stocks and flows 7.2 Corollaries of the above analysis 8. Conclusion Activities 3
4. To indicate changes in the conditions upon which land resources can be supplied. Improved techniques in constructing high-rise buildings, for example, may make flats cheaper compared with low-rise houses and flats. 5. To induce demand to respond to changes in the conditions of supply. 6. To reward the owners of land resources. Rewarding the owners of land resources is a by-product of the market. Such rewards are of two main kinds. First there is the return on capital invested. When a person looks for certain return without risk, e.g. freehold ground rents (FGRs), then the return corresponds closely with the opportunity cost, what that capital could have earned in the best alternative use, such as government stock. There is, therefore, little profit element in such return. Second there is the return for risk. The yield from a land resource usually extends far into the future. Being a fixed factor, the reward on it will depend upon demand. Thus the return is largely in the nature of economic rent. It can be high, for example to people who own land banks before an increase in demand, or it may be negative, for example to builders who have bought land banks before a slump. In short, the return, supernormal profit, arises because of the risk attached to any fixed factor. To conclude, the function of the real property market is to establish a pattern of prices so that, given sufficient time (the long period), land resources are allocated according to their most profitable (highest and best) use relative to other land resources. This occurs because competition in the market induces owners to switch resources to the use which yields the highest net return. Should, however, any of the conditions of the perfect market (see below) not hold, the allocative efficiency of the market will be impaired.
ACTIVITIES 1 1. Review your understanding of basic market theory by reference to study paper P3447. 2. It is often claimed that when you buy property, you are buying a bundle of rights. For any property with which you are familar (your house, your office space, etc.) briefly list what rights are to be found in that bundle. 3. A similar claim is that property is a bundle of characteristics. Again list what these might include for your given property. This time, try to put a monetary value on each one! 4. Draw demand and supply diagrams to show how the market: a. allocates owner-occupied houses; b. indicates a change in demand towards owner-occupied houses and away from rented accommodation; c. causes supply to respond to (b); d. would indicate improved techniques in house building; e. causes demand to respond to (d).
Atomistic market structure. There are many buyers and sellers, each too small to individually influence the prevailing price in the market. Homogeneous product. All sellers are providing goods that are identical (perfect substitutes) in the eyes of the buyers. Perfect information. Sellers are aware of the availability and prices of all factors of production and the profit opportunities within the economy, and buyers are aware of the availability and prices of all finished goods. Free entry of new firms. When profit beckons, new firms are able to enter the market without restriction and without incurring any costs that established firms avoid. Profit maximisation. It is assumed that sellers are motivated by the selfinterested pursuit of as much profit as possible. No government intervention. The government at local or national level is assumed not to modify or supplement market forces in any way. Excludability applies. Goods are marketable in the sense that the benefits may be enjoyed by those willing to pay while those not willing to pay are excluded in a practical way from enjoying those benefits. No externalities. All costs and benefits of production and consumption fall upon buyers or sellers and do not spill over to third parties. Perfect factor mobility. All factor inputs are available to all sellers at perfect market prices, irrespective of location.
It does not take much imagination to appreciate that the real property market differs in virtually every respect from this description of the perfect market. In addition, these conditions would only lead to one of many potentially efficient outcomes. The precise result will depend upon the initial distribution of resources in the economy. The pursuit of market efficiency may conflict with the distributional goals of society.
Whereas land refers to natural resources, land resources have been defined as the total natural and man-made resources over which possession of the earths surface gives control. That is, land resources are equal to the natural content of land plus any improvements attaching to or incorporated in the land. Indeed, when we talk about a transaction in land, we are usually referring to land resources. In agriculture, for instance, land would include the farmhouse and buildings, the fences and water supply, while a freehold residence is the land plus all the fixtures on the land the house, conservatory, fishponds, swimming pool, fences, and so on.
Price in the market is determined by demand and supply. In economic analysis it is usual to allow for the fact that changes in supply take time by dividing time into three main periods (Figure 1). If demand increases from D to D1 in the momentary period, no adjustment of supply is possible (Sm); in the short period, supply can be altered by engaging more variable factors (Ss). Eventually, however, in the long period supply can be increased by adding to fixed capital, thus combining the factors of production in their best proportions (SL). The price of the product changes from OP to OP1, OP2 or OP3 according to the time period.
The full response of supply to a rise in the price of buildings usually takes a very long time. The various interests in a site required for redevelopment have to be amalgamated (usually by acquiring leases), planning permission has to be obtained and any compulsory purchase orders subjected to time-consuming procedures. This means that, when applying the usual time period analysis to land resources, we have to recognise that for a considerable period of time we are virtually dealing with a fixed stock. Thus changes in demand will tend to be more significant than changes in supply in determining market price.
2 No allowance is made for the size of stocks of existing goods relative to flows of new goods coming on to the market
With most goods we do not have to pay much attention to this. Because their life is relatively short, existing goods (the stock) have to be frequently replaced by new supplies (the flow over a period). Take cars, for example. Other things being equal, any increase in the demand for cars will, in a free market, push up the price. Extra imports may help to meet this additional demand. But if manufacturers consider that the higher price is likely to be permanent, they will eventually add to plant so that the supply of cars coming on to the market increases. This flow of new supplies will be significant relative to the supply coming on to the market from existing stocks, and will thus be a main determinant, with demand, of price. But the position is somewhat different with certain goods, such as ships, aircraft, and land resources. Because such goods are so durable, stocks of them accumulate over time. As a result, new flows on to the market (additions, say, per annum) are small or insignificant in comparison with the supply to the market coming from existing stocks. As a result, new supply has relatively little influence on price: for all practical purposes, supply from old stock dominates the market. Two qualifications, however, should be made. First, it is the turnover of old stock which is really significant. Second, over the years, accumulated flows affect the size of stocks, and have their effect in this way. But the possibility of this is very limited in developed city centres. Price, therefore, is largely determined by demand; new supplies largely follow this price, rather than having much influence in determining it. The position is summarised in Figure 2.
FIGURE 2 The dominance of the stock of real property over its price
When the stock of owner-occupied housing units in the United Kingdom was approximately 15.6 million, the turnover of this stock each year, about 5% or 780,000, was large relative to the flow of additional units being produced each year, on average 180,000 for the period 198791. Indeed, in areas, like Greater London, which are surrounded by a green belt, practically every house coming on to the market is from the existing, and almost fixed, stock of houses. In such a situation, demand determines the price of houses. For example, let us assume an increase in the demand for living accommodation. In the short run, existing dwellings are used more intensively, perhaps by a decrease in or disappearance of the number of vacant dwellings, an increase in subtenancies, a doubling up of families, an increase in the number of persons per room. Eventually, the prices of existing accommodation units will rise (Figure 3). But since the flow of new houses on to the market is insufficient to affect the supply significantly, the higher price of existing houses will represent the price of all houses in the market. Any newly built house which comes on to the market will be sold at the higher price, P1. In other words, the price of new houses is determined by the price at which existing houses sell. The price paid for land for new housing is thus the residual between what the new house will sell at (determined by the demand for old houses) and what it costs to build, including normal profit. Take, for instance, a builder bidding for an odd site in London on which to erect a house. Suppose similar old houses are selling for 120,000, and that he estimates that it will cost him 80,000 (including his normal profit) to build. He can therefore afford to bid 40,000 for the land, and indeed will have to if he is to secure it in competition with other builders.
FIGURE 3 The effect of an increase in the demand for accommodation on the price of dwellings
Because houses take time to build, this explanation of price determination applies in all localities in the short period. Where building land is available, however, the high price offered for existing and, therefore, new houses will encourage builders to erect new houses so long as the production cost of new houses is less than the price of old houses. Over time the flow of these new houses on to the market will be sufficient to influence the stock of houses, and the price of old houses will tend to fall. This process is most noticeable in districts where the supply of building plots is plentiful, for example new towns, overflow towns (Swindon, Ashford, etc.) and on the fringe land of certain towns where planning permissions have been freely given to permit expansion. In the long period, therefore, these new flows affect the price of old houses and, when the prices of old and new houses coincide, the cost of building new houses does affect the price. In other words, the long-period supply curve of houses is now likely to be more gently upward sloping but it may take a very long time before this happens and, where cities are surrounded by green belts which cannot be built on, the price of houses will tend to be dominated by demand.
Such costs include the price of land, building material and labour costs, and the cost of builders borrowing, for example on overdrafts. As regards the price of land, it is sometimes stated, for example, that the high cost of land is responsible for high house prices, thus limiting homeownership. Our analysis gives scant support to this view. An increase in demand for houses causes the price of old houses to rise. This enables builders to bid more for land up to the difference between what they can sell a new house for (the price of similar existing houses) and the cost of building (including normal profit). Thus, in our example, if the price of houses rose to 200,000 and building costs remained unchanged, 120,000 could now be paid for the land.
Of course, to the individual builder, the price of land is a cost; as with building components, he has to pay the going competitive market rate to obtain it. But the individual view that land prices should be controlled because they are too high puts the cart before the horse. What we have done is to examine the underlying factors the demand for houses which determine the price of land from the point of view of builders as a whole. Land prices are determined by house prices rather than the other way round. Three other points should be noted: a. It is what would be the builders abnormal profit which represents the maximum he can bid for land. Unless this is sufficient to attract land from its next best use, for instance agriculture, he cannot build. b. Since the price of land is determined by the demand for housing, controlling the price artificially would not result in house prices falling. Instead the surplus return would simply go to somebody other than the landowner, e.g. the first purchaser, or local authorities who acquire land compulsorily at existing use values. Furthermore, controls would upset the allocative function, ensuring that scarce land is used for its highest and best use, performed by market prices. Artificially low prices, maintained by some form of price control, would lead to a wasteful demand for land in less profitable uses. c. As the price of houses rises, land costs form a greater proportion of that price. Thus, in our earlier example, when the house sold for 120,000, the land cost formed one third of that price; when the house rose to 200,000 through increased demand, the land cost rose to three fifths. Similarly, we have to ask whether a rise in the cost of building materials and labour will put up the price of houses in the short period. The answer is that, where building land is earning an economic rent (that is, its price is above its transfer or next-bestuse price), a rise in building costs has no effect on the current price of houses. Since the supply of houses comes mainly from existing stock, their price in the market is determined by demand. A rise in building costs, therefore, simply means that the builder has a smaller margin to bid for the land. Thus, in our original example, had building costs risen by 8,000, his maximum bid for land would have been only 32,000. The effect of a rise in the rate of interest must be considered from the viewpoint of both the builder and house purchaser. On the supply side, the builder has to pay more for his overdraft but this will affect only what he can bid for the land, not the house price. It is on the demand side that the rise in the rate of interest has the major effect the higher cost of borrowing on mortgages leads to a decrease in demand, and thus the price of houses will tend to fall!
Since the short period in practice tends to be very long, the government can impose a tax on land resources up to the level of economic rent they earn, since this will make no difference to their supply. It should be noted, however, that land resources include capital. If the tax should be so large as to overlap on the transfer earnings of capital or on normal profit, further building will not take place.
3 Developers can be required to cover some of the social costs of projects
A different type of tax may be imposed. So long as it does not cut into normal profit, a local authority can, as a condition of planning permission, require developers to include in their schemes either houses (although these are less profitable than offices) or improvements to the infrastructure, e.g. sewers. The first condition is largely based on political-social grounds; the second can be regarded as covering some of the social costs of the scheme. Such a tax is known as planning gain.
4 An increase in transport costs will increase economic rents at the city centre
Increased transport costs will make houses on the periphery of a city a poorer substitute for houses at the centre. This will diminish the extent to which the increase in new flows of houses can be significant compared with the existing stock. Thus the difference in economic rent between the centre and the periphery will increase as house and therefore land prices rise at the centre, and will tend to persist.
8 Conclusion
The real property market differs substantially from the benchmark of the perfect market. This suggests that inefficient allocations of societys scarce resources occur in the property sector, providing a justification for limited state intervention. However, market forces do shape the allocation of property resources through the price mechanism. A striking feature of the property market is how the stock of property is usually so large that its turnover dominates the flow of new build coming on to the market.
ACTIVITIES 3 1. Review your understanding of price elasticity of supply with reference to study paper P3449. 2. Review your understanding of economic rent with reference to study papers P3723 and P0018. 3. Reflect on the relationship between price elasticity of supply and economic rent. 4. Year 1 2 3 Average price of new dwellings 100 109 119 Average price of private sector housing land at constant average density 100 102 107 Average construction costs 100 104 118
Comment briefly on the above index figures. 5. What do houses and government stock have in common in the determination of their prices?