david ricardo is not easily denied

the law of rent and its implications

Sorry, Wednesday’s post didn’t appear due to travel and busyness, but here’s a somewhat more substantial Friday one. This is a point I’ve made a lot of times in various venues but never really put down in full, in one place. The payload here is that when you’re looking at house prices in the context of urbanism, agglomeration, abundance and all that good stuff, you need to be really careful about a measurement problem that is going to mislead you a lot of the time.

It all starts with Ricardo, of course; in particular, his “Law of Rent”, which was developed to explain the seeming paradox that in eighteenth century England, tenant farmers seemed to have an equally miserable lifestyle no matter how good the intrinsic quality of their land. Ricardo explained this by noticing that the better farmland had higher rent, and that even improvements in agricultural technology didn’t have much positive effect on the poor tenant farmers, as they were quickly reflected in higher rents.

This is actually quite easy to understand in terms of modern orthodox economics; it’s the reason why the word “rent” is sometimes used to describe the excess profit of a monopolist. The land owner is the owner of the monopoly on “being allowed to farm that particular patch of land”, and so collects monopoly profits. The tenant can’t farm without using the land, and so all the return to agriculture above the minimum needed to keep them in the farming game goes to the monopolist.

What’s that got to do with house prices? Everything.

As the estate agent proverb goes, the most important three things about a building are location, location and location. Houses are in specific places, which are usually not very close substitutes to one another, and it is really easy to forget this fact when drawing charts of aggregate price indices.

If you take agglomerationist urbanism at all seriously (even as seriously as a sceptic like me!), you’ll believe that some locations have positive and increasing returns to density, because human capital is more efficient when it’s concentrated. And “social capital”, in the sense of a network of weak ties between people in the same industry is also an important factor of production.

But if you believe that, then who would you expect to get the benefits of that agglomeration? Given that, ex hypothesi, there is an essential and non-substitutable factor of production, which is “proximity, in the sense of being physically located in a particular geographic area”?

It’s exactly the same – the monopoly owners of “the right to live and work in a particular location” would normally be expected to accrue all the excess returns. David Ricardo and his Law are not easily denied. And the property price is just the capitalised value of the rent.

In fact, something like Ricardo’s Law is at the base of my model of house prices which has served me so well in professional capacity over the course of my career. That model is simply:

1) The fixed parameter (corresponding to subsistence income for eighteenth century tenant farmers) is that people will spend roughly 30-35% of their income on rent.

2) People will typically re-establish this affordability ratio by trading up or down to the best location they can afford

3) For “major cities”, the ratio goes up to 40-45%; this reflects the split of the premium rewards to human and social capital in agglomeration areas between tenants and landlords.

4) Roughly speaking, property values should be equal to the cash amount derived from steps 1) or 3) above as appropriate, capitalised at the mortgage rate of interest. If they are far away from this value, it’s likely that property is over- or under-valued.

It can be noted that supply and demand don’t have an obvious role in this model, which appears to drive some people crazy. But I think this is telling us about a very important measurement issue – there is really, really, no such thing as “supply of housing”, because there isn’t a generic quantity of “housing” for there to be a supply of. There are a lot of local markets with their own supply and demand conditions, and these markets are very poor substitutes for one another.

By this, I mean that if house prices are high in Widgetville because wages (and therefore rents) are very high in the widget cluster, then the only supply which is relevant to pricing is supply in locations which could still be counted as part of the widget cluster. In order to affect pricing, the supply would have to be such as to reduce the premium attached to being in one of the specific places you have to live in order to be part of that cluster.

A further implication of this is that for the very best locations, pricing will be almost completely inelastic to supply. Because, just as you can increase the number of places in good school, but not the number of places in the best schools, being in limited supply is a definitional property of the very top of the market. Taking this even further, if we pretend that the economic agglomeration profile of London corresponds to the Tube map (which it kind of does), you might predict that building more housing in Zone 2 would not significantly affect prices or rents in Zone 2, but would be more likely to result in houses left completely empty in Zone 4.

This doesn’t at all mean that supply doesn’t matter – it does! Nor is economic agglomeration the only purpose of building houses. Giving people nicer houses with more space (or more dense walkable neighbourhoods with less space if that’s what turns you on) is a good thing in itself. But it does mean that there are really tricky measurement issues here, and that aggregated price indices are often very misleading when used either as evidence of a problem, or as evidence of whether a solution has or hasn’t worked.