Summary literature building economics PowerPoint week 1: ............................................................................................................................ 2 Week 2 : Real estate markets and the 4Q model.................................................................................... 3 Powerpoint week2: market dynamics ................................................................................................. 5 DiPasquale, D., Wheaton, W.C. (1992). The markets for Real Estate Assets and Space: a Conceptual Framework. Journal of the American Real Estate and Urban Economics Association 20(1), 181-197. ............................................................................................................................................................. 8 Chapter 12 Real estate markets McDonald ...................................................................................... 15 Chapter 12 Real estate markets McDonald ...................................................................................... 19 Week 3: Development of land and building projects ............................................................................ 22 Powerpoint: Development of land and building projects ................................................................. 22 13 real estate development and investment .................................................................................... 25 Week 4: Real estate markets ................................................................................................................. 30 Pp: The Call Option Model of Land Value andReal Estate Development ........................................... 30 Chapter 1 Introduction to urban economics McDonald ................................................................... 33 Chapter 4 Location decisions, agglomeration economies, and the origins of cities McDonald ....... 35 *Marginal product is the additional output a firm can produce by adding one more worker to the production process. .......................................................................................... 39 Week 5: Welfare economics ................................................................................................................. 40 Barr Economy of welfare state Chapter 1 ......................................................................................... 40 Chapter 2 | political theory: social justice and the state ................................................................. 48 Chapter 3 | Economic theory 1 - State intervention ......................................................................... 57 Week 7: Working with price indices for real estate markets + Urban economics ................................ 68 Powerpoint: price index .................................................................................................................... 68 8D land values, house prices and land area ...................................................................................... 72 Chapter 9E The business of residential mortgage lending and financial crises ................................ 74 Chapter 14E Zoning ........................................................................................................................... 78 PowerPoint week 7: location and urban structures, And overview and some critical refection...... 79 6 INTRODUCTION TO URBAN LOCATION PATTERNS: STATIC ANALYSIS ........................................... 86 7 U S I N G T H E MONOCENTRICC I T Y M O D E L ..................................................................... 92 Week 8................................................................................................................................................. 104 PowerPoint week 8: location and urban structures, And overview and some critical refection.... 104 Chapter 22 MODELS OF METROPOLITAN ECONOMIC GROWTH .................................................... 107 Chapter 23 AGGLOMER ATION ECONOMIES, TECHNICAL CHANGE, AND URBAN GROWTH.......... 114 Chapter 23 – Agglomeration economies, technical change and urban growth ...................... 117 J.Summary ..................................................................................................................................... 121 1 PowerPoint week 1: Real estate markets User market (space market) = value of real estate is based on e.g. the amount of rent that is paid Capital market (equity and debt interest)= also related, what is the value of the building Property market (value and capitalisation rates) =what is the relation of the income of housing and the underline value for investors important combination Relationship: - user market where rental are set - capital market where investors look at what are the investors returns and we put here also investors opportunities with equity and debt - property market where the value of the means of the property cash flows and required returns - government influence local, state, and national regulations are set (taxes or subsidies) Characteristic of real estate markets: in eco = about demand and supply, differences in real estate is that: - Heterogeneous products all real is estate is different nothing is the same, for example the location can not compare Building A and B - Immoble products is fixed to land, niet verplaatsbaar fixed to location (plot), location (nebrthoud), location (city) individual o Localized markets differe al lot o Segmented markets (types and price categories) housing, office, indu building o Privately negotiated transactions with high transaction costs it is not transparent 2 Pp week 2: housing market economics Markets are efficient if: - perfect information = Firms are well informed about the nature of the product and about prices () Individuals need perfect information about the future Perfect competition in all markets (individuals must be price takers and they must have equal power) Free entry and exit from the market and no monopolies No discrimination of consumers No public goods No external effects Increasing returns to scale Cornerstones of the neoclassical housing market: - Full information Inform households more about the possibilities on the regional housing markets or Combat irrational choice behavior by informing housing seekers High prices Fixation on place Organize more building plots Indispensable (onmisbaar) everyone need a house Organize temporary forms of housing Quality standards high, if they are low, price go down Lower the quality demands in the building law Adjustment problems with supply it is static, Stimulate industrial and modular production to speed up production and improve supply Product is very heterogeneous every house is different High barriers to enter or exit Improve the position of outsiders at the cost of the position of insiders elasticity Combat land speculation and related profit extraction Not always sufficient amount of sellers and buyers, so price can be manipulated Disfunctioning of the housing market; market value - Struggle between outsiders and insiders Irrational choice behaviour on the housing market (behavioural economy; optimism bias, loss aversion and bandwagon effect (meedenken met de massa)) Land is not a normal capital good and extraction profits are involved Housing market as a supply market; very low supply elasticity o referred to technically as “low elasticity of supply,” meaning that the amount of a commodity that producers supply to the market is not much affected by the price at which they are able to sell the commodity age elasticiteit van het aanbod”, wat betekent dat de hoeveelheid van een goed die producenten aan de markt leveren niet veel wordt beïnvloed door de prijs waartegen ze de grondstof kunnen verkopen Structure of the (owner occupied) housing market: Static markets - Fragmented markets different markets Domination by first time buyers Variety of sub-markets differentiated by region or housing sector Low rate of mobility of existing homeowners Self-building or self-commissioned house building Consumer good 3 - Costs of construction and land have a significant relation with house prices Structure of the housing market: dynamic and speculative markets Speculation involves trading a financial instrument involving high risk, in expectation of significant returns. Speculation is the buying of an asset or financial instrument with the hope that the price of the asset or financial instrument will increase in the future. - Unified markets New and existing dwellings compete for purchasers Existing tenures influence activities in new building construction Market sub-sectors are linked together through transactions by existing homeowners Speculative promotion Investment good Price of existing homes determines the price of new properties Speculative house building overtrevnde trap no demand get builders will built risk Dynamic markets are more sensitive than static markets. Latest developments of housing policies in the EU (Housing Europe 2019) - Structural housing problems are addressed with patchwork policy solutions (growing expenditure on housing allowance and an investment gap in affordable housing of 57 billion per year) Housing and the alarming social divide (European Citizens’ initiative for more affordable housing, housing as part of the anti-migration agenda) Cities at the forefront of the housing challenge (Vienna, Berlin, Barcelona, Amsterdam) Lack of affordability also hits the middle class Changes in housing delivery (partnerships with employment services, mobility, digitalization Housing, a priority for decision makers at local, national and European level (housing at the heart of the EU Urban Agenda, homelessness part of the European Pillar of Social Rights) Possible relation to the general economic structure and the housing market structure: - A nation that is highly sensitive to the general economic climate also has a housing market structure that is sensitive to the economic climate. Long run consequences of COVID on housing issues: - More awareness of the need for adequate living and working conditions in homes More willingness to spend a large part of income on housing Change in the use of home and the way we live in daily environment Arrears in education are difficult to catch up and effect underprivileged children for years Because of COVID more people are interested (15-20%) in housing un suburban areas. 4 Week 2 : Real estate markets and the 4Q model Rent € the value of the asses is linked to the rent you received at one period. Purchase price asset Stock m2 Prijs onder cost geen dev Development market might also be affected by a lower interest rate, because this makes a loan cheaper. - Development cost < asset value - Equilibrium exist when asset value equals the development costs New construction m2 Powerpoint week2: market dynamics Equilibrium: price at which the quantity demand equals the quantity supplied hoeveelheden gelijk aan elkaar Competition is the force that drives markets to equilibrium Model assumptions: - Space market: rent is the price paid for the use rights of space - Asset market: there is a strict separation between investors and developers - Development market: developers want to sell the property directly after completion - Use rights of space: lease agreement or ownership, both involve cost. Explanation: The markets for the use of space (where the rent is determined), for the ownership of space (where the purchase or asset price is determined) and for construction (where the volume of new construction is determined). The rent determines the asset price via the cap rate, the asset price determines the volume of construction. The size of the stock (not a market!) influences the willingness to pay because of the principle of supply and demand.5 Space market In neoclassical economics; the willingness to pay for all consumers (tenants) is combined into the demand curve. The demand curve determines the average rent level for various levels of office space stock, under constant economic conditions. 5 Price elasticity if you look at the demand curve, you see if price go up demand go down Price elasticity indicate how sensitive the demand, total number of units demanded is for a changes In price more precisely Price elasticity gives a ratio of a relative change in demand % changes in demand that is due to by % change of price - Because of the derived nature of office space demand the price elasticity is low the relative [%] change in demand is low [e.g., 2%] compared to the relative change [%] price (rent) change [e.g., 8%]) price elasticity is a measure of how reactive the marketplace is to a change in price for a given product Asset market - On the macro/meso level (national, regional, urban) we assume that an equilibrium price (value) is established. Assume that investors require on average a GIY (Gross Initial Yield) of 8%. Steeper curve = higher GIY. Flatter curve = lower GIY Development market Developers are encouraged to produce new office buildings as long as the development costs (building cost + land included) are lower than the asset (property) value. Development cost < asset value Equilibrium exists when asset value equals the development costs. A minimum asset value exists below which no new developments are started. Building costs increase with higher construction output. The total construction output is limited (limited by production factors) The curve of the graph represents increase in development costs when development output increases Stock adjustments ------- > Interrelated markets Exogenous markets influence the office real estate market. National & global economy – influences office space demand. Capital market – influences GIY. What happens when a exogenous shock occurs. Change in demand: Change in interest rate: 6 *Real Estate Cycle - Static supply & dynamic demand: hog-cycle Demand changes fast, supply gaat daar achter aan, maar als die bereikt heeft veranderd demand weer Office demand is dynamic and follows economic cycles Housing demand is less dynamic and strongly correlated with the demografics Static supply: o Long development period o Long life-span and slow reduction of stock o Constrained production capacity o Government regulation (land use & building permits) 7 DiPasquale, D., Wheaton, W.C. (1992). The markets for Real Estate Assets and Space: a Conceptual Framework. Journal of the American Real Estate and Urban Economics Association 20(1), 181-197. 4-quadrant analytical framework developed by Dipasquale and Wheaton is presented. It shows 1. The connection between space, asset market and construction activity. 2. It can be used to trace out the impact resulting of various exogenous shocks on rent, asset prices, construction activity and stock development. The model is made based on the following uitgangspunten: 1. The real estate market is comprised of two inter-related markets: the market for real estate space and for real estate assets. 2. Rent (purchasing the use of space) is determined based on the type and quality of buildings available and the needs of tenants 3. Asset price (purchasing an asset) of space is determined by the exchanging of buildings between investors When the occupier also owns the building the two markets function as one, for example single family homes. The model can still be applied: the annual mortgage payments of a family are determined by their income, the capital market however determines how these annual mortgage payments are converted into a purchase price. (For example: high inflation and low interest rates: families are willing to pay higher prices even though their annual ability to pay is unchanged) U.S. Real Estate: flows and stocks (Ik denk dat dit niet relevant is voor het tentamen but anywayzzz) A study in 1991 attempted to value all US real estate. It is estimated to be worth $8.8 trillion. 70% is residential of which 90% are single-family homes. The 30% non-residential sto1ck mainly consists of office and retail space. It is estimated that real estate constitutes roughly 56% of the nation’s wealth making it the largest component as well as the largest component of annual net private investment. The Markets for Real Estate Assets and Real Estate Space The production (development market) and price of real estate (asset market) are determined in an asset, or capital market. The price of real estate largely depends on how many households/investors wish to own units (demand) and how many units/space are available for ownership (stock). For firms demand for space is based on the firm output levels and the relative costs of space. For tenant: rent = specified in a lease agreement Firms: rent = annualized costs associated with the ownership of property - All else equal, an increase in the demand will raise prices=rent All else equal, a greater supply of space will depress prices= rent 8 The supply of real estate (stock) depends on the price of those assets (capital value) relative to the cost of replacing or constructing them (curve DM). - Long run: price of asset should be relative to the cost of replacing or constructing them Short run: the two can diverge significantly because of lags and delays in the construction process Example: demand for ownership of space ↑ --> (fixed supply of asset) prices ↑ --> asset prices are above construction costs: new construction takes place --> availability of space ↑, demand is satisfied --> prices ↓ towards the cost of replacement. Occupiers of space: - Firms: use will depend on firm output levels and relative cost of space Household demand: for space depends on income and the cost of occupying that space relative to the cost of consuming other commodities Rent is determined in the property market for space, not in the asset market for ownership. In the property market the supply of space is given from the asset market. Demand for space depends on rent and other exogenous economic factors (firm production leven, income, number of households/firms). Example: When the number of households increases/ firms expand production the demand for space use rises with fixed supply rents rise as well. Link between markets for asset and property occurs at two junctions: 1. Rent levels determined in the property market are central in determining the demand for real estate assets 2. The construction market: if construction increases, the supply of assets grow, prices are driven down in the asset market and rents decline in the property market. This is where the figure finally comes in handy (zelf vind ik die uit de lectures duidelijker): 9 1. The left two quadrants represent the property market 2. The right two quadrants represent the asset market Property market, rent determination (space market in lectures) - Two axis: horizontal, the office stock (in unit of space(m2 etc.)); vertical, the rent level (per unit of space) In an equilibrium the demand for office space (D) is equal to the stock of space (S) Taking the stock as given, rent (R) must be determined so that demand is exactly equal to the stock. Demand is a function of rent and conditions in the economy. D(R, Economy) = S Asset market, valuation - - Two axis: rent and price (per unit of space) The line formed by these two axis also represents the capitalization rate for real estate assets(ratio of rent to price) Capitalization rate is made up by four considerations o Long-term interest rate in the economy o The expected growth in rents o Risk associated with that rental income stream o Treatment of real estate in the U.S. federal tax code. A less steep line means lower capitalization rate, a steeper line means a higher cap rate. The capitalization rate is seen as exogenous, mostly determined by the broader capital market, so in the model is solely has the purpose to determine the asset price (P) from the rent level. 10 Asset market, construction - Two axis: price (per unit of space) and construction costs. The line formed by these two represents the replacement costs (CCost) of real estate. It is assumed that the costs of construction will increase with greater building activity (minder efficient ofzo). De lijn loopt eerst plat omdat er onder een minimaal (niet rendabel ) bedrag geen constructie plaats vind. The line can be more horizontal when the (future) supply is more inelastic. This can be caused by bottlenecks, scarce land among other things. There is an equilibrium when the price of replacement costs equal the asset price. That’s why P=CCost = f (C) Property market, stock adjustment - - - Annual flow of new construction is converted into a long-run stock of real estate space. A change in stock (ΔS) is equal to new construction minus losses from the stock measurd by the depreciation removal rate, d: ΔS= C-dS The line formed by the two axis represents the level of stock that requires an annual level of construction for replacement just equal to that value on the vertical axis. The level of stock will be constant over time, since depreciation leads to new construction ( the line in the lectures is adjusted and not constant, not sure why) that’s why ΔS = 0 and S=C/d Equilibrium: if the stock should not change anymore, is stays statics overtime In short: start with a stock of space property market determines rent gets translated into property prices by the asset market asset prices generates new construction yields back to the property market with new level of stock. In equilibrium when: starting and ending levels of the stock are the same No equilibrium - starting value exceeds the finishing: rent, prices and construction need to all rise to be in equilibrium. - Starting value is less than the finishing stock: rents, price and construction must decrease In the case of real estate occupied by its owner the 4 quadrants still hold but there is not a separate asset and property markets. But: - Determination of prices and rents occurs with a single decision in a combined market. - In case of the housing market, lower interest rates (yield) could imply that for the same annual payment (rent) households can afford to pay a higher purchase (asset) price. - One price is determined construction and space market will follow. 11 Some illustrative examples: Increase in demand for using Example 1: increase; in employment, production or the number of households would increase the demand for space, shifting out the demand curve: If demand rises, rents must rise, this leads to greater asset prices, this leades to new construction and eventually leads to more stock. The magnitude in changes in these variables depends on the slopes of the various curves. However, economic growth will increase all equilibrium variables and economic contraction decreases all equilibrium variables. 12 Changes in demand for owning Changes in demand may result from: - Interest rates in the rise of the economy rise/fall - Existing yield from real estate becomes low/high - Relative to fixed income securities and investors will wish to shift their funds from/into the sector - Changes in how income is trated in the U.S. federal tax code can greatly impact the demand to invest. (short tax life, accelerated depreciation schedule, increase after-tax yield generated by real estate) As seen in the illustration the yield required by investors has gone down (better/less risk investment), this raises asset prices, expands construction, this will increase the stock space, and more supply by the same demand will lower prices (rent). To reach an equilibrium in this case its more likely that the asset prices will eventually lower than it is likely that the level of space rents will rise. The negative relationship between commercial real estate values and interest rates is more of a hypnosis, as a standardized set of asset prices is not available. The 4Q model supports this hypnosis. 13 Changes supply schedule for new construction: Can be because of: - Higher short-term interest rates will increase the costs of providing a given amount of space, leads to less construction - Stricter local zoning or other building regulation can add to development costs and reduce the profitability of new construction Less construction will result in less stock of space, rent levels will rise, this will give higher asset prices 14 Chapter 12 Real estate markets McDonald I A. INTRODUCTION - equilibrium model of a real estate market that includes a vacancy rate. The model is then used to examine recent trends in residential and commercialmarkets. natural vacancy rate, the vacancy rate that is present in long run equilibriumwhen supply and demand are in balance The modeldeveloped in this chapter determines a long-run natural vacancy rate along with rent, occupied space,and total space supplied in the long run. The two critical features of this model are: o the demand for vacant space (in addition to the demand for occupied space), o the long-term equilibrium condition: annual net rent x occupancy rate (amount of stock) = annual cost of capital I B. RENT, VACANCY, AND EQUILIBRIUM: A SIMPLE MODEL - - The market price per squarefoot is net rent; i.e., rent that excludes current operating expenses. -. Price paid per m2 The demand for occupied space in the current period is a function of net rent per square foot, andthis demand shifts in response to changes in the demand for the goods and services produced by the economic sectors in 4Q model space market more demand net rent goes up the demand for occupied space is a function of gross rent: net rent + operating expenses demand schedule for occupied space Dg = the quantity for occupied space demanded as a function of gross rent 15 - - A crucial feature of this model is the assumption that there is a demand for vacant space, a demand that is expressed by the owners of the real estate (the landlords). The demand for vacant space is closely relatedto the notion from the management science field that there is a demand for slack capacity For example, the expansion of capacity to meet growing demand will exhibit slack capacity if there are economies of scale in capacity construction Demand uncertainty leads: o to a demand for slack capacity that will permit the firm to respond to demand surges. o demand for vacant space based on the theory of real options option to wait with renting out apartments can be if the price of rent is low because of over supply and you think that this will change and the price of rent will go up the higher is net rent, the lower is the demand for vacant space high rent, because of demand for space Net rent is the opportunity cost of holding space vacant for the current period. the greater is the volatility in rents, the greater is the value of the option to wait. the higher is net rent, the lower is the demand for vacant space; net rent = the opportunity cost of holding space vacant for the current period. long-run equilibrium - - The long-run equilibrium price must ensure that there is neither an incentive (stimulans) to build additional space nor an incentive not to replace the space that wears out each year.--> which states that the annual cost of capital equals net rent corrected for the occupancy rate. The equilibrium vacancy rate depicted the natural vacancy rate, the vacancy rate that isconsistent with a net rent that provides no incentive to change the size of the stock of space Short-run equilibrium - - An incentive to build more space exists, so the total inventory of space will increase until a new longrun equilibrium is established. Suppose that the market is out of long-run equilibrium because demand for occupied space had increased This increase in demand increased both net rent and the occupancy rate in the short run. net rent will respond to increase of occupancy rate Net rent continues to adjust until it reaches, the new short-run equilibrium. vacancy rate has dropped below the natural vacancy rate. 16 2 models added: Geltner & Miller (2001) and Arnott & Igarashi (2001) a higher asking rent implies a longer wait and a higher vacancy rate variations in the asking rent trace out the demand for occupied space the optimal asking rent implies on optimal vacancy rate for the building a higher optimal asking rent and optimal vacancy rate, the greater is the variance of the distribution of rents that the potential tenants are willing to pay. opportunities to match -> vacant space makes search more effective S = pool of searchers (see Figure) opportunities to match for individual searcher marginal product of searchers: opportunities to match for vacant units of space marginal product of vacant space: R* + X* = equilibrium reservation full rent R* = equilibrium net rent X* = probability of match > the rate at which tenants enter the market is equal to the rate at which matches are made and at which tenants exit the market. Q = amount of occupied space V = quantity of vacant space supplied in equilibrium estimation of natural vacancy rate by estimating an equation for rent dynamics: 17 > if the actual vacancy rate is at the natural rate, rent will not change > an increase in the demand for occupied space will increase both the rent and the occupancy rate untal a new short-run equilibrium is reached -> the vacancy rate has dropped below its natural rate, but there is no further incentive for rents to rise. > once a new short-run equilibrium has been reached, the market adjustment in the long run will increase the supply of space, increase the vacancy rate, and reduce rent from its short-run equilibrium level. > rent must fall to reach its new long-run equilibrium. equilibrium rent other model -> rent is function of tenant flow rate (arrival rate) and actual vacancy rate -> rent adjusts to deviations from equilibrium rent: model of rent adjustment -> equation for long-run equilibrium gross rent g*: exp = operating expenses Conclusion: In short-run equilibrium, net rent and the amount of occupied and vacant space are a function of the total inventory of space (taken as given) and the underlying parameters in demand functions for occupied space and vacant space. In the long-run, net rent is a function of the cost of capital and the underlying parameters in these two demand functions. Net rent then determines the quantities of occupied and vacant space and, hence, the natural vacancy rate. Therefore, the natural vacancy rate is shown to be a function of cost of capital and the parameters in the demand functions for occupied and vacant space. according to the two additional investigated models there exists an optimal vacancy rate for landlords. it is concluded that none of the practical examples presented in the chapter is fully consistent with the basic model of equilibrium because none includes an estimate of the demand for vacant space. . 18 Chapter 12 Real estate markets McDonald This chapter present a simple equilibrium model of a real estate market that includes a vacancy rate. Net rent = rent that excludes current operating expenses paid for use of the capital – one square foot of space – for the period in question. Demand schedule: Crucial feature of the model: the assumption that there is a demand for vacant space, a demand that is expressed by the owners of the real estate (the landlords). there is an optimal amount of slack capacity, demand uncertainty leads to a for slack capacity that will permit the firm to respond to demand surges. also demand uncertainty leads to a demand for vacant space based on the theory of real options . The landlord may be able to rent all available space now, but the decision to do so may eliminate the option to wait for better conditions. The greater the volatility in rents, the greater is the value of the option to wait. About the model: - The demand for vacant space is a function of net rent the higher is the net rent, the lower is the demand for vacant space (demand landlords). - Net rent is the opportunity cost of holding space vacant for the current period. - Variables: 19 Definitions: The market in long-run equilibrium: D0 = the current demand for occupied space. K = the current inventory of space. Dv = demand for vacant space, can be based on uncertainty about future demand. Also the current supply of occupied space. The long run equilibrium price must ensure that there is neither an incentive to build additional space nor an incentive not to replace the space that wears out each year: Market that is not in long-run equilibrium: This figure provides some illumination on the process of market adjustment. The occupancy rate usually adjusts more rapidly than rent because of the long-term nature of existing leases. This 20 suggests that net rent in the short run responds to an increase in the occupancy rate: the change in rent is a function of the change in the occupancy rate. Net rent continues to adjust until it reaches R’, the short-term equilibrium. In the long-run the stock of space adjusts upward because net rent R’ exceeds C/u. Theory vs reality: If the stock can adjust fully in one-time period, the size of the addition to the stock depends upon the size of the drop in vacancy rate below its natural rate in the previous period. In reality adjustments to the stock take more than one time period for some types of real estate. In this case, the more general statement is that the amount of construction that takes place in the current year is a more complicated function of previous changes in the vacancy rate. In summary, the model consists of.. … three equations: - demand function for occupied space - demand function for vacant space - long-run equilibrium condition that net rent equals the cost of capital divided by the occupancy rate … three unknowns: - net rent R - the amount of vacant space V - Total amount of space: K= Q+V followed by occupancy and vacancy rates. The model is different for the short and for the long run. For the short run, the inventory of space is fixed so the model reduces to two equations and one identity. For the long run equilibrium occupancy rate equals the cost of capital divided by the long-run equilibrium net rent. This occupancy rate can be called the “natural” occupancy rate. Conclusion: In short-run equilibrium, net rent and the amount of occupied and vacant space are a function of the total inventory of space (taken as given) and the underlying parameters in demand functions for occupied space and vacant space. In the long-run, net rent is a function of the cost of capital and the underlying parameters in these two demand functions. Net rent then determines the quantities of occupied and vacant space and, hence, the natural vacancy rate. Therefore, the natural vacancy rate is shown to be a function of cost of capital and the parameters in the demand functions for occupied and vacant space. according to the two additional investigated models there exists an optimal vacancy rate for landlords. it is concluded that none of the practical examples presented in the chapter is fully consistent with the basic model of equilibrium because none includes an estimate of the demand for vacant space. 21 Week 3: Development of land and building projects Powerpoint: Development of land and building projects Residual value of land Restwaarde grond - - residual value = The use that will produce the highest net return to the land (given legal and physical constraints) Land value is based on future cash flows wat kan je mee Land value is not based on the costs to make it, nor on past improvements – but on future cash flows Market value changes in non-improves land, exceed market value changes of built properties. Changes in market prices has a lot of influences on the residual value non-improved land -10 % of dwelling (incl vat) price leads to 50% decrease of residual value non-improved land In the figure the uncertainties regarding the exploitation of properties, rents, maintenance, etc. are not taken into account lead to more uncertainties residual value Risky way to use for ‘raw’ building land Land assembly and holdout - - Land parcellations are based on previous uses. Land assembly is needed for development. Extra value in joint development of an integrated area. This extra value (plottage value) only becomes available if all landowners join forces. Land assembly = the joining of multiple adjacent parcels of land to form a single site that can then be used to construct a larger property. o Extra value of land assembly: ’leads to plottage value Land assembly it is needed for development, harder in urban areas because of private ground Can increase residual value Land parcellations (verkaveling) are based on previous uses. Land assembly and holdout - - Holdout = people not working with assembly, there are not willing to sell solution is to give them a disproportionate share of this plottage value goes to the last landowner joining the club This extra value (plottage value) only becomes available if all landowners join forces 22 Timing: land as call option - - Real option: you can build now but, what happens in the future? maybe more profit in the future 2 choices: o A: Building now (residual value) if the ground price goes up and becomes higher than de development you know it is profitable o B: Building later (option value) market value … o Development takes place if A>B The more volatile a market is, the higher an option value. There is a time lag between demand for properties (changes swiftly) and supply of new buildings (changes slowly) Time to build - There is a time lag between demand for properties (changes swiftly) and supply of new buildings (changes slowly) causes pig cycle Office market: o if there are too many offices; no new development takes place o If supply has been used, demand for new offices is emerging o It takes years for this demand is being followed by new supply (time to build). o In all these years new projects are started to meet this urgent demand o Resulting in oversupply at the moment of completion. Highest and best use given legal and physical constraints Legal and physical constraints are not given, but often malleable. - - Legal constraints: o Lobby of landowners o Corruption o Etc. Physical constrains: o Bridged by higher perspective New infra to open up area Noise and other environmental stress o Highest and best use can be achieved at a higher level by integrated development` 23 Real estate Cycle 0 Initiative/idea - Potential development freezes land market current use (all land) idea of what can happen and influence on market volume o E.g., Farmland not sold for farm prices: so farmers cannot buy it o In urban Planning blight: potential further development and therefore now nothing is done if you know something is going to happen there, e.g. bouwen van winkelcentrum - Speculative land transfers (some of the land) o Risk that land use will not change (especially if regulatory change is needed) 1.Plan development - Future land uses determine future values looking at what will add value to the land (shopping mall, homes) - Programme in plan is most important o Defines potential land value development o Programme, target groups (Affordable housing, plots for self-building, etc) What are you going to build their o Few risks, high potential gains, especially in relation to land use regulations what are the plans that are already their and what kind of influence will they have at your plan. o Role for designers 2. Land development - Long duration (boom and bust within one process) - Risks you do now know what is going to happen e.g. changes or regulation - Public and private interests o Parties with different background makes that profits are often shifted towards other processes - Public works versus private plots - Value capturing public 3. Construction - Relative short process - Risks minimalization strategies o Start only after sales took place (75%) more finance needed high interest - Private sector 4. Property management - Long process (lifetime of properties) - Different types of managers o End users o Professionals - Usually accounted as temporary plus exit value o E.g., 10 years rent plus exit prices in t+10 5. Redevelopment cycles starts over again - The future is open - Location value is central 24 13 real estate development and investment I A. INTRODUCTION This chapter provides an introductory overview of the real estate development process, techniques to determine the financial feasibility of proposed developments or other types of real estate investments, and examination of some development case studies. I B. THE REAL ESTATE DEVELOPMENT PROCESS - Land development is acquisition of ‘‘raw’’land, addition of some infrastructure, subdividing, and selling off the lots to real estate developers Or land development involves the assembling of smaller parcels of land into a larger parcel, and selling the larger parcel to a developer Plottage value arises if the value of several parcels, when combined, exceeds the sum of the values of the individual parcels under separate ownership. goal of real estate development -> develop land for its highest and best use that will produce the highest net return to the land. legal constraints on real estate development are determined by the zoning ordinance, which determines the permissible use of the land. real estate development process stages: 1) formulation of plans, 2) project management; at each stage, there are various contracts that must be executed and approvals that are needed. Role of the Lender - - - - - Lenders take a risk because decisions of potential tenants are unknown and need to have is money back Project not in time build of in budget can lead to problems The developer is a speculator who produces a product in advance of orders— unless the lender requires that tenants shall be identified before the project begins need external financing = equity partnership (spread risk with seed money) or debt financing 3 types of external financing: o Equity partners can provide seed money, and help spread the risk o Debt financing can be obtained from banking institutions o Combinations of two 2 types of loans: o Construction loans: After you're approved for a construction loan, you won't receive all of the funds as a lump sum. Instead, the lender will make payments to your builder through a series of draws sometimes equity partners. Risk for lender if there are problems and the project, for example, is not completed on time, the person cannot pay on time o permanent take-out commitment: permits the developer to borrow at a specified interest rate within a set time period, includes: max.period, completion date, leasing requirements, interest rate,provisions & approval of changes after that the lender can stop borrowing money. Gap financing is needed if the permanent lender decides to advance only partial funding because of cost overruns or failure to meet minimum leasing requirements. can be used if the lender stops borrowing money typical floor-to-ceiling commit- ment specifies the full amount of the loan (the ceiling) and the amount disbursed (uitbetaald) (the floor) should the leasing requirement not be met An open-ended construction loan is a loangranted without a permanent take-out commitment. 25 o - - An open-end mortgage is a type of mortgage that allows the borrower to increase the amount of the mortgage principal outstanding at a later time. o Very risky, high interest rates Mini-perm loans are loans that cover the con- struction period, the lease-up period, and a few years beyond the lease-up period o Mini-perm is a type of short-term real estate financing used to pay off incomeproducing construction or commercial properties. Loan package A in- cludes a construction loan followed immediately bya permanent loan. That permanent loan is relatively risky because it begins at the beginning of the lease- up period. Loan package B has a construction loan followed by a gap loan for the lease-up period. In this case the permanent loan is less risky because it begins at the end of the lease-up period. Loan package C has a very risky open-ended construction loan followed by a safe permanent loan, package D uses a mini-perm loan that goes a few years beyond the lease-up period. Land development acquisition of land with the intention of constructing utilities and surface improvements and reselling some of the developed sites to project developers or homebuilders. land developer must proof feasibility land development plan = nature of the housing to be constructed stages of process: 1. initial contact by land broker -> site inspection, market study, cost estimation, option contract 2. option period -> soil studies, engineering, feasibility, design strategy, negotiating, submit plan 3. development period -> purchase land, close loan, implement controls, coordination 4. sales period -> implement marketing program, design controls and facility management land development loan requirements: o a) capacities of third parties to perform, o b) verification by public sector, o c) verification that third parties bear unforeseen risk, o d) estimation of interest carrying cost In summary: land acquisition and development loans are made with the purpose of acquiring, subdividing and making improvements to raw, undeveloped land. Land development loans are the riskiest loans of all real estate loans. ADC loans = acquisition, development and construction loans sometimes available but most lending institutions are unwilling to make them 26 The call option model of land value and real estate development: an option is the right without obligation, to obtain something of value upon payment.`` The owner of the land (or developer who holds an option to purchase the land) has a “real” option to develop now or to develop later. the timing of development is a matter of exercising an option. Paradoxically: uncertainty about the future can create option value. Contracts and Approvals: many contracts are executed and a number of approvals are obtained from government in the process of developing real estate. Some examples: 1. Acquisition of development rights: option, contract for sale with contingencies, binder, letter of intent. 2. Partnership agreements with equity partners 3. Financing: permanent take-out commitment, construction, gap financing 4. Tax increment financing agreement with local government 5. General contractor and construction manager contracts 6. Leases with major tenants 7. Zoning approval 8. Building permits 9. Environmental approvals 10. Payment of development impact fees 11. Utility approvals 12. Sale of developed property: listing agreement, contracts for sale Market studies attempt to analyze and predict future demand for real estate and relate that demand to existing supply conditions. This data forms the basis for the economic feasibility and physical design stages of the planning process. Residential market analysis -> housing: 1. indirect economic & physical constraints 2. size of future market 3. market-determined price range 4. type of unit justified by market demand 5. size of units 6. provided amenities Commercial development market analysis: 1. indirect economic constraints 2. square feet to lease 3. lease rate per square foot 4. types of activities to attract 5. sales volume per square foot 6. provided amenities 27 I D. FINANCIAL ANALYSIS FOR REALESTATE DEVELOPMENT - Financial analysis for real estate development serves both the developer and the lender, and determines the conditions under which a proposed project becomes economically viable - 3 steps in making an financial analysis o Step 1: ‘‘back of the envelope’’ comparison of cost to value. o Step 2: involves applying debt and equity return requirements to gauge the adequacy of the project’s cash flows in the first year of normal operations o Step 3: more complete analysis of cash flows over time and use of the present discounted value criterion. Step 1:Comparison of Cost to Value This comparison is normally done on a per-square- foot basis for commercial real estate or a per-unit basis for housing. An estimate of the total devel- opment cost per square foot is compared to the current market value per square foot of comparable, new developments net rent per square foot x occupancy rate versus annualized cost per square foot Step 2: Financial Feasibility 2 basic approaches: - front door’’ (cost approach) in which the cost of the project is used to generate therevenue stream required to justify the development. This required revenue stream is then compared with the best estimate of the actual revenue stream that can be expected. - back door’’ (mar- ket approach) in which the expected revenue stream of the project is used to compute the project’s land and development cost that can be justified. This justified cost is then compared to the actual cost of the project. Step 3: Discounted Cash-Flow Analysis The more correct approach is to lay out all of the costs and revenues over a period of several years, up to the point at which the development is sold. Then the Discounted Net Present Value of the Project is computed so that it can be compared with NPV of other possible projects the developer might undertake. a. b. c. d. Define two point in time Compute the investment cost at time zero Estimate NPV as of the time construction of the project is complete. Discount the NPV of the project at time T back to time zero using the opportunity cost of capital. e. The opportunity cost of capital for development phase is relatively high because of risk. Various methods are available for estimating the opportunity cost. 28 Risk Analysis and Financial Leverage - The analysis should consider the various risks in each phase of the project A ‘‘pessimistic scenario’’ should be run to find out how bad it can get Financial leverage can be used to increase the rate of return to equity—at the price of increased risk higher % is better more profit on own invested money financial leverage = to increase the rate of return to equity, at the price of increased risk > if the Net Operating Income falls short of the debt service, the project might become bankrupt. > great loans means greater risks that the NOI of the property will fail to cover the debt service. Financial leverage: the idea that a larger loan means a greater commitment to debt service and therefore both a greater expected return and a greater risk attached to the rate of return to equity. Also, interest expenses are deductible. Lenders normally charge a greater rate of interest for a larger loan, or they require greater security. The optimal amount of financial leverage is the loan amount that just balances the benefits of borrowing (including the tax deduction for interest) against higher interest rate that be charged by the lender and the greater risk faced by the owners. I E. THE REAL ESTATE INVESTMENTDECISION This section examines in detail the mechanics of making profitable commercial real estate invest- ment decisions. Cash Flows from Operations The primary objective in cash flow forecasting is estimating net operating income (NOI), which is income produced by the property after all operating expenses are deducted, but before debt service andincome taxes Proceeds from Sale The second major source of cash flow is from the sale of the property at the end of some holding period. Sale is often called a reversion. Income Taxation and Real Estate Alas, income taxes must be paid. The measure of most relevance to the investor is the present value of aftertax cash flow. real estate investment decision 1. forecasting cash flows from operations: estimating Net Operating Income 2. forecasting cash proceeds from sales: sale/reversion of property at the end of the holding period expected selling price is estimated by growth rate of property value over time or constant ratio of NOI to property value. 3. income taxation and real estate: measurement of present value of after-tax cash flow 4. deciding appropriate discount rate: use risk-adjusted discount rate to accomplish discount future cash and account for risk. 5. risk premium = expected rate of return that exceeds the riskless rate. 6. considering use of financial leverage -> larger loan means a greater commitment to debt service, means a greater expected return and a greater risk attached to the rate of return to equity. 7. computing net present value 8. making the investment decision. 29 Week 4: Real estate markets Pp: The Call Option Model of Land Value and Real Estate Development - - Regional price differences: what make some places more expensive than others What drives prices: o Urban amenity restraint o Public amenity hospital o Employment opportunities more productive in cities, better collaborate o Consumer faises easier to consume amenities o Commute How reachable is the place What drives: both productive and consumer advanced o Maybe for firm better option in city because of amenities to attract employment Employment: o mostly where employment is higher, prices of market higher niet altijd zo bij kust ook hoger is because of amenities available for people o but, people can also travel niet altijd wonen in gebied waar werk is intent to commute. better to look to how much employment can be reached by places in a time. Fundamental equilibrium Urban rent premium = urban wage premium + urban amenity premium (temperature) - Higher wage and amenity, higher the rent - Amsterdam has all factors high - Wadden eilanden the wages are low but it is compensated with a high urban amenity premium - Huston has high wages but low amenity therefore the rent is still high Urban wage changes ex: the economy general changes strong, Increase in wages ex: Rotterdam Balanced spatial development Need all three to get urban growth Employment / Housing = it is about affordability if the job offers the wage premium which is in line with the house prices = affordable Employment/ amenities = basically about buzz knowledge spillover to get better innovations, more amenities, improve the employment Amnesties/ housing = is about quality of life, is it attractive to life, can you do the nice thing you want to do. also public amenities (good school etc.) There is a constant balancing act for a municipality to balance the different factors that make a city liveable: 30 There is a distinction between land prices and structure prices Land Structure prices cost the built stable Price increase 300% Price increase 33% Strong corr with fundamental Weak/no corr with fundamentals Low share in new homes High share in new homes Strong influence on house price dynamics Weak influence on house price dynamics Volatile More constant Area attractive price goes up Bid rent model; WTP= wiliness to pay under Non land cost out of city Non land cost = structure cost Veder away more money to pay for traveling, therefore rent is lower Alonso, Mills, Muth conceptualisation bid-rent The rent price depreciates the further away you get from a high interest area (city centre in general) with an almost constant structure price. This idea and the resulting price curve is different per land use type: - offices, want to located to each other and want to pay a high price because Agglomeration benefits or branding Q; what is the drive of the hierarchy of the different functions: A: this is because of agglomeration economies in city this creates knowledge spillovers, - Residential: want more space - Office: want to be close to each other you want firms to be close to each other, because they can meet other firms talk about business and making connection - Retail: co-located, more attractive for people where there are multiple stores One explanation is that office time is valued higher by people than how they value their free time. Also: value of time: how we asses that time people worken (lawer), high value on time (travel kost veel tijd),but in spare time low Daarom offices dicht bij elkaar, kost minder tijd voro verplaten dus minder geld Land supply fixed? 31 - It is not necessarily fixed, different factors can impact it e.g. polders, redevelopment of agriculture land, you can go higher generating more m2 per plot. Intensifying land-use or not You can also go for more density Why do we need planning constraints? Changes at the margin The extensive margin The intensive margin Land supply for a particular use is fixed? Reimagining bid rend theory (Evans 2004) - Bid rent curves - Green belt effect (live close to nature) To prefer living close to the green area Zoning impacts the rent curve as explained on the right, you get a fragmented renting curve: planning constrains There is a general idea that land will be used according to best use value. People will keep demanding housing and rent until the point it is more valuable to use that land for agriculture. Planning will also impact these curves. The bid rent and land use patterns Alonso concept 32 Chapter 1 Introduction to urban economics McDonald Urban economics: study of economies that are organized as urban areas. Urban area: 1. Place with a very high population density, compared to the surrounding area. 2. Place with population greater than some minimum number (to distinguish urban areas from small towns). Most urban areas have an identifiable central point where population density is at a peak and declines with distance to that point. Urban economies are based on frequent contact among people and economic activities, and high population density facilitates that contact. Urban economics also include cities. We shall see that a metropolitan area that grows rapidly will see very rapid suburban growth and may have some growth in the central city, whereas a metropolitan area that grows slowly will likely experience decline in its central areas along with substantial growth in the suburbs. Urban real estate economics come in four varieties: maintstream, behavioral, conservative, and Marxist. Urban economics is largely an applied field of economic inquiry in which data are collected, patterns in date are observed, economic models are formulated and tested, and then the knowledge that is gained is used for forecasting or policy-making purposes. Kijekn of nutti is Urban economics: The study of economics that are organized as urban areas Urban area: A very high population density, compared to the surrounding area and the total population is greater than some minimum number (to distinguish urban areas from small town). Urban areas include people that uses land, buildings and other facilities in a urban area than people use. Most urban areas have a central point where the density is at a peak and declines with a distance from that point. Sometimes you have more than one point. Urban economics are based on frequent contact among people and economics. It also studies the positive and negative aspect of cities. Cities are the centre of all things. Economic, culture but also problems like crime, racial segregation and discrimination. Urban economics is related to: Regional economics: The study between the city and the land Real estate: field that studies real estate markets, institutions, investment and development Urban planning Urban sociology Urban politics Urban geography The book uses two different methods to examine the economy of an urban area Method 1: Study of location patterns within an urban area. E.g. spatial patterns of population density and location decisions (public policies regarding the provision of transport facilities and other public goods and services, local taxation and zoning and other forms of land use control. 33 Method 2: Examination of the urban economy in the aggregate. It’s focusing on the growth or decline of economy of the urban area. Most urban areas have identifiable economic function within the larger economy. The two methods are not independent. Function change has an influence on the location pattern. Metropolitan areas that grow rapidly have very rapid suburban growth and some grow in the central city. If a metropolitan area grows slowly, there will be a central decline and suburban growth. This combination has motivated the concern about urban “sprawl”. Development of the field of urban economics The ‘start’ of urban economy can be traced back to: 1930: urban economics became a separate field of study within economics. Economists started using the tools of macroeconomics to examine urban economies and real estate markets. 1956: Big Separate study called the anatomy of a metropolis by Edgar M. Hoover and Raymond Vernom. 1964: Publication William Alonso’s book Location and Land Use. It has a theoretical model that can be used for location patterns. It is still used today. He divides in his method the films and different type of firms and households. In short: idea that households and firms are willing to make bids for land at various locations. Location decisions and land use can be explained by comparing the bids made by different types of households and firms. Since 1960 a lot of progress has been made in urban economics. There are two fundamental types in the field of economics, namely: Normative economics: That includes ethical objectives and perfectly competitive markets Positive economics: determines the facts of economic life. Positive economics has typically 5 stages: gather data, systematic examination of the data, formulation of economic models for the important facts, empirical estimation and testing, using the models for forecasting and normative analysis. Purpose of this book is to teach the nature of the progress that has been made in the field of urban economics. This is done both normative and positive, but mainly positive economics. Preview of coming attractions The book has 6 parts: Economics and urban areas: Location patterns in urban areas Real estate and urban housing Government in urban areas Urban social problems Urban growth Conclusion So, urban economics is largely an applied field of economic inquiry in which data are collected, patterns in the data are observed, economic models are formulated and tested, and then the knowledge that is gained is used for forecasting or policy-making purposes. Urban economics is about the economics of urban areas. Urban areas are also linked to the larger economy. Urban economics is also about spatial patterns and economic activity within an urban area. 34 Chapter 4 Location decisions, agglomeration economies, and the origins of cities McDonald I B. LESSONS IN BASIC LOCATIONTHEORY FOR A FIRM firms need to choose a place for the assembling of inputs and from which it will distribute its output to customers. Inputs and outputs are subject to transportation costs. The book describes two theories on how this decision could be made. Theory 1: One input, one market model There is only one input and all customers are in the same location: The firm uses an input on one location (a) and processes an output that is sold a different location (b). Weight losing process: the input is more expensive to transport than the output: for example: trees are more difficult and expensive to transport than timber, so the production will be located before transport to lower the transport costs � firm will be closer to location A In a weight gaining production process, it’s the opposite (for example producing coca cola powder and adding water to it in the bars instead of producing bottles of coca cola and transporting them to the bars) (closer to location b/market location). Companies that are market-oriented will choose location (b) near their customers, input-oriented firms will choose location (a) near their input. Weight losing process > locate closer to input location = input-oriented firm Weight gaining process > locate closer to output location (market) = market-oriented firm Modeling the transportation cost of inputs and outputs for option 1 weight losing the transport loses weight : - TC output (Lower) or TC input (higher) transportation cost to the market location Total transport cost: add up both TC total is max if you located at the market, min at input location When there is a need for two inputs weight gaining production process: weight gaining because output weighs more than input Firms are drawn to their inputs or their markets. A market-oriented firm will locate in the city. A input-oriented firm will locate in a city when the input is labour. 35 One production location, various locations with customers For the second simplified option the firm should follow the principle of median location, which states that the transportation costs are minimized if the firm is located at the median customer. In the case below, customer D. The best location cannot be off the line. if G’ is added, the best location is between D & E. This method works best when there is an odd number of locations. The model that generates the principle median location can easily be transformed into one that closely resembles the one-input one-market model. This model assumes that input and production costs do not vary from place to place. The customers are located on a line and the firm needs to choose one location and transport to one customer per trip. The principle of median location can be used. According to his principle the transportation costs are minimized if the firm is located at the median customer. They need to be located near costumer principle of median location, = kies te locatie van de middelste klant, het maakt hierbij niet uit wat de verschillende lengtes van de klanten zijn E: This model helps to explain the creation of cities, and why they grow. As picture two shows the firm must locate near customer E, as this is the median customer. The city attracts firms based on access to customers. Firms choose to locate at the borders of cities to be able to deliver to clients in the city as well as clients in the hinterlands. To sum up: Theory 1: firms locate at either the input of output location Theory 2: firms must locate in the middle of the customers. A more complex version of the first model can be used to explain port cities. If the product is transported over a longer distance and different modes of transportation are used (for example trucks and boats) the transshipment points become likely locations for cities, because a labour force is needed for unloading and loading on those locations. The transport costs of raw materials and finished products are now combined with the costs of (un)loading, in some cases this leads to a input location, a production location in the port city and a location where the goods are sold. a different loading location that is not one of these three locations is not likely, as this will need extra labour for (un)loading the goods. The figure below shows a port at point P. And ships that bring in wheat. 36 The mill should be placed at point P because it is likely cheaper to transport milled wheat to the market M. The above models only take into account the transportation costs. Other factors in the location decision Labor costs – firms choose locations with low wages (before taxes) and/or locations where skilled workers are available, or where business climate is such that rules can be designed to enhance the efficiency of the operation, and quality of life in a city to attract a good workforce. Energy, capital and land – costs for energy (especially for energy intensive industries), available capital (smaller firms rely on the local/city capital, larger firms rely of the national capital) and prices of land are taken into account (is the land available? Intermediate inputs – availability of goods that need to be bought from other firms Knowledge inputs – the clustering of needed knowledge in an area (for example technical companies near a technical university or other tech companies) Taxes and public services – can be incentives for companies to choose a certain location Labor costs: the wage rate but also the quality of the workforce is important. Attracting customers depends on quality of life (locational amenities) and the wage rate. Other inputs: energy, capital, and land: the costs and availability of other inputs. The availability of capital can be an important consideration of smaller firms. Intermediate inputs: can be a long list of raw materials, parts and business services such as specialized legal, accounting, and computer services. The knowledge input: is the location suitable to keep up with the latest trends? (Fashion designers in NY, Paris or Milan). Taxes and public services: Taxes show up as a significant location factor less often in studies of location choice from among a group of urban areas. Business may be offered tax breaks, low-interest loans, job training programs targeted to the needs, construction of needed infrastructure and other inducements. (Example Shell from lectures). Incentives for businesses are a part of location decisions in the modern economy. 37 Agglomeration economies This chapter describes theoretical approaches to explain agglomeration economies, of Alfred Marshall, Bertil Ohlin, Hoover, Rosenthal and Strange and Erwin Mills. Economy agglomeration = cost reductions occur because economic activities are located in one place. Also called “localized industries” by Marshall. Google: localization economies occur when an increase in the size of an industry in a city leads to an increase in productivity of a particular activity. Urbanization economies arise when the size of the city leads to an increase in productivity. Marshal: Cost reductions occur due to external to the firm but internal to the local economy (one person starts an idea, another person takes this idea further, etc.) or external to the local economy but internal to the firm (subsidiary trades go up) A more systematic approach was needed Bertil Ohlin: static Different kind of agglomeration economies: Sees agglomeration as static o Economies of scale, within the firm unit costs goes down when the output goes up (fixed costs are spread over more units etc) o Localization economies, which are external to the individual firm arise from the size of the local industry (the larger the local industry gets, the lower are the costs, and the larger the industry gets) denk aan silicon valley o Urbanization economies, which are external to the local industry arise from the size of the local economy (a large urban area is not just a large version of a small urban area, it offers goods and services that do not exist in small urban areas) op stedelijk gebied, door gebruik te kunnen maken van infrastructuur, labourforce, vliegvelden Hoover (1937) Industry linkages: arise from transportation saving in purchases of intermediate inputs (inputs other than labor, capital, land and entrepreneurship Ohlin’s categories refer to static, rather than dynamic, agglomeration economies. Dynamic agglomeration economies are important for the growth of an urban area. Agglomeration of firms in an urban area may be the result of: interindustry linkages, which arise from transportation cost savings in purchase of intermediate inputs. Rosental and strange: Classification for the dimensions of agglomeration economies o Industry: can vary from localization within a single economy up to the size of an urban area, all points in between are possible sources of agglomeration effects o Geographic: effect is attenuated by distance between two establishments o Temporal: effect takes place over time o Organization of the industry: competitiveness has a positive effect on productivity Increasing the size of cities could eventually lead to diseconomies (economic disadvantages from economies of scale) such as pollution, congestion and social problems. 38 Henderson found that: localization economies die out once the local industry has reached some critical size. (for some manufacturing sectors) Static theory of external economies and diseconomies The basic idea in each case is that the person who is making an economic decision, such as whether to produce more output, makes that decision on the basis of his own marginal costs and marginal benefits, and ignores costs or benefits that affect others. for example, the marginal costs for others, the air pollution, is not being taken into account. Main take away is dat bij een bepaalde grote negatieve effecten ontstaan n Figure 4.6 shows a case of the external diseconomies of urbanization: D = demand curve for labour (increased in comparison with the former situation) S = supply curve of labour W*= is the wages that companies use to decide how many employees (L*) they hire (at the equilibrium) VMP= value of marginal product Bedrijf A labour (marginal input) is meer waard (punt 1 grafiek) dan labour van bedrijf B (punt 2 in rafiek), omdat zij boven aan de rivier zitten. Bedrijf 2 moet meer labour (marginal input) doen om dezelfde output te kunnen regelen Dus marginal input van bedrijf 2 lager en de VMP ook driehoek is totaal waarde vermindering eerlijk zou zijn punt 3 kan doormiddel van afspraken In een normale situatie is er een equilibrium waar demand voor labour en supply of labour elkaar kruisen. In een nieuwe situatie voor diseconomie is de eigenlijke toevoeging van elke nieuwe werknemer kleiner. Namelijk: lijn D staat voor de demand/marginal product of labour van bedrijf A, VMP staat voor de waarde van het marginal product voor de hele urban area. Wanneer bedrijf A een werknemer aanneemt kan dit de waarde van het werk voor andere bedrijven in het gebied aflaten nemen (door meer file, polution etc). Bedrijf A neemt een werknemer op punt 1 aan. het equilibrium. voor de bedrijven in de omgeving is daardoor een nieuwe werknemer eigenlijk maar VMP* waard (punt 2), ipv w*. Dit verschil is de (negatieve) waarde van de diseconomie. Door middel van bribes moet er eigenlijk een nieuw equilibrium gevonden worden, namelijk op punt 3 met w** en L**. The chapter concludes with a brief discussion of the creation of urban areas in the U.S. in the first sixty years of the nineteenth century. *Marginal product is the additional output a firm can produce by adding one more worker to the production process. 39 Week 5: Welfare economics 1 assignment: Discussion: The best form of political intervention gives an outcome if: it about values diffente schools - Pareto = at least one person is better off, and nobody is made worse off then intervention in eco is oke - Kaldor and Kaldor-Hicks If more persons are better off and a minority is less well off but could theoretically be compensated eco is growing some people not make money but become more pore, as long the majority is doing well it is oke the be involved o Also possible to composited by e.g. subsidies outcome of intervention could be changed - (Raws) It maximizes the position of the least well off individual or as a group More left wing, progressive (liberal) point of view, invention in eco should also be on the bottom on the society Barr Economy of welfare state Chapter 1 Central argument of Barr - The proper place of ideology is in choice of objectives (what should be the outcome of the system: how should distribution be organised, how should wealthy be organised) particularly the definition of social justice what is fare? and its trade-off with economic efficiency but, once these aims have been agreed, the choice of method should be regarded as mainly a technical issue, not an ideological one Barr Chapter 1.1 | The approach Duties of the state (Adam Smith, 1776): 1. Protecting the society from the violence and invasion of other independent societies. 2. Protecting as far as possible, every member of the society from the injustice or oppression of every other member of it. 3. Erecting and maintaining those public institutions and those public works which, though they may be in the highest degreed advantageous to a great society, are of such nature, that the profit could never repay the expense to any individual or small number of individuals. 1.1.1 The central argument In stressing the importance of economics, two results stand out: 1. The welfare state is not a subject apart, but fits very naturally into the framework of economic analysis. 2. The theoretical arguments support the existence of the welfare state not only for wellunderstood equity reasons but also very much in efficiency terms. The book addresses two broad questions: 1. What are the aims of policy? is explicitly normative and largely ideological. 2. By what methods are those aims best achieved? technical question, raises positive issue. 40 Aims: efficiency, equity, justice, individual freedom can be defined in different ways. Utilitarian: aim is to maximize welfare Rawls: social justice defined in different ways and may be accorded different weights. Libertarians: individual freedom. Socialists: equality. Beveridge’s goal was to conquest what he called the five giants of want: disease, ignorance, squalor, and idleness. The distinction between aims and methods is fundamental. Barr 1.2 | Defining the welfare state The welfare state in principle Three areas of complication stand out by defining the welfare state: 1. Welfare derives from many sources in addition to state activity. Individual welfare derives not only, nor necessarily primarily, from state institutions, but from at least four sources: a. The labour market: wage income & occupational welfare (welzijn op het werk) b. Private provision: voluntary private insurance & individual saving. c. Voluntary welfare: within family and outside. d. State intervenes by providing cash benefits and benefits in kind. 2. Modes of delivery are also diverse: the issue of privatization.--> hoe gaat state om met distribution (health care, free drugs, tax relief, etc.) 3. Boundaries of the welfare state are not well defined. Throughout the book the term ‘welfare state’ us used as a shorthand for the state’s activities in four broad areas: cash benefits, health care, education; and food housing and other welfare services. Cash benefits have 3 major components welfare state according to Barr: - Social insurance: awarded without an income or wealth test becoming unemployed, specified age or sick Non-contributory benefits: universal benefits (specified on contingency such as having children) Everyone can use this child support Non-contributory benefits: social assistance (awarded on income test).--> WAO 41 The objectives of the welfare state Efficiency: to maximize the production of goods and services (at the lowest costs) (right wing orientated) cheap and perfect outcome, many could be profitable Efficiency Objective: - Economic efficiency = making the best use of limited resources we have, tech available Resource scarcity = output is limited Pareto optimal and improvement, this is one way but could also other ways of distribution outcomes of the system Efficiency, ideology and distributional goals Markets are efficient if: - firms are well informed about the nature of the product and about prices (perfect information) Individuals need perfect information about the future Perfect competition in all markets (individuals must be price takers and they must have equal power) Free entry and exit from the market and no monopolies No discrimination of consumers No public goods No external effects Increasing returns to scale How should we organise it (no complete free market) State interventions for reason of Efficiency: Staats interventies vanwege efficiëntie - Regulation Finance (subsidies and taxes) redistribution Public production = not happing in economies in west e.g. Income transfers very important one, it is not target at for instance low income Equity: to provide all citizens with a basic and equal minimum of income, goods and services (left wing orientated) for example also how you tax welfare on income Demand = market based it is about what is exactly effective demand, people asking for thins (houses) Need = policy based look house market 30, - many private houses empty, problem people could not buy them. also hard the determine what is need? Administrative feasibility if you intervene do it in a prober way (not like toeslagenaffaire) The objectives of social institutions, as in many other area of economic policy, are efficiency, equity and administrative feasibility. 42 The welfare state is a way of governing in which the state or an established group of social institutions provides basic economic security for its citizens I. Objectives of Efficiency, three aspects referred to as external efficiency = about health care and eduction for example : 1. Macro-efficiency: the efficient fraction GDP should be devoted to the totality of welfare-state institutions. not too much cost explotions, on national lvl 2. Micro-efficiency: policy should ensure efficient division of total welfare state resources between the different cash benefits, different medical treatment and kinds of education. personal lvl 3. Incentives (Stimulansen): where institutions are publicly funded, the finance and the construction of benefits should avoid unnecessary adverse effects on labour supply and employment, and saving. example, is you give someone money but does not work support to people but does not work Objective of Equity and how to organise it? Supporting living standards: Equity 4. Insurance/risk sharing (efficiency and equity dimension): reduce unexpected drops in living standards niemand mag dat hebben (Aspect of the broader aim: economic security) Fire insurance for the house 5. Income/consumption smoothing (efficiency and equity dimension): enable individuals to reallocate resources (actuarial private pension scheme), Def: you distribute the payment overtime (Aspect of the broader aim: economic security ) Subsidy for first time buyers i. aow (done by government). the idea that the consumption over time is not the same, therefore need to have extra money. Know you pay a little bit end later you get it later back. changing consumption overtime. ii. Students loan is the same, now costly to study, give a live and pay it back in 30 years, you are smoothing the consumption 6. Poverty relief: eliminate or alleviate poverty. Setting the poverty line is normative. Measuring poverty is about how many, how much and how long are people beyond the poverty line. making a lvl of a minimus based you need in a month to function in society rent subsidy III. The reduction of inequality: Equity 7. Vertical equity: The system should redistribute towards individuals or families with lower incomes. This aim is contentious. based on income, low income you get more housing allowance 8. Horizontal equity: differences in benefits should take account of age, family size, etc. and differences in medical treatment should reflect only factors which ae regarded as relevant, but not irrelevant factors like ethnic background. it is to support families subsidy for solar panels IV. Addressing social exclusion: broader goals Equity 9. Dignity: cash benefits and health care should be delivered so as to preserve individual dignity and without unnecessary stigma. make sure that it is not opvallend that het duidelijk is dat mensen hulp krijgen minder kansen of beoordeeld worden (stigma) your part of that group all subsidies without a clear stigma II. 43 V. 10. Social solidarity: cash benefits and health care should foster social solidarity (frequently stated goal in mainland Europe). Benefits should depend on criteria which are unrelated to socio-economic status(hoe veel je verdient), moet dus het zelfde zijn voor iedereen. E.g. Retirement pension or medical care aim is to relieving income poverty subsidies for special housing for disabled people Administrative feasibility 11. Intelligibility: the system should be simple, easy to understand, and as cheap to administer as possible. 12. Absence of abuse: benefits should be as little open to abuse as possible. not fraud possible. Problems: Many problems, mostly about (conflicting) definitions and variables that are very hard to measure or to set. The choice of objectives and of priorities between them is a fundamental normative issue. Barr 1.4 | Finance The following government expenditures are important to distinguish: - Absorption of goods and services which includes o Current spending; i.e. public consumption in the form of teachers' salaries) o Capital spending. (i.e. public investment, such as the costs of building new schools). - Transfer payments, which include o Current grants to the personal sector; e.g. student scholarships o Capital grants to the private sector. Contributions to the cost of university building Tax expenditures are belastinguitgaven - Implicit public expenditures in the form of tax relief. - Explicit transfer = Cash assistance to help tenants to pay their rent - Implicit transfer = tax relief on mortgage interest payments. Tax expenditures can be done in two ways. - Tax allowances can subsidize particular activities. - Tax credits differ: a person’s tax bill can fall below zero. Assessing the efficiency and redistributive impacts of the welfare state is a vast undertaking that raises both methodological and measurement problems. Two aspects assume special relevance: - the notion of tax incidence (who pays the tax, who benefits, and how much?); and the importance of considering benefits and taxes together. The general Equilibrium incidence argument To be sure of the efficiency of any policy or of its redistributive effects, it is necessary also to see how the general equilibrium of its production, consumption, and distribution is affected. The discussion of incidence concentrates on the effect, ceteris paribus, of changes in taxation or expenditure on the relative position of different income groups. The ceteris paribus condition is important because we are trying to separate the distributional effect of a given change in tax (or expenditure) from any other change in the system 44 Barr 1.5 | A changing world: challenges and responses Trends of major implications of the welfare state: Globalization: boundaries are becoming less prevalent. This makes it harder to work with different welfare states. Demographic change: Life expectancy has increased in all industrial countries while birth rates have declined, simultaneously increasing the number of the older people and reducing the number of younger workers. Changes in family structure: have become more fluid, more divorces, women more independent. Changes in the structure of jobs: worries about increasing polarization between a core of skilled workers and a peripheral workforce` minder arbeiders Rising expenditure on the welfare state. - Rising income leads to demands for higher insurance benefits and more extensive consumption smoothing, to the adoption of a poverty line that rises in real terms. more advanced medical technology extends the range of what is possible. Besides, population ageing will increase spending on age-related benefits, notably pensions, health care, and social care. Economic crisis. In the short run there was little change in the structure of benefits, with higher public spending on social protection financed by higher borrowing. Resulting challenges and responses: 2 challenges: economic policy and social policy (1) the welfare state is based on past social order and (2) the conflict between economic growth and equality has become shaper over the years. Two challenges stand out. A problem, both for economic and social policy, is the possibility that the strategic design of the welfare state is based, at least in part, on a past social order with stable, two-parent families, with high levels of employments, and where most jobs were full-time and relatively stable. Also, the conflict between economic growth and equality has become sharper of the years. The social-democratic approach, was to try, especially in Scandinavian countries, to increase the demand for labour through active labour-market policies and increased public sector employment. problem: its cost. The corporatist approach, was that the rest of the mainland tried to reduce the supply of labour, through early retirement leading to increasing fiscal pressure. The neo-liberal approach (zuidhof). – broadly the Anglo-Saxon model – Policy sought to increase the demand for labour by liberalizing labour market not least through increased wage flexibility. Advantages: not face heavy fiscal costs and employment growth. Problem: rising inequality and poverty. o DEF: important to understand, not about the liberalism, but about organising society like a market and that is also with regulations - Government constructs new markets: emission rights, congestion measurements, personal vouchers for care - Way of regulating and public management - Less democratic control ppb eerste Insurance, nu krijgen mensen zelf een budget 45 - Markets are used to solve political problems Accountability difficult to organise; market outcome becomes the norm o Both liberals and social-democrats should be aware of the effects of neo-liberal market politics 2.0 The problem with: Capital in the twenty –first century (Piketty) income not a big problem, it is about equity - Capital grows historically faster than the economy if you has some equity richer Capital as source of income becomes more important Leads to more inequality In almost every country the poorest 50% of the population owns not more than 5% of the total capital Households with high capital receive more profit Inheritance (erfinis)of capital becomes more important Misconceptions of the theory of Neo-liberalism (Oudenampsen) (2) - Neo-liberalism in the Netherlands is not imported in the 80’s (was al market) from the USA After WOII Dutch economists were advocating neo-liberalism; a reason for the late extension of the welfare state in the Netherlands (strong position in Christian democratic party) Struggle in the 70’s between Keynisians and neo-liberals; victory for the neo-liberals The idea was: o The economy should be organized on the basis of the market: o the government should organise this market: minimum wages, standards for production (no laisser-faire liberalism) o important to understand, not about the liberalism, but about organising society like a market and that is also with regulations Misconceptions of the theory of Neo- liberalism (Oudenampsen) (2) IF YOU HAVA AN ECONOMY LIKE THIS THEN: - Strengthening the supply side of the economy (Kenysians more on stimulating demand); o export driven supply o low wages lower expenditure then you can produce more means more supply o rent support - 1965-1975: Kenysian intermezzo o strengthening of the welfare state and more government interventions o battle between different schools among civel servants - the end 1982: paper of Shell CEO Wagner: wage moderation, deregulation and reform of social security: implement by Lubbers - No real public debate about this choice: o Based on technocratic approach; o civil servants are leading - Nowadays o More about political debate more orientated on cultural aspects (“Black Piet”) o Less on the economy (more difficult) - The corona crisis a new crossroad in political economy (Biden in US and rainbow government in Germany) 46 A typology of Welfare States, how welfare is organised 1. Liberal (Anglo Saxon World) = organised by market, but a lot of regulations 2. Corporatist (Western Europe) = society based on big institutions structures (not in income) i. like labour unions, church 3. Social Democratic (Nordic countries) = welfare organised by basis on income, not on group like Corporatist 4. Family based (Southern Europe) = family more important i. you do not need pension systems, because younger people take care of the elderly ii. Culture important 5. Needs based (Australia and New Zeeland) = asset based Assignment 2 The best form of government intervention is as less intervention as possible: A= if you are give people as much responsiblty, people are getting stronger them self Reasons for government intervention on the housing market - The right of decent housing is a fundamental right (constitutional law and universal declaration of the rights of human beings) - Government is responsible for sufficient affordable, qualitative descent housing on the right place - Place, production, affordability, distribution, quality Housing as the wobbly pillar of the welfare state: Harloe/Thorgersen why is it so difficult in our welfare state discussion housing - Absence of standard there is no standard, every country is different Definition of housing need what is need? Can be different by for person Changes in achievements in the past gave lot of subside for first time buyers, now moeten we dat nog wel doen? Broad government goals always connection with other policy areas which means other policies o E.g physical planning people had health issues therefore prober buildings Housing as the wobbly pillar of the welfare state: Van der Schaar - - - how to intervene o From non-intervention to turn down the market: way of steering/influence do nothing and give it to the market What should we organise? verk o Way of intervention: partial – integral o should we organise whole housing sector or only part of it should you intervene on the demand side or de supply side of the housing market? o supply side: building affordable housing o demand side: huur toeslag libar more this, because target people 47 Chapter 2 | political theory: social justice and the state Theorie of society Libertarian. = no or as less intervention of the state market based Libertarians: individual freedom. These are the descendants of 19th-century liberalism, though with important differences between ‘natural-rights’ and ‘empirical’ libertarians. - - (e.g. Nozick, Rand) natural-rights libertarians’: i. argue that state intervention is morally wrong and that every intervention is wrong except In strictly limited circumstances. ii. If you support someone it is the wrong decision, you should not support them (also if some is sick) everyone should do it be them self. (e.g. Hayek, Friedman) ‘empirical or utilitarian’ libertarians: i. are the modern inheritors of the classical liberal tradition. They argue against state intervention not on moral grounds, but because it will reduce welfare. ii. some government intervention is oke (health or army), but still against it. Or the help the Poverty relief iii. Liberal. (MacMillan) much more organised markets, not to much government intervention. Organize the market in a proper way sothat is can function for supply and demand. Utilitarian: aim is to maximize welfare Rawls: social justice defined in different ways and may be accorded different weights. Beveridge’s goal was to conquest what he called the five giants of want: disease, ignorance, squalor, and idleness. 48 Collectivism. organised by government and society Socialists: equality. - - Democratic socialists (Attle, Wilson, Blair) present an intermediate case. Though sharing to some extent the egalitarian view of Marxists, their analysis has much more in common with liberal thinking. Marxist (Castro)= everything is organised by the state theory draws it philosophy from Marx and its policies from writers such as Harold Laski. The theory assumes industrial society as consisting of social classes in terms of their relation to the means of production. Private property only has a limited role, and the allocation and distribution of resources in accordance with individual need is a primary concern of the state. 2.2. Libertarian views Laissez faire is a belief in the efficiency and effectiveness of market allocation and derives from two very different philosophical roots. Sometimes on a utilitarian or empirical basis, out of belief that such institutions maximize welfare. In contrast, sometimes by defending private property on moral grounds, as a natural right. Natural rights libertarians (Nozick, Rand). Based on justice in holdings, which is everyone has the right to distribute the rewards of its own labour. which has three elements a person is entitled to a holding if he has acquired it through o justice in acquisition = through earnings o justice in transfer geld gekregen van iemand anders = the inheritance of wealth that was itself justly acquired o Holdings that do not apply to neither principle cannot be justified, hence government may redistribute holdings acquired illegally (= the principle of rectification). The propositions support the libertarian predilection for a ‘night watchman’ state with strictly circumscribed powers: the state can provide only one and only one public good – the defense our person and property, including enforcement of contracts, but has no distributional role. 49 Empirical libertarians. (e.g. Hayek, Friedman) o The primacy of individual freedom; the value of the market mechanism; and the assertion that the pursuit of social justice is not only fruitless (because there is no such thing) but actively harmful. nagana van o Freedom is defined as the absence of coercion or restraint; it includes political liberty, freedom of speech, and economic freedom (market beneficial because it protects that), since the pursuit of equality will reduce/destroy liberty. o View of hatkey’s on social justice almost same as Ralws (libral), outcome of free econmice market, can be good or bad for some people, but never just of unjust. Should leave it in peace so long it makes those happy who hold it, but never strive for it. This will lead to destruction of personal freedom. o The state has no distributional role, other than for certain public goods and for strictly limited measures to alleviate destitution (armoede verlichten). o The new right: faith in individuals and not in government the market is the best coordinator of vast amounts of decentralized information and is thus efficient. Benefits: consumers because competitive pressures maximize choice, minimize costs, and reduce the power of providers Does not depend on: the goodwill of service providers and hence, it is argued, accords better with the realities of human nature 3.3. Liberal theories of society Liberal theories referred to as the middle way (combination of capitalism and government interfering). What is different between the New right: 1. Capitalism is regarded as more efficient than any other system 2. Though efficient, capitalism has major cost in terms of poverty and inequality 3. Government can ameliorate (verlichten) those cost Therefore, a combination of capitalism and government action jointly maximizes efficiency and equity. 2 strand of thinking: utilitarian analysis and philosopher John Rawls. 3.3.1 Utilitarianism The utilitarian aim is to distribute goods (= goods, services, rights, freedoms, and political power) so as to maximize the total utility of the members of society. Maximizing total welfare 2 aspects (also called equitable distribution): Goods must be produced and allocated efficiently; they must be distributed in accordance with equity (though not necessarily equally). AB = total income to be distributed totaal te verdelen inkomen A= Individual marginal utility (read from left to right), and is assumed to diminish (dalen) as his income rises. 50 B= Individual B's marginal utility, which declines from right to left, A & B at C = Total utility is maximized when income is shared equally in the middle Utilitarianism can therefore justify redistributive activity by the state in pursuit of an egalitarian outcome, but this result depends crucially on two conditions. 1. A & B must have identical marginal utility of income functions. AD is not in middle 2. utilitarianism can fully specify the optimal distribution only where the utility of A and B can be measured cardinally 2 fundamental criticism points: An unjust outcome: Utilitarianism can sanction injustice by justifying harm to the least welloff if this maximizes total utility. wordt gebaseerd op welzijn en hoe blij je bent, maar als B minder blij is omdat die ziek is, zal het naar D leiden daarom zou B minder krijgen dan A dit is onrachvaardig. The impossibility of a Paretian liberal: problems with individual freedom (incl judge of ther own best welfare) and maximizing total welfare. not possible to achieve both, some can have idea that for example wealthy people can not have yacht Rawls on social justice According to Rawls, justice is desirable for its own sake on moral grounds, also, and importantly, institutions will survive only if they are perceived to be just. Rawls argues that there exists a definition of justice that is both general (i.e. not specific to any particular culture) and can be derived by a process that everyone can agree is fair. The original position is Rawls starting point. A contemplate group of rational individuals, all concerned only with their own self-interest, come together to negotiate principles to determine the distribution of goods. They are free agents in the negotiation, but they must abide by the resulting principle (zich houden aan het resulterende principe). Therefore, rawls uses the convention of a social contract. These negotiations will yield principles of justice that command universal acceptance. Therefore, Rawls abstracts the negotiators from their own society by placing them behind a veil of ignorance. They have general knowledge but each is deprived of all knowledge about himself – i.e. of his characteristics/endowments, his position in society, and the country or historical period into which he is born. The negotiators seek to advance their own interests, but are unable to distinguish them from anyone else’s. veil of ignorance. = To distance ourselves from personal interests we (i.e. citizens through our elected representatives) zorgt ervoor dat niet het eigen belang voorop gezet wordt The only rational choice is to select principle in terms of the maximin rule – maximize the position of the least well-off individual/group. The original position, together with the veil of ignorance plays to 2 distinct roles 1. It is an analytical device, which reduces a relatively complex problem, the social choice of the principles of justice, to a more manageable (beheersbaar) problem, the rational individual choice of principles. 2. Also, Rawls sees the procedure as a moral justification of the resulting principle – they will be seen to be fair, because they are selected in a manner that is both rational and fair; hence his term justice as fairness. 51 The principles of justice: Because of the veil of ignorance, the negotiators will choose to maximize liberty for everyone (= the first principle ( ‘the liberty principle’). choses rationally and unanimously by negotiators. Then, they will turn to the distribution of goods other than liberty. Each will reject any principle of distribution that could leave him disadvantaged or exploit. The second principle (the 'difference principle'). 'Social and economic inequalities are to be arranged so that they are both (a) to the greatest benefit of the least advantaged and (b) attached to offices and positions open to all under conditions of fair equality of opportunity' Possible conflict between the two principles is ruled out by a priority principle, which gives the first principle absolute priority over the second. A reduction in the liberty of the least well off cannot be justified even if it is to their economic advantage Conclusion: Subject to these priorities the two principles can be regarded as a special case of a simpler, more general conception of justice, in which 'all social primary goods—liberty and opportunity, income and wealth . . . are to be distributed equally unless an unequal distribution of any or all of these goods is to the advantage of the least favoured. RAWLS AND UTILITARIANISM. Rawls is an explicit opponent of utilitarianism. He thinks it is illogical (it would be rejected by the negotiators) and unjust (in that it can sanction injustice in the interests of maximizing total welfare). The two theories can have very different implications. Suppose a given policy change makes at least one person better off without making anyone else worse off. This is an increase in Pareto efficiency, Rawls's difference principle, in contrast, would oppose the policy unless it were also (though not necessarily only) to the advantage of the least well off. Thus an efficient answer in Paretian terms will not always be a just answer in a Rawlsian sense. CRITICISMS OF RAWLS'S THEORY It has been argued that the negotiators would be unable to make any decisions behind the veil of ignorance. Also similarly argues that removing all cultural knowledge will immobilize the negotiators; but failure to do so, though permitting them to make a decision, will result in a culture-bound definition of justice. Rawls’s list of liberties (1ste principle) may be too narrow, because the principle of toleration (e.g. the diversity of goals) inherent in Rawls’s definition of liberty may reflect class bias, and because some issues are left unresolved. Also, some writers dispute the priority given to liberty: poor people might be willing to trade some liberty for greater social or economic advantage. Besides, an optimal outcome under the maximin rule implies very restrictive assumptions. MILLER'S ANALYSIS OF SOCIAL JUSTICE. Some people emphasize that Rawls developed a liberal theory instead of a general theory of justice. According to Miller, social justice has three distinct elements: 1. rights (e.g. political liberty; equality before the law); waar heb je recht op 1. deserts (i.e. the recognition of each person’s actions and qualities someone who works longer hours should receive more pay); wat zou je moeten krijgen als je iets doet/hebt distributive justice. 2. needs (i.e. the prerequisites for fulfilling individual plans of life that an individual incapable of work should not be allowed to starve.). iets wat je nodig hebt. Conflict may arise between the elements desert and need. if I am rich and healthy and you are poor and ill, then either I am taxed (and do not receive my deserts) to pay for your medical treatment, or you receive no treatment (hence your need is not met) so as to protect my deserts. Miller criticizes utilitarians and Rawls because they blur everything in a single indistinct whole (no divorce like he does). He also criticizes Rawls because there is not one definition of justice (everyone has his own) 52 2.4 collectivist views Democratic socialism Collectivist writers agree on the importance of equality. They regard resources as available for collective use, and consequently favour government action; but historically they have disagreed about whether socialist goals could be achieved within a market order. Socialist aims vary widely, but three – equality, freedom and fraternity (broederschap) – are central points. Equality is a variant of vertical equity and fraternity of the social solidarity aim. These aims can clash; and different writers assign different weights to the different terms; but together they make up the social definition of justice. Equality (gelijheid): Positive equalizing measures are needed, though not necessarily complete equality of income. Freedom: The socialist concept embraces: - freedom of choice i. which is possible only if there is no poverty and no substantial inequality of wealth and power), - and extends from legal and political relations to economic security. i. people some power, relation to work. In sharp contrast with libertarian views, socialists regard government action as an essential and active component of freedom. Fraternity: cooperation and altruism rather than competition and self-interest - Broederschap: samenwerking en altruïsme in plaats van concurrentie en eigenbelang Socialists have criticism of the free market, 4 points: 1. it starts form the motive attributed to individuals to pursue personal advantage rather than the general good, and denies the libertarian view that the former brings out the latter. 2. They regard the free market as undemocratic, in that some decisions with widespread effects are taken by a small elite, and the others are left to the arbitrary distributional effects of market forces. 3. They say the markets are unjust because it distributes rewards that are unrelated to individual need or merit. 4. they state that the free market is not self-regulating. The market has not been able to abolish poverty, let alone inequality. DEMOCRATIC SOCIALISM. Mainstream writers see two great changes in the capitalist system: 1. government today has a large role to play in economic life as well as in other areas; 2. the classic entrepreneur has largely disappeared, the ownership of modern corporations being both diffuse and largely separate from the people who manage them. It is argued in consequence that capitalism has been 'tamed', and that the resulting mixed economy, with an active role for government in the distribution of goods, income, and power, is fully compatible with socialist objectives. 53 Marxists In considering the Marxist view of capitalism, we need to turn our minds to three things: 1. the contrast between the Marxist approach and that of conventional economic analysis; 2. its analysis of the exploitation of labour; 3. and its view of the role of government in supporting capitalism. Exploitation of labour under capitalism is central in Marxist thought. In conventional economics, individuals are selling their labour services freely in a competitive market; wage is established at the point where labour demand equals its supply, this wage rate is equal to the marginal product of labour. Similarly, capital receives a marginal product, which is equal to the normal rate of profit plus any risk premium. Marx’s argument is in essence that exploitation arose because the capitalist was obliged to pay only a weekly wage sufficient to support the worker and his family at around subsistence, but could then extract as much output as possible by imposing long working hours. The surplus value is the difference between the value of a worker’s output and his wage and is, according to Marx, much greater than that necessary to yield a ‘normal’ rate if profit. Individuals with the only source being the sale of their labour have less power than the (fewer) people who own wealth or have independent access to the means of production. The capitalist mode of production causes conflict between the exploited working class and the small ruling class which derives power from wealth and/or political influence; that conflict is, according to Marx, inevitable. The role of government in a capitalist society The ruling class dominates government decisions because of its economic power and because members of the economic elite share a common education and social class with the political elite (political power). Accordingly, the government in a capitalist society prefers the ruling social society. The last is the power of the ruling class over the ideas. Liberty cannot exist where economic and/or political power is distributed unequally; freedom, moreover, includes substantial equality and economic security. Social justice: freedom and equality 2 intermingled aspects verwerven in elkaar Equality to a Marxist does not necessarily imply complete equalization (gelijkstelling). It can be argued that the Marxist aim is not equality but meeting need. - reward based on effort or ability Implication for the role of the state Theoretical issues Criticism of liberalism by libertarians centre largely on the definition of individual freedom. - The liberal concept includes economic security, so that social justice embraces needs as well as right and deserts. - Libertarians criticize the inclusion of needs, at any rate above subsistence, because the resulting institutions (e.g taxation) reduce efficiency, abridge (verkorten) natural right and are part of a slippery slope towards totalitarianism (= a system of government that is centralized and dictatorial and requires complete subservience to the state). There are counter-arguments: - It is not possible to define social justice (concerns to Hayek’s argument). Many concepts, including poverty and inequality are hard to define but it does not imply that it doesn’t exist. The propriety of the liberty principle is explicit protection against the Hayekian slippery slope; and also, that redistribution does not violate individual rights where it is part of a social contract agreed behind the veil of ignorance. 54 Criticism of liberalism by collectivists arise, first, because of the greater collectivist emphasis on needs. Collectivists adopt a broader definition of freedom and thus criticize Rawl liberty principle because it underestimated the effect of economic inequality on political liberties. Marxists also criticize liberal theories because they leave out class conflict. Criticism of libertarianism - There is no opposition by liberals to free markets per se. they attack the weight given by libertarians to free markets, which can distribute resources unjustly by failing to meet individual need. - Collectivists criticize the libertarian definition of freedom as too narrow, and regard equality and economic security as inseparable aspects of freedom. - Marxists reject the free market system entirely. Criticism of collectivism - Natural-rights libertarians entirely reject collectivist views since attempts of redistribute resources equally or in accordance with need are seen as violation of individual freedom. - Empirical libertarians and liberals criticized collectivism not because it included meeting need as an objective, but because it gives it priority. It can be argued that collectivism is defined in terms of it methods has been discredited. - Democratic socialism, however, is defined in terms of its aims. Policy implications - Private property o is inviolate only to natural-rights libertarians for whom justice in holdings implies total freedom for the individual to allocate as she chooses those resources that the has justly required. completely free aan de hand wat ze zelf gekregen of verdient hebben o Empirical libertarians accord private property a major but not overriding role; o To liberals – private property and public ownership are a pragmatic matter moet nuttig zijn government can always intervene, but is about whichever mix is most helpful to achieve policy aims o democratic socialists allow it a more important role than formerly. o To Marxists – resource are available collectively to be distributed according to need public ownership - Taxation o natural-rights libertarians: means that an individual will work partly for himself and partly for the government; therefore it is taxation, not private property which is a form of theft. o Empirical libertarians concede the need for some taxation for the provision of public goods and for poverty relief. o To liberals – regard taxation as an appropriate means toward policy objective, though they are concerned about its disincentive effects. o To collectivists – taxation for any social purpose is legitimate 55 - Redistribution. Distributive justice is not a problem for everyone. o Libertarian, more focused on rights o For the others, more on needs o Natural-rights libertarians – concentrate entirely on right and deserts. Resources are produces by individuals, who thereby acquire the right to allocate them. by individuals, decide yourself what you want to do with it.. Both focused on desert and need o Empirical libertarians – may oppose progressive taxation, but do not entirely rule out redistribution. public action to relive destitution (armoede verlichten) o Utilitarians– favour redistributive activity which increases total welfare but are concerned about the trade-off with efficiency. o To Marxists – resources are available for collective allocation on the basis of need - Public production. o Libertarians – countenance provision by the state of at most limited public goods (law and order). alleen de echt nodige dingen o To liberals – the issue of public versus market production and allocation is pragmatic which method most effective o Marxists – state supplies all basic goods and services and distributes them in accordance with individual needs. Attitudes towards the welfare state - Natural-rights libertarians – regard a welfare state of any sort of an anathema (vervloeking), seeing its pursuit of the spurious goal of equality as an unacceptable violation of individual liberty. - Empirical libertarians – state that a residual welfare state is essential to their idea of a civilized society. It is therefore not inconsistent when they attack existing social arrangements but support more limited welfare institutions. - Liberals and democratic socialists – support the welfare state. The British welfare state is seen not just as an outcome of working-class pressure nor a creation of the post-war labour government but as an all-party creation. For socialists, the welfare state is not a complete solution to society’s ills, but a step along the way. - Marxists – The welfare state has contradictory functions. ‘It embodies tendencies to enhance social welfare, to develop the powers of individuals, to exert social control over the blind play of market forces; and tendencies to repress and control people, to adapt them to the requirements of the capitalist economy.’ Whether the welfare state contributes to justice is clearly a matter of perspective. 56 Chapter 3 | Economic theory 1 - State intervention 3.1 The formal structure of the problem The main aim of the chapter is to develop a framework that explains and justifies the fact that the state has considerable involvement in the finance and/or delivery of some goods but leaves others to the private market. The main issue concerns economic efficiency and social justice. The starting point for economic theory is the social-welfare-maximization problem. The aim of policy is to maximize social welfare subject to three sets of constrains: zorgen dat iedereen tevreden is Tastes =Utilites - Technology - Resources Uitleg bij deze sommen in de tekst -------> Aim maximize social welfare (W), in functions of utilities of individuals A and B Problem: Joint maximization of efficiency and social justice Utilities measured by the consumption of goods (X and Y) by individuals A and B Utilities= hoeveel je gebruik maakt van goods, hoeveel gebruik je kan maken van good 1 en good 2 the pleasure or satisfaction that a consumer obtains from his or her consumption of goods and services A first-best equilibrium occurs in a perfectly competitive market when no imperfections or distortions are present. A second-best equilibrium arises whenever a market includes one or more imperfections or distortions. lumpsum lump-sum taxation= A lump-sum tax is a special way of taxation, based on a fixed amount, rather than on the real circumstance of the taxed entity. In this, the entity cannot do anything to change their liability The problem formulated relates to a first-best economy, which implies one of two situations: - Either there are no obstacles to efficiency, and also an optimal distribution of financial donations (endowment) - Or government can counter inefficiency or maldistribution with first-best policies (e.g. through lump-sum taxation) overheid kan tegenaaan op inefficiente of slechte verdling Important by first-best assumptions: completive market will allocate resources efficiently, state has no role in distribution The conditions are stringent, as is the assumption that lump-sum taxation is feasible. A second-best economy faces additional constraints: - Imperfect information is a recurring theme, leading to unrestricted markets to be inefficient or inequitable, and intervention may improve matters. Externalities are present, and may justify intervention in various forms. 57 3.2 Why economic efficiency is one of the aims of policy The concept of economic efficiency Economic efficiency is about making the best use of limited resources given people’s taste. IT involves the choice of an output bundle. Where Xi is the output of the ith good, with the property that any deviations from these quantities will make at least one person worse off. Regarding economic efficiency, three conditions must hold simultaneously: 1. Productive efficiency - which means that activity should be organized to obtain the maximum output from given inputs. Figure 3.2 shows the maximum quantities of the two goods that can be produced with available resources. Productive efficiency means that production is at a point on – rather than inside – the transformation curve (all points on the transformation curve conform with productive efficiency. This is however not enough for allocative efficiency, which required two additional conditions to hold. 2. Efficiency in product mix means that the optimal combination of goods should be produces given existing production technology and customer tastes. Formally, production is not at any point on the transformation curve in figure 3.2, but at a specific point a, at which the ratio of marginal production costs (i.e. the slope of the transformation curve) is equal to the ratio of marginal rates of substitution in consumption (i.e. the slope of the social indifference curve, I-I). is wanneer 3. Efficiency in consumption means that a person’s consumption choices should maximize his/her utility – the marginal rate of substitution must be equal for all individuals. 58 This last meaning is summarized in the Edgeworth box in figure 3.3 (shows the relationship between efficiency and social welfare). Any movement away from the contract curve makes at least 1 person worse off. Thus point c is neither productively nor allocatively efficient. Economic efficiency, in the sense of a movement to an appropriate subset of the contract curve, is an important aim under all the definitions of social justice as discussed in chapter 2; and in a first-best economy no distribution can be socially just unless it is also efficient. - - - Line U = how poor or rich a person is, or how happy or sad the or she is. Different points at the same indifference curves, means same lvl of utility maakt dus neit uit waar op de lijn de person is hij of zij is even blij. how meer de curve naar rechts gaat ( dus de persoon komt op een nieuwe curve) hoe meer de lvl of utility zal stijgen persoon rijker of meer blij Same curve will be made for person B with same amount of good at X and Y Dan wordt map geroteerd Edgeworth box o Persoon A (rood) = links onder niet tevreden, en hoe meer naar recht boven hoe meer tevreden begin x weinig goods einde x veel o Persoon B (groend)= recht boven niet tevreden, en hoe meer naar links onder hoe meer tevreden Als de indifference curves elkaar raken dan is = marginal rate of substitution must be equal Dan wordt er een lijn getrokken tussen alle punte maakt de contract curve, which represent all Pareto efficiënt allocations= means all allocations outside the contracted curve can be improved Kijk naar punt I, ligt op 3 cruve for person A (rijk) en 1ste curve voor person B (arm) nu wilt persoon B naar punt G omdat die dan op ze 2de curve komt, dus rijker maar omdat er geen verschil zit tussen de verschillende de punten op 1 curve wordt de utitlity level van A er niet slechter van. = Pareto improvement, because Pareto efficiency is reached = Social welfare is increase if one person is made better off and nobody worse off 59 The relevance of efficiency to different theories of society Pareto efficiency incorporates to value judgements: - Social welfare is increase if one person is made better off and nobody worse off. van punt I naar G person A blijft op zelfde U curve dus blijft tevreden alleen persoon B gaat naar zijn 2de curve dus wordt meer tevreden - Individuals are the best judges of their own welfare. The fixed-factor case assumes an Edgeworth box of given size, and also that the conditions for efficiency in production and product mix hold. This is equivalent to discussing a first-best solution. Kijk voor de uitleg van dit stukje en de conclusies over figuur 3.3 nog even in de tekst - Libertarianism. Welfare is increased by any Pareto improvement. only source of welfare gain o elk verplaatsing op C tussen d en e verbeter welfare (ook uiteinde) - Utilitarianism. This aims to maximize total utility, and any Pareto improvement increases welfare. o verplaating van C naar the contract curve tussen eb op de punten d en b verbter werlfare - Rawls. The aim is to distribute resources in accordance with social justice. o A Rawlsian improvement (RI) benefits the less advantaged individual. In a first-best economy all Rawlsian socially just distributions lie on the contract curve. According to Rawls, goods should be distributed equally, unless any other distribution benefits the least well off. start op punt c alleen verbetere van wefare als van C naar E aan gaat om verbeteren of te less advantage individueel van C naar k kan is ook niet RI, persoon B dan slechter af - Socialism. Under one interpretation resources should be shared equally. o A movement that reduces relative inequality is a socialist improvement (SI) From c to e, it raises the welfare of the (poor) person A reducing relative inequality van c naar d geen SI o . SI is a subset of RI, and all first-best solutions that are just in a socialist sense lie on the contract curve; and, like Rawls, socialists will favor any movement along the contract curve towards k (figure 3.3). 60 Relaxing the fixed-factor supply assumption complicates matters because of the need, in the absence of lump-sum taxation, to analyse policies in a second-best economy. - It is a standard proposition that lump-sum transfers, being based on characteristics external cause to the taxpayer, can bring about any desired distribution of income without efficiency loss. - Taxes related to income, including any indirect tax whose payment rises with income, are not lump sum, and generally cause inefficiency, inter alia among other thing through their effect on individual labor supply. However, attempts to achieve social justice involve redistribution; hence taxation must inevitably relate to income. - Consequently, any practicable system of taxation may cause inefficiency in production and/or product mix. Thus, there may be a trade-off between efficiency and equity. Trade-off = afweging tussen efficiëntie en rechtvaardigheid. The distribution that jointly optimizes efficiency and social justice depends on 2 sets of factors 1. The efficiency cost of redistribution (mainly technical matter, depends on inter alia, of elastic of factor supply) 2. Relative weight attached to efficiency and equity (ideological matter) In face of this trade-off there will be different views about the desirability of an increase (wenselijkheid van een verhoging) in efficiency, which will not be seen as a welfare gain if its equity cost is too high. Verhogen van efficient, niet goed voor welvaard als er meer betaald moet worden met het eigen geld - To some libertarians it might have zero weight. - For utilitarians this might be an open question: o a given efficiency gain may (not) increase welfare; o and the utilitarian optimum will not necessarily be efficiency (i.e. utilitarians will tolerate some efficiency loss in the interest of greater justice). - Rawlsians and socialists give social justice more weight, and will therefore tend to accept a higher efficiency loss to achieve a just distribution. However, note that no theory of society gives social justice complete priority. - Even a Marxist would resist the pursuit of distributional objectives if the resulting efficiency costs reduced output to zero. 61 Efficiency Objective: - Economic efficiency = making the best use of limited resources we have, tech available Resource scarcity = output is limited Pareto optimal and improvement, this is one way but could also other ways of distribution outcomes of the system boven benoemd Efficiency, ideology and distributional goals Markets are efficient if: - firms are well informed about the nature of the product and about prices (perfect information) Individuals need perfect information about the future Perfect competition in all markets (individuals must be price takers and they must have equal power) Free entry and exit from the market and no monopolies No discrimination of consumers No public goods No external effects Increasing returns to scale How should we organise it (no complete free market) State interventions for reason of Efficiency: Staats interventies vanwege efficiëntie - Regulation Finance (subsidies and taxes) redistribution Public production = not happing in economies in west e.g. Income transfers very important one, it is not target at for instance low income 62 3.3 Intervention for reason of efficiency methods, how question The fundamental theorems of welfare economics in a first-best economy which market allocation is efficient In a first-best economy, the two Fundamental Theorems of welfare economics apply. A first-best economy has a series of characteristics: Markets are efficient if: - Perfect competition; No problems such as externalities, public goods or increasing returns to scale; Perfect information on the part of buyers and sellers; Maximizing behavior in the context of well-behaved utility and production functions; Complete markets; No distortionary taxation. 2 fundamental theorem of welfare economic 1. The first fundamental theorem shows that in a first-best economy, the operation of perfect competition will lead to a Pareto-efficient allocation of resources, i.e. to a point on the contract curve in the Edgeworth box. perfecte markt a. based on appropriate conditions of the market 2. The second fundamental theorem shows that in a first- best economy it is possible to reach any desired point on the contract curve by establishing a suitable set of initial endowments, and then letting agents trade. beetje geld geven a. financial schenink geven en dat laten gebruiken om zich te verbetern start point g, and letting agents trade, leading to point sush as k b. No interfering with market allocations other than transferring resources The First Fundamental Theorem asserts that if the assumptions apply, the market clearing set of outputs in equation will be the efficient output bundle. Where the assumptions hold, there is no justification for intervention on efficiency grounds, but if one or more fails, the resultion market equilibrium may be inefficient, and state intervention in one or more ways may be appropriate. The state can intervene in four generic ways: - Regulations. The state interferes with the free market through many regulations (e.g. shopopening hours). o Some have more to do with social values than economics. o But many are directly relevant to the efficient or equitable operation of market, especially where knowledge is imperfect. o There are regulations on quality (e.g. hygiene laws to production and sale of food) quantity, more affect on individual demand (e.g. social-insurance, and price (e.g. minimum wages and rent control) - Finance. Involves subsidies or taxes applied to the prices of specific commodities or affecting the incomes of individuals and firms. o Price subsidies affect economic activity by changing the slope of the budget constraint facing individual firms. o Taxes, e.g. tax on pollution o Price, e.g. free pharmaceutical drugs for elderly - Production. The state can take over the supply side by producing goods and services itself. o In such cases the state owns the capital inputs (e.g. making school buildings o and employs the necessary labour (e.g. teachers). o Finance and production are separate forms of intervention. 63 - Income transfers. Can be tied to specific types of expenditure or unties. not target at for instance low income iedereen Belasting op je centjes o First-best transfers take the form of a lump sum and therefore affect economic activity by changing the incomes of individuals. Expenditure: E.g. education vouchers or housing benefits Unties: e.. social-security benefits o But redistributive transfers are not of this sort, and so cannot be regarded in efficiency terms. Maar herverdelende overdrachten zijn niet van deze soort en kunnen dus niet worden beschouwd in termen van efficiëntie.. In sum, a first-best economy is characterized by perfect competition, perfect information, rational behaviour, complete markets and non-distortionary taxation Deviations from first-best: Imperfect competition, public goods, externalities and increasing returns to scale - Imperfect competition. It is a standard proposition that a monopolist can be given an incentive to produce the efficiency output either though the imposition of a maximum price (i.e. regulation) or via an appropriate price subsidy. - Public goods. Those exhibit three technical characteristics: o non-rivalness in consumption, = that marginal cost of an extra user is zero through not of an extra unit of output o non-excludability = good is produced, makes it impossible to prevent people from using it not possible to levy charges market fail entirely o non-rejectability, o which together imply that the market is likely to produce inefficiently, if at all one of those 3 characteristics is true . o if a public good is to provide at all, The appropriate form of intervention is generally public production. - External effects. These arise when an act of A imposes costs or confers benefits on B for which no compensation from A to B, or payment from B to A, takes place. o A technological externality arises when A’s utility function or production function is interrelated with B’s. For an external cost (benefit), the market clearing output will generally exceed (falls short of) the efficient output. The problem might be solved by a merger, negotiation between the two parties, regulation, or an appropriate Pigovian tax or subsidy. - Increasing returns to scale. The presence of increasing returns to scale at all levels of output implies that average cost will exceed marginal cost. The appropriate intervention is subsidy or public production, or both. However, these deviations only justify residual welfare state, not an institutional welfare state, because it gives no efficiency argument for public production. 64 Deviations from first-best: The economics of information nodig Complete information requires at least three types of knowledge: about the quality of the product, about prices and about the future. - - Quality. The assumption that economic agents have perfect knowledge about the nature of the product implies that individuals have well-defined indifference maps, and firms, similarly, well-defined isoquants. This is not always true. Where information is seriously deficient and/or complex, market outcomes may be less efficient than some sort of administrative solution and there may be a justification for public production and allocation. Markets are generally more efficient: o (1) the better is consumer information; o (2) the more cheaply and effectively it can be improved; o (3) the easier it is for consumers to understand available information; o (4) the lower are the costs of choosing badly; and o (5) the more diverse are consumer tastes. Asymmetric information. Sometimes one side of the market is less informed than the other. - Price. Efficient choice requires that agents are well informed about prices – that is, that they face a well-defined budget constraint. Where the assumption fails, the market may supply the necessary information, but where the market does not resolve the problem, state intervention via regulation may be necessary. - The future. Inter-temporal utility maximization requires perfect information about the future. In a world of certainty, the welfare state only has a small role: o (1) insurance is not necessary, since there is no risk; o (2) people save voluntary, borrow in perfect capital markets and, thus, consumption smoothing takes place through voluntary action using private institutions; o (3) transient (i.e. temporary) poverty is also dealt with by borrowing or saving; and o (4) the only reason for a welfare state in such world is to provide poverty relief for a person who is lifetime poor. The efficiency advantages of perfect competition are contingent on perfect information. Deviations from first-best: Behavioural economics Bounded rationality. This arises where the complexity of choices leads to an inability to know what to do. Deviations form rationality arise in many guises. Rules of thumb. In the face of information-processing problems people may adopt rules of thumb. Mental accounting is a particular type of rule of thumb. vuistregels Framing. Choices can be influenced by how they are presented. There is also evidence that choices differ depending on whether information is presented as a table of graph. Irrational choices. Rationality suggests that people should seek to maximize the expected value of assets, which implies that gains and losses are treated together on a net basis. But in practice many people act as though the utility gain from the rise in the value of an asset is smaller than the utility loss if the value of an asset falls (loss aversion) Bounded will-power. Another problem arises where people know very well what behavior is in their best interests, but do not act on that knowledge. An explanation is hyperbolic utility functions, with a low rate of time preference for the future, but a high rate of time preference in the present. Solutions include commitment devices, where people voluntarily put themselves into a situation where it is difficult to change there mind. Another solution is autoenrolment – that is, a situation where someone is enrolled automatically, they can opt out, but have to take action to do so. 65 Deviations from first-best: Incomplete markets Incomplete markets – Markets provide all current and future goods and services for which individuals are prepared to pay a price that covers their costs. Markets are often incomplete and fail to supply public goods; certain risks are uninsurable; capital markets may in some circumstances fail to provide loans; there may be no futures market; a commodity may not be supplied because a complementary market is absent; and incomplete contracts. Incomplete contracts – are in some respect a form of information failure, arising where neither the individual nor the government can monitor quality effectively. Arguments for private delivery – The core argument for private delivery is that ownership affects the incentives that agents face, e.g. to reduce costs, to innovate. Also, the more clearly the government can specify its wishes in a contract with the private provider. Besides, it is easier to monitor that the contractual conditions are being met, and the stronger are the incentives for private providers to maintain quality, e.g. where reputational effects are strong.--> contract duidelijk, daardoor controleren of voldaan wordt etc. - - The case for public delivery – arises where one or more of the conditions for private delivery fail sufficiently badly. Competitive pressures to reduce costs may reduce quality. o First, imperfectly informed consumers may be unable to monitor quality effectively. o Second, consumers may be able to monitor quality, but, because of unequal power, be unable to translate this knowledge into action. o Finally, because of the nature of the product, government may be unable to monitor quality effectively. Motivations for government delivery – might be poverty relief, ensuring access to core social services, and maintaining high levels of employment. Deviations from first-best: Distortionary taxation Taxes cause distortions if they change behavior. A standard proposition is that lump-sum taxation is non-distortionary, since individuals cannot avoid it by changing their behavior (therefore this is compatible with the second fundamental theorem). However, sometimes the state imposes distortionary taxes e.g. for poverty relief issues. Conclusion: Why do we have a welfare state? The two Fundamental Theorems show that in a first-best economy competitive behaviour will lead to an efficient allocation of resources, that is, a point on the contract curve in Figure 3.3. And that it is possible to reach any point on the contract curve by using lump-sum taxation to achieve a suitable set of initial endowments. There is no case for a welfare state in a world which is? (a) Characterized by perfect competition, perfect information, rational behaviour, complete markets and no distortionary taxation (b) Where we have no concerns about the distribution of resources, or where distributive concerns can be addressed by lump-sum taxation The case for a widerranging welfare state, including regulations and public production, comer from: Recognition of significant and widespread problems of imperfect information Bounded rationality Bounded will-power Missing or imcomplete markets, problems that can arise in goods markets, insurance markets and capital markets. A central justification for the welfare state is its role in addressing this series of market imperfections 66 The market’s efficient advantages are tempered by the possibility of market failure and, separately, by the fact that market outcomes can be inequitable. A prima facie case for intervention translates into a case for action only if intervention can improve on an imperfect market outcome. Intervention must be cost effective. This is more likely in the case of a market failure and the more effective and non-corrupt the government is. The size of the public sector depends also on demand, which has a political-economy as well as an economic dimension. 67 Week 7: Working with price indices for real estate markets + Urban economics Powerpoint: price index - - - - Constant quality price index = the quality is the same (you do not know anything about is) , but in time price goes up are development of the price Why index o getting an impression of the capital and asset market o valuate the real estate in that market Q: in which city is buying a house the most affordable in 2015? A:I have no idea: this is because it does not say anything about the starting price, only about the development of the price does not say anything about lvl Price indices do not contain information on levels, just on development, without a start lvl you cannot say anything about if something has a high price From 2009 to 2010 is the gap in development between A and B, what happened? In,de of what gap? A: what gap this is because they use a refence moment. look at 2010, lines are different, so the use of the refence moment determine how you interpret. o You start at a refence moment and put that on 100 but hoe het wordt laten zien wordt anders o Main: the price development is always the same Price indices and the change in % is the same 68 Construction of a price index Input (data) throughput/transformation (method) output (price index) - - Data o Transactions: the real prices, where buyer and seller agreed on can be done on: Population Sample issue client influence o Valuations: what the transaction price could be Population Sample issue client influence o Issues within data Valuation error: Lack of accuracy in the determination of a valuation someone looks at your house and apprised it objective Lagging: Valuation are based on information of the past future own house, each year tax later with they look how much you house is worth wordt gedaan jaar ervoor en dan ergens, veel verandern always uses information from the past Therefore lack Smoothing: Valuations tend to be more ‘normal’ than actual prices beter maken Client influence: The sample is based on the ‘client selection’ of the data provide made by banks, have made it own their on clients depents on what kind of your clients you habe maybe alleen rijk Method o Start with buying in based period and in refence period measure the difference o Price indices tend to describe multidimensional phenomena not een brood maar een group van verschillende broden set of things that vallen onder brood multidimensional phenomena= set of things that fall under the same subject o Also possible the other way: buy in refences period look what is cost in base can be done if something of the base period is not their anymore Conclusion: each choice you made leads to other price index it are estimations - - Method in real estate o Never the same, the quality of the building in the refence period will always be different Method Stratification: Make comparable subgroups more homogeneous the same o Advantages Not a lot of variables required (prices, subgroup-variable) Price changes at stratum level more precisely o Disadvantages Requires sufficient number of observations per stratum less observation omdat je bijv alleen appartement neemt neemt uit Amsterdam Does not correct for all heterogeneity never the same set of real estate heterogeniteit - Het opgebouwd zijn uit ongelijke delen, elementen of kenmerken 69 - Repeat Sales: Make pairs over a longer period of repeatedly sold houses if your house sold in jan 2000 and jan 2020 price change of 20 years - do for al observation gives you pairs o Advantages The exact same houses are compared more apple and apple o Disadvantages Does not control for interim adjustments to the house (depreciation/improvement) assum niks aangepast in de tussen de tijd -> je vergelijk een oiuwe en een nieuwe apple Dependent of pairs a lot of data is not used Does not control for mix of sold houses (sample selection bias) Price index is subject to revision - Sale Price Appraisal Ratio (SPAR): Compare sales prices (period T) to valuations (period T – 1) used in Netherlands only possible if there are valuation in you data base o How: you have an transaction price and you compare it with a valuation with a period before o o - Advantages Almost all data is used If period T and T-1 are close to each other, then interim adjustments to the house are unlikely Disadvantages Dependent on valuations (despite correction factor) Valuation error If period T and T-1 are far from each other, then interim adjustments to the house are more likely Hedonic regression relation of growth with x and y x increase by some Y increases o 𝑦=𝛼+𝛽𝑥 what you want to estimate is the beta relation of x and y o Breaking down prices into quality determining elements o 1. Regression – calculate coherence between sale price (P) and quality characteristics (a,b,c,n) prices go up based on that characteristics o 2. Calculate regression for two periods (based 0 and refence 1) o 3. Calculate price difference o 4. Keep quality characteristics (based on one period) constant for both periods compare better can do both ways Laspeyres (base period) and Paashce (reference period) also also geometric average of both fischer for new dwellings o Advantages: almost all data is used; corrects for quality and mix of sold objects if characteristics are solid o Disadvantages: requires quality determining elements not always available (floor area belangrijk, neit aanwezig niet goed) requires a lot of choices affect the rustling in difference price index 70 Q: if the index based on averages (not corrected) is higher than the quality corrected index Hedonic regression, what does that indicates? more information then just the price A: more qualitative houses are sold if you do not have a correction for quality, your capturing by definition is quality dit komt omdat je quality vast houdt bij berekening (1 periode). If your average go up, quality goes up, you are not correcting for that Price indices Capture developments, not levels Refer to a specific period Are estimations and its quality depends on data and method 71 8D land values, house prices and land area This chapter discusses different theories that try to prove/disprove the bid-rent function. Monocentric city model = Monocentric cities were a natural starting point for modelling early cities, in which most business activity ocurred around a single point. think, for example, about a coastal trade city with a single port. Most trade of goods and services would occur around the port, and residents would commute to the port daily. Land values, house prices and land area Direct use of the bid-rent function for land would be the most direct way of testing the monocentric city model. However data on land is hard to find because 1. there is not a lot of vacant land in urban centers 2. house prices include building + land value Two attempts have been made that both involve the city of Chicago as there is a lot of records available from land transactions (from 1833 till 1933) conclusions that are drawn from this model: 1. Each additional mile from the city center reduced land values by 31,3%. 2. Most of the points that are well above the estimated function (straight line) are located near Lake Michigan (nice place to live I guess) amesites 3. The upturn in house prices after 10 miles does not need to be explained as the city center of Chicago was not bigger than 5 miles. This particular bid-rent model does not need to explain farmland prices. More recent models: Olcott’s model: long-term decline in the land value gradient (percentage of the decline in land values per extra mile) is consistent with the predictions of the previous model, and: decline in commuting costs lead to flatter land-value ratio’s. McDonald (1990): land values increased with distance in the area just outside of the central business district McMillen (1996): adding extra values like distance from lake Michigan, O’hare and midway airports could explain Mcdonalds rise in prices, and thus again proves the claim that Chicago's central business district still dominates Chicago’s land market. Robert Margo (1998): recorded asking prices of vacant lots in New York: rates declined by 81% for each additional mile from CBD in 1845. The gradient declined over time as the NYC public transportation system was improved. Ahfeldt and wendland (2009): Berlin land value gradient declined over time just as in the American cities, the decline was less steep tho. 72 gradient = the ratio between average prices in the center and suburbs by city That is the percentage by which the price of land falls per mile further from the CBD So the better/cheaper the public transport is in a cityThe slower the decline in land prices Minder lang onderweg dus minder erg om te reizen However, lots of research on the monocentricity of cities is faulty because they used house prices and not land prices Recap from chapter 7: price per unit of housing declines with the distance from the city centre, the quantity of housing increases with distance. House prices are high where high-income households live. Blabla lots of variables and functions, conclusion: homes sales cannot be used to test the prediction of the monocentric city model. A final approach (jeej) to test the monocentric model is by Brueckner and fansler (1983): big study, lots of population, lots of urbanized areas (40). Conclusion: income elasticity of demand for housing is greater than the income elasticity of commuting cost. This study predicts that urbanized land areas will be larger when: commuting costs are lower: percentage that uses public transport and percentage that owns one or more cars: idea is that public transport is more costly and commuting is cheaper when more households have cars: variables are not measured accurately yet. (en een beetje outdated imo) incomes are higher, the urban population is higher duh? Agricultural land rent is lower goedkoper om nieuwe woningen te ontwikkelen denk ik? These four variables can explain nearly 80% of the variation in urbanized land. McGrath (2005): zelfde conclusie andere variabelen om de commuting costs te berekenen: finds evidence that higher commuting costs lead to smaller land areas. All these study approaches directly tests the monocentric city model predictions regarding the overall size of the urban areas. ‘Sprawl’ is still simplistic in these models. As two urban areas may cover the same total land area, a city with large suburban homes more ‘sprawling’ that a city with only high rise buildings that ends abruptly. Burchfield et al (2006): define urban sprawl as: the amount of undeveloped land surrounding an average urban dwelling. Conclusions: Sprawl is positively associated with the degree to which employment is dispersed: the reliance of a city on the automobile over public transport: fast population growth, value of holding on to undeveloped plots of land, rugged terrains, no high mountains, temperate climate.. Summary (including the other sections of CH8): The monocentric city model is a simplification of reality. It uses a simple idea – people will pay premium to avoid lengthy commutes – to predict spatial patterns of population and employment density, house prices, land values, building heights, and floorarea ratios. Population density, land values, employment density, building heights, floor-area ratios tend to decline with distance from the city center. Over time, the functions have flattened and urban areas have become increasingly decentralized as commuting costs have declined. But the central business district still is the largest single employment site in most cities, and it exerts a powerful influence on the spatial layout of urban areas. 73 Chapter 9E The business of residential mortgage lending and financial crises The financial institutions that provide housing loans include commercial banks, saving and loans institutions called thrifts, and mortgage companies. Financial institutions that provide housing loans: Thrifts/Depository institutions: commercial banks, savings and loan institutions: accept deposits from the public, pay interest on those deposits and lend the money to borrowers. Mortgage companies: create loans that are immediately sold on the secondary mortgage market: they earn a fee for creating the loans. Fatal flaw in the business of residential lending is that: lenders take short term deposits and use the deposits to make long-term loans with typical duration of 30 years. depositors a person who keeps money in a bank or building society account. is het in bewaring geven van geld aan een bank Interest rate risk: Interest paid on the mortgage loans is not higher then interest paid to depositors. Lender becomes insolvent unable to pay debts owed. anders gunstiger om te lenen 1. Can be the case if the institution is sitting on assets consisting largely of long-term fixed rate mortgages, and short term interest rates rise. 2. If borrowers are unable to make their interest payments (depression in the early 1930s) “Pass- through” securities: Basic flaw of mortgage lending was recognized and different institutions were set up hat enable investors to invest in bundles of home mortgages that are purchased from the original lender. basic idea is that risks are reduced by bundling many mortgages together, to then place the securities with long term investors To protect the lender 1. The U.S. Federal Housing Administration (FHA): program to guarantee mortgage payments to the lender from borrowers who did not have funds for a down payment (e.g. 20% of the sales price) voor mensen die niet genoeg geld hadden om te voldoen aan 20% van total prijs 2. Federal National Mortgage Association (Fannie Mae): borrowing funds to purchase mortgages from lenders, thereby increasing the supply for funds for housing finance 3. Federal Home Loan Mortgage Corporation (Freddie Mac): same function. Secondary market for FHA and veterans administration mortgages. The savings and loan debacle of the early 1980s. The start: As long as interest rates remained low and stable, thrifts would operate on the 3-5-3 principle: take on 3% interest deposits make home mortgage loans 5% golf course at 3pm. Thrifts are essentially savings and loan associations that help members' savings grow at a higher interest rate- is een financiële instelling die gespecialiseerd is in het accepteren van spaardeposito's en het verstrekken van (hypotheek) leningen. 1960s: federal deflicts drove nominal interest rates up o Response: Interest Control Act of 1966 gave authority to federal regulators to set ceilings on interest rates paid by thrifts (spaargeld). 1970s: sharp increase in nominal interest rates made attempts to regulate rates paid by banks and thrifts self-defeating. (from 6.49% in January 1979 to 15.61% in August 1981) o Response: money market mutual funds were created. Ordinary investors could invest in treasury securities, this drained deposits from banks and thrifts 74 o o Federal regulators allowed banks and thrifts to pay market interest rates Banks and thrifts had a cruel choice: 1. Pay high interest rates on deposits and suffer operating losses, 2. Refuse to pay high interest rates and watch deposits migrate to the money market mutual funds (this would force them to sell mortgages below market price): losses could not be avoided. Two major congress acts followed: depository institutions deregulation and monetary control act of 1980 (DIDMCA) + Garn-St. Germain Act of 1982: These laws included the following provisions o Thrifts were permitted to offer adjustable rate mortgages (ARMS) that would adjust up or downward with the general interest rate level o Types of loans permitted to federally charted thrifts was greatly expanded o Regulation of interest rates payable to depositors was phased out o Interest of checking accounts was authorized for banks and thrifts o Maximum insured deposit amount for increased to $100.000 Net effect of the new system was to induce many thrifts to take on excessive risk, with disastrous consequences o Thrifts industry expanded rapidly in mid-1980 into new areas of lending o Thrift executives were overly optimistic, aggressive, careless, ignorant, criminal etc. o By the time de regulation agency tightened the regulation reg. safety it was too late o 1/3 of the thrift agencies became insolvent FSLIC (deposit insurance agent for thrifts) became insolvent This led to the passage of the financial institutions reform, recovery and enforcement act of 1989 (FIRREA) o Provided funds for dealing with the costs of disposing of the remaining insolvent thrusts. o Deposit insurance for trusts under new insurance premium rules o Resolution trust corporation RTC to handle disposal of insolvent thrifts o Created the office of thrift supervisions (OTS) to tighten safety and soundness regulations End of the 1980 debacle And they lived happily ever after with low and stable interest rates and big rise in homeownership. Till the next crisis happened (dus eigenlijk ging het maar 10 jaar goed) The 1999-2009 bubble The start: the bubble developed when Americans starting buying a house, not because they needed a place to live but because they thought housing was a great investment: “price has risen, so it will continue to do so”. The bubble is based on housing price-to-rent ratio. This ratio was 14-16 from 1988 to 2002, and was 25 at its height in 2005. The bubble was born out of the boom. The boom had been based on solid demand and supply fundamentals, such as affordable homes, strong incomes, and ample household savings Chapter 1: what bloomed the bubble: Here is an incomplete timeline The federal banks lowered the federal funds from 6.4% to 1.26%: the rate that banks charged each other for overnight loans this action is seen as seriously ‘off-track’ and exaggerated the housing price bubble Interest rates on 30-year mortgage loans fell (not as fast as the federal rates) from 8.06% in 2000 to 5.82% in 2003. This is a drop of 28% Home lending was extended through sub-prime lending market to buyer who previously would not have qualified for loans. meer mensen konen kopen Home lending standard became lax, buyers didn’t even have to show income statements 75 Homeowners took second mortgages on the extra market value of their home so this money could be spend Use of adjustable rate mortgage loans increased: the initial mortgage rates would start low and would be adjusted upwards in a couple of years The use of mortgage-backed securities boomed: Fannie Mae and Freddie Mac. But turns out the risk of bundling the mortgages together was not reduced. Bond rating agencies (private firms) rated the mortgage backed securities at unrealistically high levels. Investors relied heavily on these ratings as the risks of these securities are hard to understand. All participants in the mortgage financing process evaded responsibility. Some major insurance companies provided insurance in huge amounts to investors in mortgage backed securities Fannie mae and Freddie mac entered the sub-prime and risky lines of mortgage business Government failed to regulate many of the risky practices (commercial banks are regulated, investment banks were not) The home building industry bloomed. Housing construction increased and the number of vacant homes for sale increased from 1.25 to 2.1 million within 3 years. Many actors in the market increased leverage (borrowing) dramatically) People argue whether market bubbles act as epidemics, started before 1997 and the previous list is the results (Shiller, 2008). Others put more blame on the federal policy that started this list (Taylor, 2009) Chapter 2: the downfall House prices began to fall in 2006 Many households that purchased a house found that they owed more on the house than it was worth in the market Mortgage defaults (borrowers who are late in making their mortgage payment) rise from 775.000 (2005) to 1.500.000 (summer 2007) Investors and banks were getting worried. In 2007 A big bank (Bear Stearns) announced it closed down two hedge funds that heavily invested in mortgage backed securities Private mortgage lending plunged, trading of mortgage backed securities froze Bear Stears was bought and helped by the federal reserve because it was feared that the closing would have gigantic consequences for the entire market Since late 2007 us government implemented in rapid succession large package of monetary and fiscal policies to save the financial system from itself and help homeowners First policy was to provide liquidity (liquidity was thought to be the problem). By fall 2008 it became apparent that the problem was fear of risk that had been underestimated Keynes: in a situation of this nature no amount of additional liquidity can get financial institutions back into business of lending money when they think borrowers cant repay their loans: more direct stimulation of the economy through fiscal policy was needed. As of writing in 2009, this includes: Federal reserve increased the federal funds rate to 5.25% The federal reserve took several steps to provide liquidity to the banking system Housing and economic recovery act was passed: o 1) provides a tax credit up to $8000 for first time buyers, o 2) $300 billion to help homeowners in danger of foreclosure o 3) help renegotiate mortgages, o 4) nationalize and wiping out all stakeholders of Fannie Mae and Freddie Mac The limit on insured accounts was raised from $100.000 to $200.000 Troubled Asset Relief Program (TARP): money in funds was used to acquire preferred equity in major banks, thereby expanding their capital bases in hope that this will enable them to make loans: some banks started to repay these funds in June 2009. 76 Some tarp funds was used to bail out General Motors and Crysler as they thought their bankruptcy would hurt the economy even further Obama came up with The American Recovery and Reinvestment Act of 2009: a stimulus package consisting of fiscal policy-spending and tax cuts. A set of financial regulations is proposed that further helps homeowners and regulate large financial institutions that are important to the functioning of the entire financial system. (requiring them to hold 5% of the loan, control abusive lending practices, etc.) 77 Chapter 14E Zoning Zoning Zoning is a form of regulation of the use of land that takes the form of an ordinance (regeersbesluit) adopted by a local government It includes a zoning map that specifies the allowable uses of every parcel of privately owned land in the jurisdiction. Allowables = mostly categories like residential, commercial, and industrial The movement to adopt zoning ordinances (bestemmingsplan) grew from rapid urbanization and industrialization. The common law was unable to mitigate the harmful external effects of urbanization and industrialization. The goal with introducing zoning codes was to: Lessen congestion (unstopping) in the streets Secure safety from fire panic etc. Promote health and general welfare Provide adequate light and air Prevent overcrowding Facilitate adequate provision of transportation water sewerages schools, parks and other public requirements. Zoning ordinances contain two basic features: 1. Type of land use permitted on each parcel 2. Controls of the density of use of ach parcel (mostly Floor-area ratio (FAR)). Other use methods local jurisdiction can use for controlling land are: Building codes that sets standards for quality of construction and appearance regulation Performance standards for certain activities/ prohibition(verbod) of certain activities Subdivision regulation (Verkavelingsregelgeving) to lay street pattern, impose lot dimension rules and impose exactions for needed public facilities. Original intent of zoning codes was to mitigate negative external effects, however the zoning codes themselves gave negative effects too: Sub-codes were used to only allow Caucasian (blanke) buyers to buy lend now illegal Low and moderate income households were excluded by the local gov as they designed only designing large (and unaffordable) lots. Governments used it to earn extra money through taxes Research found that property was more expensive in areas with growth control that was made possible by zoning restrictions Houston is the only city in the US without zoning. 78 PowerPoint week 7: location and urban structures, And overview and some critical refection. Part 1: location theory - - - - All location theories are based on centrality 2 versions i. central point the centroid = the geometric center of a shape. ii. Centre of mass Mostly (urban) centrality takes one or more variable into account. For example, jobs locations, population, amenities you can look at the mass of that variable, waar zijn deze het grootse en waar ligt dus het centrale point NOTE: it is a observations, it can be a self-fulfilling prophecy What is normale The centrality on maps is mostly a mixture of variables used ending up in: i. Gradient (no dingle point) vervaagd/ongeveer ii. Hierarchy one place more important than other iii. Depends on what kind of variable you use jobs locations centrality has 2 components: i. Morphological: mostly starting point 1. for example: population denticity and you look the centrality in that 2. Number of built-up m2 3. Typology of buildings ii. Functional: there is a functional centrality based on that is has a function location of how close you are to jobs ams most central that assumes that you are indeed functionally close connected 1. For example: Commuting patterns, mifgrations Part 1: location history David Ricardo (1772-1823): was the first of specialisation productive on that ground He says that: Even that Portugal is more productive in both sections, Portugal should focus on wine, because they are more productive in that and England should focus on textile Both export their things to each other and specialisation and benefits them both no difference in transportation cost and no/perfect competition iedereen Portugal zelfde niet ene iets beter of meer tax betalen Main point: not the value of the land determines the prices of the product, but the price of the product determines the price of the land or how fertile the ground is look at chapter. The rent depends on quality of the land. if you can produce more on the land, so be more productive, the land price will be higher. 79 In Portugal: the price of land for wine is higher than for textile, because wine is more productive this means the higher the productivity you are per m2, how lower your input cost is , so more you earn therefore value of land will go up Von Thunen’s agricultural model (1783-1850 model of equilibrium Find the optimal spatial allocation for cultures a fixed market centre M The most important things are close by the market centre milk production and firewood and lumber production It uses 3 variables: Transportation cost, considered to be linearly proportional with distance Market price, determined by competition and not influenced by farmers Productive per crop, a fixed variable The location of a crop is thus based on the sale price at M, and cost per unit of distance transport, determine de circles. NOTE one market at M Statement about land price is opposite of Ricardo he says fertility is the same everywhere, but the distance from the market decides the value of the land the higher the transport cost, the closer you must be to the market to be able to pay the rent how land rent varies by distance to central market place. Land rents will be higher for sites with low shipping costs that are close to market places than for more distance sites. Albert Weber (1868-1958) added industrial functions to location theory Basic: how production and technological conditions in manufacturing were important for determining the location also transport important Main innovation: material index It explains in how much raw material is eventually used in production Weight losing process > locate closer to input location = input-oriented firm Weight gaining process > locate closer to output location (market) = market-oriented firm Modeling the transportation cost of inputs and outputs for option 1 weight losing the transport loses weight : - TC output (Lower) or TC input (higher) transportation cost to the market location Total transport cost: add up both TC total is max if you located at the market, min at input location When there is a need for two inputs weight gaining production process: weight gaining because output weighs more than input 80 Location of steel plants: first the location where near the raw materials (mines), because very expensive to transport coal and iron ore later cheaper to mine and transport could be shipped around the word locations near port conclusion you locate somewhere so that the transportation cost is the lowest He also introduced Isotims and isodapanes in location decision of a firm baes of different suppliers and its market GOAL: minimize the total transport cost (was then the biggest cost) more by P christaller made a central place theory added services shown how important that are for the economy objective: to explain the size, number and spatial distribution of cities (defined as centers of supplying services to population: e.g. hospitals, restaurant ect.) cities no longer the place where the product are brought to but also where the product are made. It is a mix of geography and economy. - Geographical centrality; supply vs demand Transportation cost only by the client it goes to the product Hiërarchie of servies not all same important ene ga je vaker naar de andere The ideaal locatie of distrubtion of places of cities are in hexagon spatial model of hierarchical city centres Central place theory – there are different organizational patterns possible that nest centers in efficient patterns. GOAL: minimize the number of centres and to minimize the road network Losch combined the work of Christaller, Wever and Von Thunen and explained the relation of markets/cities in the spatial distribution of productions . In the spatial distribution of production. The shape of the markets is influences by the movement of goods being distributed. ------ > 81 William Alonso He modelled the monocentric city model = Assmumtions of his model”: - Land is only for housing not for other All jobs are located in a single point at Central Business District (CBD) All road network is dense no traffic jams Landowners - The landowners spent their housing rent out of the system not buy more house within tax-free regimes The landowners receive a default an agricultural land rent Ra= basically the base priced out of the city Landowners rent the land to the highest bidder always Households - - - Household are identical (same number of people in family) and work all at the CBD, earning the same wage Y Household only consume 2 things: \ i. cost of housing (s) ii. other things (z) food, clothes (consuming goods) Household incur i. commuting cost T veder van CBD higher T ii. housing rent R closer to CBD higher R households: rational (do the logical thing), the choice they made is utility function U the city has a fringe, beyond that it is to expensive to work at CBD based on Y the land rent is equal to the agricultural rent NOTE: it is a equilibrium models, so every want stays where they are. And the Utility is equal to U across the city The curves are indifference, the utility is the same along the curve The goal of the household is to remain on the left of the U curve - - z(0) & s(0) = city centre (max what they can spend) where straight line touched the U curve = location of household fam wants to spent less on non-housing (z) (schuine stippenlijn) you follow the line plot a line form the new z until touch U curve more money for s can buy bigger house/plot, but also further from city Changed in model: people living further away from the city center, have larger houses, because the rent goes down and they can spend more on housing but can spend less on other goods 82 Modelling the whole city - - R rent= Closer to CBD higher the rent, further away lower unit it touches the rent paid for of agriculture rent end of the city - not useful for commercial, manucaturing or residential wel for farmers (the bid for the land rent Is higher than what the farmers can do Closer to CBD lower the cost for housing (s), smaller the houses with higher rent verder grote huizen, meer maintenance Closer to CBD more money voor z activities NOTE: - It explains why the populations density decreases from the city houses bigger also household are similar If you lower transport cost curve (R) will be lager (the city will be larger) Do take into account it is about i. morphological centrality (based on location of static variables place job and location house ii. assuming a functional centrality by closer to CBD the more intense the relation is between the job and people living their in reality also explaind in book - zoning policies, refusing some land use functions are not possible households differ - market changes people changes job mobility patterns differ cars, bike, train 83 Manual Castell and Dickens; - first take into globalization a competition diffent places places at the word Castell: transport does not play a role any more all digital Dickens: he explains why how global process goes in difference levels but still connect, beter Open op the isolated models, Includes specialization (was in Ricardo), but now of production across the world uses thing from across the word Part 2: agglomeration theories Agglomeration economies = explain the productivity advantages that follow to a spatial concentration (also called clustering) of economical activities of firm and works places explain why a city exits constatation of activities that together have advantages into other option where activities are separated close to each other advantages used to out compete a similar of the same activities out of the city Economies of scale internal, firm can decide it self it is about that the higher you go in volume, the more you produce, the less money you spend on making that product, because (reality) you have a basic cost (fixed production cost machines), by making more product with same input of machines or labour the price per unit decease in the graph output Q Q2 the average cost per units goes down C to C1 higher in output, in fact you decrease the cost per unit product you search for op there is a tipping point (curve going up) in the long run average cost (LRAC) increases again, e.g the market wordt groter, dus veder shippen daardoor worden de kosten hoger. Also searching for an equilibrium (optimum) if you do not take a keep searching for the optimum, possible that some else make a cheaper product Out compete you How: Fixed production costs,Specialization and division of labour Specialisatie en taakverdeling & Cost reduction through bulk purchases Localization economies The external effect of clustering MAR (Marshall, Arrow + Romer) externalities: - Concentration: Firm within the same sector (bakery), they benefit from their proximity (nabijheid), because they share knowledge (knowledge spillover), they cover also the same market people easy to find them leads to innovations and growth Porter: - He included competition, because of that you keep each other sharp and that leads to advantages. Jacobs: - Not only of firms of the same sector that explain innovations it us the diversity of different sectors that explains the advantages (unrelatedness) more stimulating for the pro-duction of new ideas than is the greater size of an individual industry firm from other sector can react on problem in other sector 84 Urbanization economies Productivity advantage that arise from the size of the entire local economy better accessible = related to the city around it the productivity of the firms increases from the size of the local economy why better infrastructure, but also because of the diversity of good and services and more amenities all together leads to advantages to the firms firms tent to locate in cities, people tent to go to study and work there, which in the end leads in the end that firms more want to be their because there is more talent (e.g. randstand = polycentric) Part 3: Monocentric/polycentric If an agglomeration economy becomes to large there is tipping point, the negative effects are: - House prices to high, Cumming times to high in city, environmental problems, Polycentric cities could be an answer to mitigate the fast growing (industrial) cities basically in the city centre you work and very well connected you have the households located. this model links different centers that are limited in growth to each other. Polycentric urban development describes a range of urban patterns including transport connectivity, democratic processes, planning decisions and urban design concepts. Polycentricity Difference with the monocentric (concentric circle around a centre) Polycentric links different centres that are limited in growth to each other Agglomeration difficulties Functionality, that is the main problem in locations theory within agglomeration al based on`: - morphological centrality (based on e.g. number of firms, population within cent rain geography) It assumes that the proximity of those variables (morp) leads to functional increased relations This brings agglomeration effects REMEMBER that centrality itself has 2 focuses: morphological centrality mass Easy to measure and understand - Functionality centrality connection understand easy measure not 2. Why hard to measure: about transfer of ideas or knowledge only measure those relation with proxies e.g patterns, use patterns as a whay how knowledge transfers locations 3. Polycentric is measure mostly based on using commuting data (people travel from roffa to ams) based as proxies to understand how well or not is roffa connected to ams All these variables remains proxies of the function relation as we assume that is their because it is proxies It always remains am assuming of a relation - 85 Agglomeration is politics main points models are abstractions and observations if models are used in a way around (pr]o-active) can be a self-fulfilling prophecy 6 INTRODUCTION TO URBAN LOCATION PATTERNS: STATIC ANALYSIS The standard urban spatial model is known as the monocentric city model. As the name implies, the standard model is based on an assumption that the city revolves around a single center. The center is referred to as the central business district (or CBD). The CBD is the center of the stylized city’s economic life. All jobs are located there, and people commute from the surrounding residential areas to their jobs in the center Monocentric city model = Monocentric cities were a natural starting point for modelling early cities, I B. AGGLOMERATIONS OF ECONOMIC ACTIVITY IN URBAN AREAS The theory of the urban land market begins with the observation that economic activity tends to be concentrated in certain locations within an urban area. The modern urban area contains several types of economic agglomerations: the downtown central business district, major airports and other transportation and distribution centers. An urban area contains a collection of such centers of economic activity that depends upon its economic history and its functions in the modern economy. Most monocentric cities started at a port, near commercial activities, the railroad were focused on an existing port and its related concentration of economic activity The basic message here is that the analysis of an urban land market for some point in time begins with the enumeration of the important focal points for economic activity. In many cases, these centers of activity are still located at the initial site of a port or a railroad center. In some cases, it is still suffi- cient to assume a monocentric urban area. Sectors in the Urban Economy Economy can be divided into household and business. Household provided labor to business and business provided products. This forms the basic model of the urban economy and the land market could be based on this primary principal. Businesses can be divided into 3 categories: 1) producing to export 2) to import 3) to produce to supply to locals. Different kinds of industrial spaces based on the activities like commercial, retail space or production space, etc. Different kinds of residential spaces depending on age, race, income level, etc. The role of the government is to provide for facilities like parks, street lights, roads (etc.) and to regulate the use of the land. Land use categories include: residential, manufacturing, transportation, communication and public utilities, commercial, public buildings, public open space, parking, streets & unusable (water bodies). 86 Role of transportation infrastructure Transport facilitated changes in the layout of urban areas. Long distance transportation began in early 19th century thanks to ships and railroad locomotives. Before that, it was by carriages and was expensive and risky. Moving people faster in urban areas was facilitated by using railroads. Also carrying workers who resided miles away to the downtown area for work besides transporting freight. The use of steam energy was replaced by electricity which aided more efficiency, less noxious transit systems and permitted the construction of subways. The idea was to build beltway rail lines and rail yards for assembly and disassembly of trains to supplement the existing rail lines. Great use of this due to manufacturing enterprises. Large bridges and streets came up. Freeways gave more space to urban land use. Urban location patterns must begin with careful examination of urban transport to minimize commuting time Theory of Rent, Land Rent & Bid rent Rent is defined as price paid per year/month for the services of a factor of production that is fixed in supply. Rent is thus a term that can be applied : to the earnings of land, the price for the services of uniquely talented people the earnings of some other inelastically supplied input. However pure economic rent emphasize that it is payments per year to an input beyond the payment needed to call forth the existing supply. Rent-earnings of land, the price for services of uniquely talented people or earning of some inelastically supplied input. SS fixed supply (vertical line) DD demand R rent is determined by height of the demand curve (increase in demand D’D gets translated directly into increase in rent R’). Market value is present value of the stream of rent and the asset which will be earned. In a competitive market for asset, value is set so the buyer does not earn a higher V = R / r is a result when asset has a life of infinite length. This implies that an asset’s value is proportionate to its rent when the rent is constant over time. Rent is proportionate to market value. By definition, a market is in equilibrium when there is no tendency toward change in prices or quantities. Therefore, rents will not be changing over time in a market that is in equilibrium, and values will be proportional to rent 87 Early theory of land rent David Ricardo’s (1821) definition based on agricultural land with reference to fertility of land. Definition of land rent: compensation which is paid to the owner of land for the use of its original and indestructible powers. There is a fixed supply of land. The rent depends on quality of the land. if you can produce more on the land, so be more productive, the land price will be higher. driven by the notion of scarcity. Concepts in theory of land rent: 1. 2. 3. 4. Land varies in its natural endowment or advantage for the user; Land of a given level of natural endowment or advantage is in fixed supply; The land market is governed by perfect competition; Land rent is determined by the natural endowment or advantage of land. Johann Heinrich von Thunen (1826). His insight is that land varies in locations, but fertility is the same everywhere, to show how land rent varies by distance to central market place. Land rents will be higher for sites with low shipping costs that are close to market places than for more distance sites. vergelijken met CBD, land in de buurt duurder omdat meer mensen in CBD werken en dicht bij willen wonen The Urban Land Market As with other forms of economic rent, land rents exist because land is in fixed supply. However, the supply of land for a particular use is not fixed in supply Land rent as defined previously is a market price, but bid rent is only a hypothetical price. Bid rent household Bid rent for a household for a particular urban site is the maximum rent per unit of land that the household can pay to reside at location x and maintain some given level of utility. the function depicts the relationship between location and bid rent at given utility level There is a bid-rent function for each hypothetical utility level of the household The bid rent for a household changes as location changes so as to keep utility constant Bid rent firms bid rent for a business is the maximum rent per unit of land that it can pay for a particular urban site and maintain a given profit level bid rent can be thought of as a residual amount that is paid for land once the attributes of a location have been taken into account. Bid rent theory for firms William Alonso inspired by Von Thunen model, bid rent is only a hypothetical price Businesses prefer setting up closer to the central business district (CBD). Bid rent changes per location, so as to keep profit constant. It is forced on the firm to be in the competition for land amongst all firms in the industry. 1. When profit is zero: pQ – c – txQ – R = 0 2. Bid rent function: R = pQ – cQ – txQ (land rent = price for products - prices for labor - prices for transport) p = price of product 88 Q = units of output (products) c = average costs of labor and capital for each unit of output t = transportation costs per kilometer per unit of output x = distance to central site (km) R = land rent The basic idea of a bid rent function is to set profit at some level and then trace out how land rent varies. Land rent declines with distance to market place because manufacturers are ready to pay more for land with low transportation cost. Fig 6.3 shows function with zero profit and Fig 6.4 shows the effect on profit when the distance for transportation changes. Fig 6.6 shows effect of reduction in transportation cost on bid rent less transportation cost can located more out of the city Fig 6.7 Shows effect of an output increase on bid rent with relation to transportation distance. However, the increase in output per acre also means that the firm’s transportation costs are greater because more output must be transported. as shown below: they can pay more 1. An increase in the price of output (p) shifts the bid-rent function up in a parallel fashion; 2. An increase in the average of production cost (c) shifts the bid rent function down in a parallel fashion; 3. A reduction in transportation cost (t) makes the bid-rent function flatter but does not change the interception; 4. An increase in output per acre shifts the intercept of the bid rent function up and makes the function steeper. 89 Bid rent theory for households The maximum rent per unit of land that a household can pay for a particular location X and maintain some given level of utility. Bid rent changes per location & keeps utility constant. Conditions: households derive utility from and land and other goods. The attribute that counts is distance to workplace i.e time and convenience of traveling. Based on figure 6.8 the slope of the bid rent function is a combination of two effects: utility and rent level. lower utility = higher rent (mensen minder blij dat ze meer moeten betalen minder uit kunnen geven aan Z) Figure 6.9 shows the change in the bid rent function as commuting cost Declines. rent become higher Since communication cost over a period of time and land rate both need to be considered. decline in communication cos, bid rent function becomes flatter minder betalen voor afstand dus meer geld over voor land and other goods If rents do not change, they will have enjoyed an increase in utility. But bid-rent is defined for a given level of utility. To keep utility at the given level, rents will have to increase at all sites 90 Land use patterns (three sector model) Each urban site is allocated to the sector with the highest bid rent, land value is just the discounted value of the stream of highest bid rents. - Face to face communication with customers, suppliers and government (law firms, financial institutes, advertising agencies) leads to a high bid for downtown location and relatively low for other urban areas - High fashion clothing manufacturers and publishers need immediacy of the downtown location. They may locate at the fringes of downtown area or nearby. - Light industries such as furniture or other manufacturers bid for land in industrial district close to labor force or with transportation modes close by. - Heavy industries such as metal, oil refining, transport equipments are located near a mode of transport since input or output is bulky hence require heavy duty transport systems. Bid rent function for residential sector Include access to downtown employment, shopping, workplace location, health services and government services such as educational institutes, police stations, parks, recreation are important. Crime, noise, pollution, taxes, congestion are negative factors. Family type plays and important role, such as isolated areas without parks not in demand for households with kids. It also depends on who stays nearby, the kind of neighborhoods, etc. - These rents make the firms indifferent between all location with this rent because it will achieve the same level of profit everywhere (in reality not true as there are more factors) 91 7 U S I N G T H E MONOCENTRICC I T Y M O D E L The monocentric city model is based on the bid rent model and relies on simple assumptions to produce important insights into the workings of urban land markets. Bid rents for both firms and households are predicted to decline with distance from the city center. o Fundamental insight of bid rents = people will pay a premium to be near any amenity you care to define (apart from city center; a nice park or a coastline for example) The rate of decline is highest near the city center, and tails off in locations farther from the city center. Extreme version of the monocentric model: ● ● ● ● All employment is at the city center ○ The goods are produced and sold in the CBD ○ Urban area workers work in either the export industry or in the retail stores ○ The firms’ bid rents decline with distance from the port Each household has one worker who commutes to the center each day: to work and to purchase the all-purchase consumption good ○ Each household makes the same number of trips to the CBD each year ○ Household bid rent functions decline with distance from the CBD Household bid-rent function is flatter than the firms’ function ○ Firms outbid households for land in the CBD ○ The city ends where farmers outbid households for land Circular urban area ○ Transportation costs are equal in all directions ○ A fixed proportion of space is available for residential use at each distance 92 This extreme version allows interesting predictions regarding the spatial layout of an urban area where several important variables change: - A reduction in the cost of commuting within the urban area A decline in the agricultural land rent at the fringe of the urban area An increase in population (and labor supply) in the urban area An increase in the income of every household in the urban area Each of these changes leads to predictions of changes in land values, house prices, building heights, and population density. Utility, in economics, refers to the usefulness or enjoyment a consumer can get from a service or good Households ● Wage income (W) = amount spent on housing + all-purpose consumption + commuting ○ Higher commuting costs indirectly lower utility by leaving less to spend on housing and the consumption good increase in income ● Figure 7.1 illustrates the choice problem for the household increase in income ○ The household has a set of indifference curves for the two goods, housing and the all-purpose consumption good. An increase in income will increase the consumption of both goods. ● Budget constraint: W – tx = G + PHH ○ W is the wage income ○ t is the constant cost of an additional mile from the CBD ○ x is the distance from the edge of downtown ○ G is the amount of the all-purpose good ○ H is the consumption of housing (includes any relevant housing characteristics, m2 kan uitgebreid worden door utilities ruimte voor garage, airco enzo ) ○ PH is the price of one unit of housing (price of m2 hangt af van de plek) ● the household maximizes utility on indifference curve IC1 by choosing point E. 93 ● The household’s choice problem can be reduced to a simple indifference curve diagram, with G on the horizontal axis and H on the vertical axis. The slope of the budget constraint is found to be -PH by writing: G = (W – tx) – RL ○ At a given distance x1, the household has W – tx1 to spend on the two consumer goods. Given this income an the prices of the two goods (1 and PH), the household maximizes utility on indifference curve IC1 by choosing point E (fig. 7.1). ● Figure 7.2 shows the budget constraint of a distance x1 and x2 ○ At distance x2, the household has W – tx2 to spend on the two consumer goods, an amount that is less than W – tx1. ○ For the household to reach the same indifference curve as before (IC1), the price of a unit of housing at distance x2 (PH(x2)) must be less than distance x1 (PH(x1)). Prices decline with distance from the CBD. ■ This means that the budget constraint at distance x2 is flatter than the one at x1. The household now chooses point E’’ rather than E’. Komt er op neer het verschil van x1 en x2 is bijv 1000 daardoor minder gled voor two consumer goods op x2 voor een same idfference curve en equilibrium de prijs of a unit of housing op x2 moet minder zijn dan x1 (verschil 1000) prices decline with distance from the CBD 94 ● Figure 7.3 shows the bid-rent function for housing (as translated from the information in figure 7.2). ○ The price for a unit of housing is high near the city center and low farther away. ● Figure 7.4 shows the shape of the function for housing consumption. ○ The consumption of housing is high where the price is low, and housing consumption is low where the price is high. ● Figure 7.5 shows the shape of the function for the consumption of the all-purpose good (G). ○ When the price of a unit of housing is high near the CBD, consumers substitute away from housing and toward other goods. ○ When the price of a unit of housing is low, consumers substitute towards housing and away from the all-purpose consumption. 95 Housing Production ● The producer’s profit = PHH(K, L) – PKK – RL ○ Housing is produced by combining capital (K) and land (L). ■ H(K, L) is the production function for housing ■ PH is the rent price to households, as given by the bid-rent ● PHH(K, L) is the revenue ○ PKK is the rental price of capital (producing cost) ○ RL is the land rent (producing cost) ● Households are willing to bid more for sites close to the city center because these sites lead to low commuting costs. ● The bid-rent function is found by setting profit to zero (in equilibrium) and solving for land rent per acre: R = (PHH – PKK)/L ● Land rent is high where house prices are high, which is close to the CBD. ○ Therefore, the bid-rent function for land looks much like the bid-rent function for housing, see figure 7.6: ● Higher bid-rent functions are associated with lower levels of profit. ○ Since land rents are high near the CBD, producers substitute away from land and toward capital in these locations: the capital/land ratio is higher near the city center. The Residential Sector ● Although the units obviously differ, the qualitative results are the same for each of the following variable: ○ the price of a unit of housing (PH) ○ land rent per acre (R) ○ the ratio of capital to land (K/L) ○ the quantity of the consumption good (G) ○ population density ○ building heights ■ All of these variables change in the same direction 96 ● Figure 7.7 shows a situation whereby there is a change in the urban area that causes the house price function to rotate counter clockwise. (Muth-Mills model.) ○ For some reason, house prices fall near the city center and increase at sites far from the CBD. ■ x* is the boundary between locations where house prices increase and where they decrease” ● The increase in bid-rent for housing to the right of x* leads housing producers to bid more for these locations ● Higher house prices lead households to substitute away from housing and toward other goods in consumption ● Higher land rents lead producers to substitute away from land and toward capital in production, which leads to a higher capital/land ratio ● Higher capital/land ratios mean taller buildings and higher population density 97 ● Figure 7.8 shows that the function for housing consumption is the mirror image of the other functions: when the bid-rent function for housing rotates counter-clockwise, the function showing the consumption for housing rotates clockwise. The Central Business District ● Assuming that each employee in both the retail and export industries requires a fixed amount of land (le), the total area of the CBD is leH, where H is the total number of workers and households. The radius of the CBD is therefore written as: - The requirement for land for the central business district establishes the distance at which residential land begins. - Given that xc has been determined, the bid-rent curve that is consistent with the number of households H that live in the urban area and have a member who works in the CBD can be selected. ● Figure 7.9 shows three functions. ○ The boundary between the commercial and the residential areas is at distance x1 ■ It is assumed that the commercial sector (bid-rent function RcRc) is willing to pay more for land at the city center than the residential sector, and that the commercial sector declines rapidly with distance from the center. 98 ■ ○ The bid-rent function for land in the residential sector (RR) is lower than the commercial function up to distance x1. After x1., housing producers will bid more for land than the commercial firms will. The urban area ends at the point where farmers will pay more for the land than housing producers will (at distance x2). ■ It is assumed that the agricultural land rent, Ra, is a constant that does not vary with distance from the city center. Using the model to analyze changes in important variables 7.10 ➢ Decrease in commuting costs (decline in t) only effects the residential sector ○ It is assumed that the decline in commuting costs only affects the residential sector. ○ Decline of commuting costs rise of utility meer geld over voor leueke dinge, dus liever naar buiten de city ○ NEW BID rent function will have lower slope ○ Leads to a more decentralized city with higher housing prices and land rents in more distant locations and lower housing prices and rents near the city center. minder kosten voor reizen meer geld over voor rent mensen vinden het minder erg om te reizen, dus hoeven ook niet perse direct dicht bij CBD (minder demand) meer demand buiten stad, dichter natuur dus beter voor utlility hoger rijzen 99 The open city But the open city model is based on an assumption that population changes to keep utility constant. The increase in utility causes people to move into the urban area from other places. With a given number of firms offering employment, the increased supply of labor leads to a lower wage. Lower wages cause the bid-rent function to shift down a bit. We end up with the same outcome as shown in Figure 7.11. Rest is closed: ➢ Increase in income (W goes up) ○ Is quite complex, due to the fact that it shows two opposing effects: ■ Since the demand for housing increases with income, higher incomes push households towards distant locations where the price of a unit of housing it low. However, higher-income households will want to reduce their commuting time if time is a normal good. If the income elasticity of demand for housing is greater than the income elasticity of commuting time, an increase in income has the same effect as a decrease in commuting costs. The city becomes more decentralized, with higher housing prices, land rents, population densities, capital/land ratios and building heights at distant sites and lower values of these variables at locations close to the city center. ■ If the income elasticity condition is reversed, the effects are exactly opposite. If the income elasticity of demand for housing is less than the income elasticity of commuting time, an increase in income causes the city to become more centralized, with lower housing prices, land rents, population densities, capital/land ratios and building heights at distant sites and higher values of these variables at locations close to the city center. for a closed city, the labour market needs to be introduced. if for instance, the salary of the people living in the residential sector went up, they have more to spend. The increased competition from the residential sector for sites closer to the city center takes land away from the commercial sector. 100 ➢ Increase in Agricultural Land Rent (Ra goes up) ○ Household: Utility falls bid rent up neeed to pay more for house ○ Commercial: les profit higher bid rent ○ Housin producers build more in city, higher rent ○ This leads to a more densely populated urban area (compact), with higher housing prices, land rents, population densities, capital/land ratios, and building heights at all locations ➢ Increase in population ○ More demand for housing in all locations ○ It is assumed that the population increase has no effect on commuting costs or on the going wage rate. If these assumptions are correct, then the bid-rent function for housing shifts up and parallel to the original function. rent higher, because more demand for a house ○ This leads to a more densely populated urban area, with higher housing prices, land rents, population densities, capital/land ratios, and building heights at all locations 101 ➢ Pollution and bid rents ○ If negative externalities such as pollution, noise, and crime are concentrated near the city center, than bid-rents may increase with distance from the center until the point the problems are no longer severe. ○ Negative externalities are likely to lead to decentralized cities that cover more ground than is optimal. 102 ➢ Zoning and bid-rent functions ○ Many zoning policies can be analyzed using the tools provided by the monocentric city model. ○ Zoning often leads to discontinuities between land rents at the border between districts. ■ If zoning restricts the area that is available for low-income housing, lowincome housing prices and land rents are higher than they would have been without this form of exclusionary zoning. plek voor amre mensen, maar met hoge prijzen, goeie plek At the same time, house prices and land rents fall in high-income areas. ■ Land-owners at the boundary between the zones have an incentive to try to get their parcels included in the low-income district, where land rents are high. This discontinuity in the land-rent function does not occur in a market where land use is determined by simply allowing the people who bid the most for land to use it as they please (figure 7.16). ■ An urban growth boundary is a restrictive zoning practice that confines urban development to areas closer to the city center than would be the case if development were left to the private market. In places where these policies are explicit, developers are not allowed to build homes in areas beyond distance x2 (figure 7.17). The boundary at distance x2 leads to an upward shift in the bid-rent function as the same number of households is forced to compete for a smaller land area. Zoning boundary less space available in the area, because of zoning prices go up 103 ■ ○ Figure 7.18 shows a more complicated case where a district is in the middle of the urban are rather than at one of the two ends. In this case it is supposed that a district with unusually high-quality schools is created between distances D1 and D2. Bid rents rise within this district as people move to take advantage of the high-quality schools. Bid rents drop in other areas as people are drawn to the new district. Sharp differences in land rents at district boundaries tend to make zoning unstable as landowners lobby the local zoning board for changes in zoning designations. Week 8 PowerPoint week 8: location and urban structures, And overview and some critical refection. The ‘city’ The city is an idea (stated to changes after indu revolution) ‘problem’ = that geography, planning and even history is based on quantitative economics ideas and models how we view, represent and act the way we uses models are simplifications bepaald veel hoe we uitkomsten zien SUM:The city became an object wherein increasingly “nature’ became an opposite of ‘society’ (human) 104 City as the split between nature and society Hoe komt dat: Because of a lot was based on the industrial revolution (1944), and change of labour and patterns: - - changes in nature and society. it became embedded with it surroundings manufacturing become more important i. Location moved to cities because they needed labour (not out their) ii. It creates a new working class (working class, socialism) brings new: 1. Political ideas 2. Cultural 3. Collaborative infrastructures cities more political, social, and economic weight more verschil tussen country and city Before industrial revolution city seen as political body in society Model of Chicago School of sociology Main difference with Von Thunen, no nature in the model. Perception of the model: - City can exist on its own (zonder nature) - idea was wrong you need things out nature (gas, water, CO2) City became more a self-contained social system of people and social relation concentric circles After 1970 it became clear that growth of city has impact on nature Started the Industrial ecology = the study the relation between nature and society also looks at materials flows how it goes in the city and out of and what the impact is. human not mentioned at al 105 Part 5 Global urbanization explain why models not always help us to explain urbanization often not western perspective. Urbanization in the golf region Dubai Spectacular urbanization = - Fast-paced snel groeiend Based on phantasies, consumption and infrastructure at the heart pf the urban project All building are not stand alone, they are their for a part of a broader project: creating a brand: try to make Dubia incorporation Not really about agglomeration but about process that are stated, because a lot of money Tried to make networks Why Spectacular urbanization in Dubai? First had a lot of olie maar was bijna op, en wilde dus toch blijven groeien daarom You see a lot that of urban growth has a trigger: revolutions: Indu revolution: new innovations that changes a lot Irian revolution (reason for Dubai) = rich people needed to flee and went do Dubai and brough all their network, finance and knowledge with them. Is it a sustainable urbanization? It is extremely sensitive to global shocks e.g. financial crisis iedereen stond schulde en vluchten 106 Chapter 22 MODELS OF METROPOLITAN ECONOMIC GROWTH Introduction Economic growth is a topic central to the entire discipline of economics. The field of economic growth is thinking about the growth on national level, while economic development concentrates on the problems of economic growth in less-developed countries such as India, China and Mexico. More recently, urban planners and public officials in the U.S. have decided to use the term economic development to refer to the study of the problems of growth of state and local economies in the U.S. You should be aware that different people will use the term ‘‘economic development’’ in these two senses. Solow’s basic framework describes that there exists a production function for an entire national economy that relates real gross domestic product (GDP) to capital and labour inputs and an autonomous growth factor that might be called ‘‘technological change.’ The purpose of this chapter of this book is to help you to understand the various models of economic growth that can be used to examine an urban area, to learn what is known empirically about the determinants of local economic growth, and to gain a perspective on local ‘‘economic development’’ policy. Google: technological change.’ = A technical change is a term used in economics to describe a change in the amount of output produced from the same amount of inputs. daarom goedkoper om output te maken en daarom meer geld verdienen dus economical growth Economic base analysis based on export and import (short run in export) The first economic model that was used to study the local economy was invented in the late 1930s, and is called economic base analysis. Given when it was invented, it is not surprising that economic base analysis is similar to Keynesian multiplier models. The GDP of the nation is written using the final output approach as: Y=C+I Where Y is the GDP of a nation, C is consumption, and I is investment spending. The economic base model for urban areas focuses attention on trade with the rest of the economy. One good way to focus on exports and imports is to add them to the basic Keynesian model. They ad exports and imports to the model where exports is X and the import function is M. So, the formula is: Y=C+I+X–M Striking is that in this model no government is added. With government (G) in the model the definition of total local expenditure and income is: Y=C+I+G+X–M The local economy is partitioned into two parts, the sector that produces goods and services for export outside the urban area and the sector that produces for local use. The fundamental equation for total employment T is: T=B+L Where B is basic (export) employment and L is employment for the production of locally consumed goods and services. They continuously talk about a kind of multiplier but I don’t facking know what that is. The economic base model is used widely, but they do not recommend the use of the simple model. There are two further problems with this type of model of the economic growth of an urban area: 107 1. Keynesian multiplier models (and economic base models) presume that there is unemployment. Total output is surely constrained by the supply of inputs, but this kind of model has nothing to say about the supply side. 2. The model emphasizes exports (and other exogenous spending) as the engine of growth. That is fine as far as it goes, but it does not go very far. In truth, the economic base model is an adaptation of the Keynesian multiplier model, which was expressly intended as a tool for short-run analysis. Economic growth is ultimately a long-run business. These are harsh criticisms, but we do not mean to suggest that we should ignore that fact that exports and imports are very important aspects of an urban economy. An alternative model with exports and imports is proposed in Section G. One sector Neoclassical growth theory Solow’s model of economic growth is called neoclassical because it is based on a production function for the economy in which it is possible to substitute capital for labor continuously, holding output constant. mogelijk om kapitaal continu te vervangen door arbeid, waarbij de output constant wordt gehouden. Neoclassical economics is a school of economics with different approaches that focus on determining prices, goods and services supplied and the distribution of income in markets through supply and demand. Then they go explaining the mechanics of neoclassical growth theory and its only formulas. I don’t understand anything of this theory but most important is italic text that describes neoclassical growth. It is basically a model with different approaches. Explanations of U.S. economic growth In this chapter they examine the economic growth at national level. To understand the economic growth at the urban or regional level must have an understanding of it at national level. Out of an empirical research of Robert Solow, who won the Nobel Prize, is the study of sources of U.S. economic growth from 1909 to 1949. Out of this came that technical change is the main source of growth. Solow used the phrase ‘‘technical change’’ to refer to the autonomous growth factor. Further in this chapter they give a lot of examples of empirical studies on national level in the U.S. over time. This part exist of a lot of numbers and different researchers with different point of views. There are maybe a few conclusions from this: Understanding economic growth is a complicated matter. No study as comprehensive as that of Jorgenson, Gollop, and Fraumeni (1987) has been done at the urban or regional level. Indeed, given the data requirements, there is little prospect that such a study can be done for urban areas anytime soon. Another message from these studies is pretty clear. Economic growth policy at the national level can focus first on investment in capital goods, although policy might also focus on labor quality and technical change. 108 Neoclassical models of metropolitan growth The basic neoclassical model has been used to study economic growth at the metropolitan level. This section outlines the methods for such a study, and reviews some of the empirical findings. Growth models for urban areas concentrate attention on the growth rates of capital and labor, which depend critically on migration from or to other parts of the nation. It is conventional to assume that capital and labor move from urban area to urban area in response to factor price differentials. Thus the rate of growth of labor in an urban area is the natural increase in the labor force plus a component that is a function of the difference between the wage in the urban area in question and average for all other urban areas. rate of growth of labor = natuurlijke toenamen van beroepsbevolking + een functie van het verschil tussen het loon in het betreffende stedelijk gebied en het gemiddelde voor alle andere stedelijke gebieden Similarly, the rate of growth of capital in an urban area is the ‘‘natural’’ increase in capital derived from saving and investment within the urban area plus interurban capital movement that is a function of the difference between the rental price of capital in that urban area and the average rental price for all other urban areas.--> the rate of growth of capital= ''natuurlijke'' kapitaaltoename die wordt verkregen door sparen en investeren binnen het stedelijk gebied + interstedelijk kapitaalverkeer dat een functie is van het verschil tussen de huurprijs van kapitaal in dat gebied. stedelijk gebied en de gemiddelde huurprijs voor alle andere stedelijke gebieden It is also conventional to assume that labor and capital do not respond instantly to such price differentials. A ‘‘partial adjustment’’ mechanism is assumed; labor and capital respond to price differentials, but not enough so that the price differential is eliminated in one year. The movement of labor and capital in response to factor price differentials should, in the long run, eliminate those factor price differentials. - - Urban areas (or states or regions) with high ratios of labor to capital presumably have low wages and high rental prices of capital daarom weg uit stad. Labor migrates away from and capital migrates to such areas. veel werk en weining huizen Urban areas with high ratios of capital to labor have low rental prices of capital and high wages. If capital responds more rapidly than labor to factor price differentials, then the lower wage regions will grow more rapidly than higher wage regions. veel huizen en weinig werk In the end wages in all urban areas (or states or regions) converge to the national average—except for wage differences related to amenities associated with living in particular places. I think that the conclusion is that the neoclassical model can also be applied on metropolitan level, but they do not end with a specific conclusion. Further it is only empirical studies. 109 Modern growth theory and emphasizes the importance of technical change as neither a conventional good nor a public good The ‘‘new’’ theory of economic growth is now 20 years old. This theory places innovation at the center of economic growth and development, and provides an explanation for innovation. The older theory of economic growth (based on the work of Robert Solow in the 1950s) recognized the importance of ‘‘technological change’’ as a primary force in economic growth (in addition to capital accumulation), but did not explain how technological change occurs. The purpose of this section is to outline the new theory of economic growth and development as it applies to major urban areas, and to assess the empirical evidence that has been done to test the theory. Metropolitan areas that are successful in economic development require to have: - The stock of knowledge, and the creation of additional knowledge, is the primary basis for improvements in the standard of living. Knowledge can be turned into economically relevant innovations. Research universities that create and transmit knowledge R&D activities in both universities and private firms (with highly educated and skilled workers) to create innovations Mechanisms for adoption of innovations Entrepreneurs (with backers). Neoclassical export base models of urban growth This section will examine a two-sector neoclassical model of urban growth in which: The export good faces a perfectly elastic demand curve, and capital can be imported freely at the national price. Under these circumstances the growth of the local economy is determined by the growth rate of the labor force and by technical change. An increase in the demand for exports means that the price of exports rises. An increase in the price of the export good will increase the wage in the local economy. - one sector: produces a product for export capital-intensive sector the other sector produces a good only for local consumption labor-intensive sector. This model shall be called a ‘‘neoclassical export base model.’’ This type of model is more complex than the one-sector models discussed previously, but the greater complexity also yields a richer set of possible outcomes that can be explained by the model. If the economy of the state is disaggregated to two sectors, then the growth rate in the real wage does not depend solely upon the growth in the autonomous growth factor and the capital-labor ratio (as in the one-sector model). An increase in the ratio of capital to labor (veel huizen, lage rent en hoge lonen) in a state may not lead to a rise in the ratio of capital to labor in each of the two sectors; - a reallocation of output may occur in favor of the commodity produced (geproduceerde grondstoffen) by the relatively capital-intensive sector. This reallocation of output releases a relatively large amount of labor from the laborintensive sector veel arbeid vrij in labor sector . This labor is employed in the capital-intensive sector, but these workers who shift sectors now require a greater amount of capital per worker than before. meer ruimte voor huizen 110 - - For the wage to rise, capital accumulation must raise the ratio of capital to labor in both output sectors. This requires that capital accumulation be accompanied by an increase in the relative price of output in the sector that is relatively labor intensive. om dit te behalen moet prijs van output stijfen in secotr waar veel arbeit is If, during capital accumulation, the relative output prices remain unchanged, the factor proportions do not change in both sectors. niks gebreurt met output prijzen, gebeurt niks in beide scotrne Synthesis of mainstream economics: preliminary version A conclusion of the synthesis of the two mainstream economic models is formulated: - - as follows by Borts and Stein (1964. An increase in labor supply increases employment and decreases the wage) The decrease in the wage depends upon the elasticity of demand for labor, of course. If Borts and Stein (1964) are correct in asserting that the demand for labor in a local economy is highly elastic, then employment will increase and the wage will not decline very much. Assuming that the increase in employment increases aggregate demand in the local economy, there will be an increase in the demand for local goods (and imports, as well). This further increases the demand for labor to produce local goods. These increases in employment can then stimulate further increases in labor supply through migration, and the process can start again. Input-output analysis Now there comes a enormous load of text, tables and number about the input-output model and why this works better for urban and state areas. This model is more specific and takes in to account all the inputs and outputs plus the added value, but is focused on the regional demand side. The earlier models are mostly not complete and to gather good information a complex mix of models is needed. Besides that, there are no real empirical evidences of for this. But finally the input-output model shortly summarized according to the text. The input-output analysis is a short-run tool. - It is useful for making projections and performing impact analyses that are of short duration. It is not really a tool for the analysis of long-run growth because the model really has no supply side. The model presumes that the needed supplies of labor, capital, land, and intermediate products will be forthcoming when there is an exogenous increase in final demand. It may be perfectly reasonable to assume all of this in the short run, but the long run is a different story, as the neoclassical growth model tells us. Economic history and urban growth and development Now we make a big 180 degrees U-turn a go further into the field of economic history. Economic history is an important tool for understanding urban economies. The best modern economic historians combine analyses of the institutions and historical context of the urban area and its region, economic analysis, and political economy to provide a convincing narrative of what happened and why. This is explained by two examples of economic history as applied to American city or region. 111 The first example is from Cronon (1991) about Chicago. He describes the development of Chicago by three factors. The first was an increase in lumber wood because of new train rails and a canal. This established the economic position of Chicago. Second, the packing of meat was ideal in Chicago because of the advantageous location and infrastructure. And third because of the excellent transportation connections Chicago became a natural site for manufacturers. However, perhaps the more important point is that his methods of historical and economic scholarship can be applied to many other urban areas around the nation (and the world, for that matter). The second example is from wright (1986) and is about the southern region of the U.S. The relevant part of Wright’s analysis is his account of how and why the South was transformed from an economic backwater in 1930 to an integral part of the economy of the nation in 1980. Below are the several factors that contributed to southern economic development: 1. Market incentives brought capital and skilled and educated labor to the South, particularly to its urban areas. 2. Federal spending (defense spending in particular) that the South once shunned was now sought. 3. Favorable climate and other amenities worked in the South’s favor (especially after the invention of air conditioning). 4. The South invented state and local economic development policies such as industrial revenue bonds, long-term tax exemptions, active local economic development corporations, etc. 5. The South had a relatively clean slate in terms of absence of labor unions, entrenched bureaucracies, restrictive legislation—a good ‘‘business climate.’’ 6. Lastly, a shift was made from relatively high to relatively low taxes on business. There really is little evidence at this time to suggest that local governments can successfully pursue such a course. Indeed, the national debate over industrial policy seems to have subsided with the general conclusion that the public sector is probably not very effective at targeting industries as strategic industries. This guarded conclusion regarding local public policy does not, however, suggest that researchers should abandon work that uncovers the historic roots of a local economy. Also, methods for improving the studies that are done of the local economy should be pursued. The product cycle and urban growth Historical studies have established the existence of industrial life cycles. New industries experience a period of rapid growth after an initial phase of incubation, and, as a consequence of competition from still newer industries, eventually face a retardation of growth or absolute decline. The early stages of the industrial life cycle exhibit rapid technical change requiring flexible, labor-intensive production processes. The later stages involve a stabilizing of technology, saturation of product markets, and increasing concern with cutting unit production costs through the attainment of scale economies. There may be a connection between industrial life cycles and urban growth and decline. The growth of an urban area or a region is stimulated by the presence of industries in the rapid growth phase of their life cycles, and retarded by the presence of industries in the slow growth or decline phase. Generally it is true that new industries are formed by new businesses. Only rarely do existing large firms in already established industries become the driving force for the creation of entirely new 112 industries. However, once employment opportunities begin to decline in mature industries in an urban area, then the prospects for the formation of new businesses begin to change. Another modified model of the product life cycle is the profit life cycle. The profit life cycle has five characteristics: 1. zero profit, corresponding to the initial birth and design stage of the industry; 2. super profit, corresponding to the era of excess profit from an innovative edge; 3. normal profit, corresponding to the stage of open entry and movement toward market saturation; 4. normal plus or normal minus profit, corresponding to the post-saturation stage in which the industry becomes an oligopoly or excessively competitive; and 5. negative profit, corresponding to the obsolescence stage The profit cycle model is a useful method for organizing information about industries, and it can be quite useful to know the stage of the cycle for a particular industry at a particular time. However, there are two fundamental difficulties with the profit cycle model. First of all, it is not really a theory. It is a tautological method for organizing information about industries. New industries are born somewhere, and then disperse once the basic innovations have been made. Secondly, the profit cycle model has no policy implications at the urban or regional level. What is correlated with metropolitan growth As this chapter demonstrates, economists are adept at devising theories about growth. But as a more practical matter, what is known empirically about metropolitan growth? Numerous econometric studies have been conducted to determine whether these factors have been related to metropolitan economic growth. This is what they concluded from this empirical evidence. Do these studies provide a guide for policy? The most consistent finding is that educational attainment— college education in particular—is strongly positively related to growth, measured as population growth, employment growth, and increases in income. Other policy variables either do not appear in the studies or do not produce consistent results. However, the fact that a policy variable has not been tested or does not produce consistent results in these large-scale studies does not mean that it is not potentially important for some metropolitan areas. The studies tell us that education is important, but they fail to tell us everything else that might be important. Chapter 24 is devoted to questions of policies for the growth and development of metropolitan areas. Summary This chapter has introduced four basic models of economic growth that can be applied to urban areas. 1. The economic base model 2. The one-sector neoclassical growth model 3. The two-sector neoclassical growth model 4. The synthesis of the economic base model and two-sector neoclassical growth model In addition, this chapter has surveyed several other approaches to urban economic growth. The mechanics of input-output analysis have been presented to clarify our thinking about the structure of 113 a local economy, and to emphasize the intermediate inputs as well as value added. The eclectic works of urban and regional economic history have been discussed briefly to point out the importance of historical factors in the development of an area. The potential importance of the product cycle for urban areas was explored as well. As an empirical matter, metropolitan population, employment, and income growth in the U.S. is positively associated with the human capital embodied in the local population. Chapter 23 AGGLOMER ATION ECONOMIES, TECHNICAL CHANGE, AND URBAN GROWTH Introduction Chinitz (1961), asked: "How does the growth of one industry in an area affect the area's suitability as a location for other industries?" How might industrial diversity foster growth? Chinitz supplied hypotheses that remain fresh today. He suggested that competitive industries, as opposed to oligopolistic industries, have more entrepreneurs—people who are willing and able to take the risk of starting a new business. Suggested is that an urban economy with competitive and diversified industry will grow more rapidly than one with oligopolistic and undiversified industry. These ideas, and others, have been tested empirically and largely confirmed in recent research. The neoclassical production function revisited Starting with the basic concept of the production function, but following the two-sector neoclassical model in Chapter 22, we shall assume that a particular production function pertains to an industry in an urban area. Most of the empirical studies of manufacturing industries in urban areas indicate that economies of scale exist at the industry level for some industries. Such economies of scale are external to the individual firm in the urban area, but are internal to the industry. This is precisely what is meant by localization economies. There is a critical distinction between agglomeration economies and technical progress. Technical progress means that a firm that adopts the new technology can produce more output with the same amounts of capital and labor inputs. Technical progress, when implemented, is internal to the individual firm. Agglomeration economies are, by definition, external to the individual firm in an urban area. One distinction is between agglomeration economies that are static and those that are dynamic. Static agglomeration economies mean that the level of some agglomerative factor is associated with some level of industry output. In contrast, a dynamic agglomeration economy means that the level of the agglomerative factor is associated with an increase in industry output that continues through time. The other essential distinction is, between static and dynamic localization and urbanization economies. Dynamic agglomeration economies mean that the level of the agglomerative factor creates continuous reductions in costs for the industry. They also lead to continuous increases in the output of the industry, but it does not indicate whether a higher level of an agglomeration factor is associated with increases in output that are larger in absolute or percentage terms. 114 Dynamic agglomeration economies This section reviews the arguments that are made in favor of putting knowledge at the center of dynamic agglomeration economies, and the following section examines the empirical studies that have been done to test hypotheses. Something of a revolution has been going on in economic growth theory in the past 10 years, External economies arising from knowledge spillovers are thought to be critical to the productivity level or the rate of economic growth of a nation. The general idea of knowledge spillovers is too vague to generate hypotheses that can be tested. There are three theories about knowledge spillovers. 1. 2. 3. The first theory argues that the knowledge spillovers occur largely within a local industry. This is one form of localization economies. exchange of ambiguous information, with its frequent generation of new ideas, can take place in any field of endeavor that relies on ideas and applies also to localization economies. Jane Jacobs (1969) stressed that knowledge spillovers take place across different industries and lines of work. She argued that diversity of industry in an urban area is more stimulating for the production of new ideas than is the greater size of an individual industry. Industrial organization economists study the economics of technical change without giving much consideration to the spatial dimension. It is generally agreed that both the development and the adoption of new technology depends upon: • • • appropriability (ability to capture the benefits), market structure, and technological opportunity. In fact, modern economists generally agree that R&D spending depends primarily upon appropriability and technological opportunity, and not on market concentration. The adoption of new technologies, however, is probably stimulated by competitive markets. Empirical studies of agglomeration economies There are two types of empirical studies that seek to test for the presence of agglomeration economies in urban areas. Studies of the first type estimate a version of the growth equation for output. These studies are confined to the aggregate manufacturing sector in urban areas because only the industries in this sector have the required data for output (value added). The second type of study is of specific industries in urban areas. Most studies are based on industry-level data, but recent studies increasingly make use of data on individual establishments. Findings of section D, E, F and I Some findings are emerging that confirm the existence of agglomeration economies that have enhanced growth in urban areas. The size of the local industry (localization economies) seems to matter, but dynamic localization economies may not be as strong as some have thought, except in some fairly unusual cases such as the early auto industry in Detroit, the semiconductor industry in Silicon Valley, and other high-tech industries. Urbanization economies have an influence in some industries, but urbanization economies also may not be as pervasive as some have suggested. A more competitive urban industry, as measured by smaller size of the firms, grows more rapidly. This 115 is a very important recent finding that adds greatly to our knowledge. Also, some evidence points toward diversity in the local economy as a contributor to the growth of an industry. In brief, what we think we know at the moment is that an industry in an urban area will grow more rapidly if it produces a product that is in demand, is competitive, is already of some size in the urban area (and was of some size in the past), is located in a larger urban area (but not too large), and is surrounded by a diverse collection of industries (maybe). All of this is not complete conjecture, but the result of solid, time-consuming empirical research. Hard work—there is no substitute for it. In addition researchers have begun to establish connections between university research, patents, and growth of firms in urban areas. Finally, we considered briefly the research on the relationship between urban growth and development and changing spatial patterns in urban areas. The shift to the "service economy" has major implications for urban areas. Research on the topic shows that the suburbs are growing on a broad front and downtowns in major urban areas are doing reasonably well. However, central city neighborhoods outside the downtown area struggle unless they are located in an urban area that is growing rapidly or somehow become part of the downtown growth (e.g., condos for those downtown lawyers). The connections between urban growth and development and urban location patterns are good topics for further research. The business of local economic development policy is considered in the next chapter 116 Chapter 23 – Agglomeration economies, technical change and urban growth A. Introduction Agglomeration economies – creating cost advantages for firms in an industry that are concentrated in a particular urban area (localization economies), or that are located in larger urban areas (urbanization economies). The role of technical change – a factor of considerable importance in determining the national growth rate. - An urban area full of competitive industries is likely to create new businesses and more growth. The presence of competitive industries means that finan- cial institutions that supply loans to businesses must be prepared to deal with smaller borrowers and, therefore, be more receptive to the entrepreneur. A more diversified local economy will have a more diversified demand for labor, and will therefore call forth a greater supply of labor, especially among women. An urban economy with competitive and diversified industry will grow more rapidly than one with oligopolistic and undiversified industry. B. The neoclassical production function revisited There is a critical distinction between agglomeration economies and technical progress. Technical progress = that a firm that adopts the new technology can produce more output with the same amounts of capital and labor inputs. Technical progress, when implemented, is internal to the individual firm. Agglomeration economies are, by definition, external to the individual firm in an urban area. However, it may be that some agglomeration economies act by increasing the rate of technical change for firms in a particular urban area. One distinction is between agglomeration economies that are static and those that are dynamic. - - - - Static agglomeration economies = that the level of some agglomerative factor is associated with some level of industry output. invloed van agglomeration aan de hand van niveau van ouput in de industy Dynamic agglomeration economy = the level of the agglomerative factor is associated with an increase in industry output that continues through time. invloed van agglomeration aan de hand van verhogen van ouput van de industy voor een lange tijd i. the level of the agglomerative factor creates continuous reductions in costs for the industry. ii. They also lead to continuous increases in the output of the industry, but it does not indicate whether a higher level of an agglomeration factor is associated with increases in output that are larger in absolute or percentage terms. 117 C. Dynamic agglomeration economies External economies arising from knowledge spillovers The knowledge spillover idea is that a greater concentration of firms in a particular industry in an urban area will cause a greater rate of new product development, improvements in existing products, and improvements in the methods for producing those products. More details about how knowledge spillovers work is needed, and it turns out that there are three somewhat different theories that all fall into the category of knowledge spillovers. 1. - The first theory argues that the knowledge spillovers occur largely within a local industry. This is one form of localization economies. 2. exchange of ambiguous information, with its frequent generation of new ideas, can take place in any field of endeavor that relies on ideas and applies also to localization economies. 3. Jane Jacobs (1969) stressed that knowledge spillovers take place across different industries and lines of work. She argued that diversity of industry in an urban area is more stimulating for the production of new ideas than is the greater size of an individual industry. A dynamic theory must posit a mechanism for continued reductions in costs for firms in an urban area. Both the development and the adoption of new technology depends upon: Appropriability (ability to capture benefits) Market structure Technological opportunity The bottom line on the market structure argument is that the nature of the market structure for the industry in an urban area may be a separate dynamic localization economy. D. Empirical studies of agglomeration economies There are two types of empirical studies that seek to test for the presence of agglomeration economies in urban areas. Studies of the first type estimate a version of the growth equation for output. These studies are confined to the aggregate manufacturing sector in urban areas because only the industries in this sector have the required data for output (value added). These studies also require data on growth in capital and labor. The second type of study is of specific industries in urban areas. Most studies are based on industry level data, but recent studies increasingly make use of data on individual establishments. Studies that use the production function equation to test hypotheses regarding agglomeration economies at the metropolitan level: 118 - - Studies are – testing for static urbanization economies and localization economies for the manufacturing sector as a whole, and that they are not testing a market structure hypothesis They are testing whether the age of the urban area and the spatial pattern of manufacturing have impacts on productivity The result for economies of scale indicates the presence of economies external to the firm but internal to the manufacturing sector as a whole. The finding that productivity growth is related to output growth is a finding of a static localization economy. The dimensions of agglomeration economies should consist of four types: Industry effects (localization, economies, urbanization economies and possibilities in between) Geographic effects in which distance attenuates the agglomeration effect Temporal (i.e. dynamic agglomeration economies) Organizational; the degree of competitiveness of the local industry/economy The possible microeconomic sources of agglomeration economies are: Labor market pooling effects Input sharing (economies of scale in input production) Knowledge spillovers Natural advantages (natural resources, etc.) Home market effects (local demand stimulated the industry) Consumption opportunities (primarily for productive and highly paid workers) Rent seeking, which means that firms are attracted to cities where the politically powerful reside Studies found that: Localization economies are rarely strong enough to increase the growth rate of employment in a local industry, but that some larger absolute increases in employment are often generated Employment demand depends upon the wage rate, the rental price of capital, demand for output, the level of technology, and agglomeration economies Holding the other factors constant, an increase in the wage rate reduces employment because of both the substitution effect (toward the capital input) and the output effect (resulting from a higher marginal cost and price of output). An increase in the price of capital may increase or decrease employment because the substitution effect operates to increase employment, but the output effect works to reduce employment. An increase in demand increases output and employment. Technical change and agglomeration economies can increase or decrease employment Changes in the local wage rate and in local demand are important factors in manufacturing employment change Results of studies: 119 - E. Dynamic localization economies exist in growing industries, but not in a form that is strong enough to cause the rate of employment growth in a local industry to increase. Dynamic urbanization economies also exist in some industries. A more competitive local industry (in terms of smaller firms) generates more employment growth Diversity in the local economy also contributes to employment growth in an industry The spatial pattern of the manufacturing sector can influence its growth Research on modern growth theory and metropolitan growth Modern growth theory suggests that technical change is produced by rational economic actors who see innovation as a partially excludable good. F. Identification of industries with dynamic agglomeration economies An urban area that is growing rapidly overall may indeed have dynamic agglomeration economies operating in a large number of sectors, but it is likely that those sectors are growing more rapidly than ‘‘average’’ in some sense. An economy that is growing rapidly as a whole will pull along in- dustries that are not dynamic generators of growth, and it is reasonable to suppose that such industries perform no better than the average for the local economy. What is more, an urban area that is not growing rapidly as a whole (e.g., New York and Chicago) may contain dynamic industries. How can such industries be identified in that sort of environment? A technique exists that puts these thoughts into numerical terms. The method is known as shiftshare analysis, and it is a method for dividing the growth of an industry in an urban area into components that are helpful in identifying dynamic ag- glomeration economies. G. A synthesis of mainstream economics: later version The dynamic localization economies increase the productivity of the inputs, leading to reductions in cost and market price and an increase in output. The presence of dynamic localization economies means that the employment and output increases will lead to even larger improvements in productivity than otherwise would occur at that time. The demand curve for labor is constantly shifting outward, but an increase in labor supply will cause a one-time jump in labor demand that may have further dynamic effects. I.Metropolitan growth and urban spatial patterns In Chapter 1, we hypothesized that urban growth and changes in location patterns are related. Population growth will shift the population density function up—density will tend to increase at all locations. The change in the population of the central city is the net outcome of these two forces; suburbanization and growth of the urban area. 120 The shift of the economy toward the production of services has taken place in urban areas that are experiencing decline in the industrial sector of the central city and development of suburbs with more diverse industrial and office employment bases. Three important changes in urban areas that have taken place since the 1970s: 1. The downtown areas of major cities have been transformed and rebuilt by the growth of the service sector—finance, insurance, real estate, professional services, and so on. Downtown employers still rely on commuters from the suburbs, although an increasing number of downtown workers have decided to live in certain areas of the central city. 2. The new suburbanization has created large centers of employment and agglomeration economies that place the suburbs in direct competition with downtown and other older employment areas. Suburban employment centers have become the centers of economic growth in urban areas. Suburban employment growth has been robust on a broad front and manufacturing employment in the suburbs has generally been stable. 3. The demand for workers has shifted sharply in favor of workers with higher levels of education and training. These changes in the economy of urban areas have created even greater challenges for the central city outside the downtown area because employers find that such locations (e.g., old, industrial areas) are not suitable for service sector activity. The basic idea is that face-to-face contacts are still important for a variety of activities in the business and public sectors and that location in the central business district offers a lower cost for making those contacts. J.Summary The existence of agglomeration economies that have enhanced growth in urban areas is confirmed. The size of the local industry (local- ization economies) seems to matter, but dynamic localization economies may not be as strong as some have thought, except in some fairly unusual cases Urbanization economies have an influence in some industries, but urbanization econo- mies also may not be as pervasive as some have suggested. An industry in an urban area will grow more rapidly if it produces a product that is in demand, is competitive, is already of some size in the urban area (and was of some size in the past), is located in a larger urban area (but not too large), and is surrounded by a diverse collection of industries (maybe). The shift to the ‘‘service economy’’ has major implications for urban areas. Research on the topic shows that the suburbs are growing on a broad front and downtowns in major urban areas are doing reasonably well. How- ever, central city neighborhoods outside the downtown area struggle unless they are located in an urban area that is growing rapidly or somehow become part of the downtown growth (e.g., condos for those downtown lawyers). 121
