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This year in the online Mises Academy I have been leading students through Murray Rothbard's classic treatise, Man, Economy, and State. (For details on the current class, covering the final third of the book, see here.) In the previous class we covered Rothbard's analysis of the pricing of land. This is an illuminating topic because it involves capitalization and entrepreneurship, two areas where Austrians have made seminal contributions to economic theory.

Land Prices and Rents

In the opening of chapter 9, Rothbard offers a succinct summary of much of the preceding analysis in the book:

We have been using the term rent in our analysis to signify the hire price of the services of goods. This price is paid for unit services, as distinguished from the prices of the whole factors yielding the service. Since all goods have unit services, all goods will earn rents, whether they be consumers' goods or any type of producers' goods. Future rents of durable goods tend to be capitalized and embodied in their capital value and therefore in the money presently needed to acquire them. As a result, the investors and producers of these goods tend to earn simply an interest return on their investment. (pp. 557–558)

Although he packs a lot into this paragraph, Rothbard's statements are straightforward. All factors of production — whether a tractor, light bulb, or plot of land — yield a flow of services per unit time. The economist can explain the rental price of a factor according to its marginal productivity.

Suppose that sharecroppers calculate that an additional acre of Farmer Smith's land would allow them to increase their annual earnings by $250. If we have open competition (i.e., no government restrictions), then in equilibrium we would expect that the sharecroppers would pay rent of (nearly) $250 per acre per year for the use of Farmer Smith's land.

Now suppose that instead of renting out his land, Farmer Smith wants to sell it outright. How much could he expect to get for it?

In the baseline case of certainty about the future, the answer is that Smith would capitalize the present discounted value of all future rental payments accruing to the farmland. For example, suppose the farmland is expected to yield a perpetual annual flow of $250 rental payments. At a constant rate of interest of 5 percent, the market price of an acre of Smith's land would therefore be $5,000. That's how much Smith can ask for, and should receive, for selling off his land, at least in a world where everyone is certain about the land's future earning power and the constant interest rate.

"The Austrian School is known for its contributions to the theory of capital and income, as well as entrepreneurship. These issues all come together in the explanation of the market price of land."

To see why this is the answer, consider an investor with $5,000. He can use that money to buy a bond yielding 5 percent per year (because we assumed that was the interest rate). That means our investor can reap a perpetual stream of $250 dividend payments from his bond. In a world of certainty, it's no riskier to invest in land than in bonds, so an acre of Farmer Smith's land — which also yields a perpetual income stream of $250 per year — must command a purchase price of $5,000 as well.

Once we understand the basic process, it's easy to see how changes in the underlying fundamentals will influence land prices. For example, if increased population drives up the demand for food, such that the sharecroppers will now pay $500 per year in rent, then the market price for the parcel of land will rise from $5,000 to $10,000.

On the other hand, suppose that the rental price of the land remains at $250 per year, but that the community's time preferences (degree of impatience) increase so that the interest rate rises to 10 percent. Now the capitalized asset value of the land drops from $5,000 down to $2,500. Even though the land is just as productive (even in terms of annual income) as before, the higher interest rate places twice as heavy a discount on future cash flows. Thus the current market price of the land falls in half when the interest rate doubles.

Marginal Land Earns a Positive Rent

Rothbard explains that, in our world, it is an empirical fact that labor is scarcer than land. (This just happens to be the case; we could logically imagine the reverse being true.) Consequently, depending on population size and other factors, at any given time we can arrange the plots of land in a spectrum from least valuable to most valuable.

Because land is more abundant than labor, there will always be a threshold denoting the marginal plot of land, meaning the plot of land that it is just worthwhile to bring into cultivation. The land that is more fertile (or otherwise desirable) is the supramarginal land, which earns higher rents than the marginal land. In contrast, the submarginal land earns no rent and is not integrated into the production process.

Rothbard distinguishes the Austrian perspective from the standard mainstream approach:

It is important to recognize … that the marginal land will earn not zero, but only close to zero, rent. The reason is that, in human action, there is no infinite continuity, and action cannot proceed in infinitely small steps. Mathematically minded writers tend to think in such terms, so that the points before and after the point under consideration all tend to merge into one. Using marginal land, however, will pay only if it earns some rent, even though a small one. (p. 560)

In other words, mainstream economists tend to think of marginal land earning zero rent, because that is the only logical conclusion if we divide the spectrum of land fertility into infinitesimal units. But in the Austrian approach — characterized by purposeful choice, rather than indifference — somebody will obviously bring a parcel of land into cultivation only if it offers a prospective rent (however small).

Introducing Uncertainty

Thus far we have dealt with the simple but unrealistic case where the rental earnings from a piece of land are constant. Rothbard discusses the complications from changes, and how entrepreneurs deal with it:

At this point, let us consider a great bugaboo of the Henry Georgists — speculation in land that withholds productive land from use. According to the Georgists, a whole host of economic evils, including the depressions of the business cycle, stem from speculative withholding of ground land from use, causing an artificial scarcity and high rents for the sites in use.… In many cases, however, a land site, once committed to a certain line of production, could not easily or without substantial cost be shifted to another line. Where the landowner anticipates that a better line of use will soon become available or is in doubt on the best commitment for the land, he will withhold the land site from use if his saving in "change-over cost" will be greater than his opportunity cost of waiting and of forgoing presently obtainable rents. The speculative site-owner is, then, performing a great service to consumers and to the market in not committing the land to a poorer productive use. By waiting to place the land in a superior productive use, he is allocating the land to the uses most desired by the consumers. What probably confuses the Georgists is the fact that many sites lie unused and yet command a capital price on the market. The capital price of the site might even increase while the site continues to remain idle. This does not mean, however, that some sort of villainy is afoot. It simply means that no rents on the site are expected for the first few years, although it will earn positive rents thereafter. The capital value of ground land, as we have seen, sums up the discounted total of all future rents, and these rental sums may exert a tangible influence from a considerable distance in the future, depending on the rate of interest. There is therefore no mystery in the fact of a capital value for an idle site, or in its rise. The site is not being villainously withheld from production. (pp. 570-571)

We can illustrate Rothbard's analysis with two examples. First, consider something that is all too typical these days: An empty commercial building with a "FOR RENT" sign in the window. Further suppose that this building remains in such an idle condition for several months. What should we make of this strange outcome?

At first glance — and if we disregard the real-world problems of uncertainty — the owner of the building appears to be a fool. After all, if she just lowered her asking price, surely she could get some tenant to move into the building and start paying her rent. No matter how low the price, something is better than nothing, assuming the tenant won't physically damage the premises.

In reality, this critique of our hypothetical building owner is unfair. In the real world, the building owner doesn't know exactly what potential tenants are willing to pay to rent her space. If and when she does accept a new tenant, they will presumably sign a contract guaranteeing the tenant the space for a certain time (perhaps a year or longer), subject to various conditions. This is because the tenant wouldn't want to go to the trouble of setting up the space for his business, only to be kicked out two months later because the owner found a tenant willing to pay more rent.

Given that this is the type of arrangement she will reach with a new tenant, the building owner will not simply lower the asking price hour to hour until she closes a deal after the first day of vacancy. Rather, she will set a price (perhaps optimistically) for which she would be happy to rent the space. It's worth it to her to let the space stay vacant, perhaps for several months, waiting to find that special tenant willing to pay the price.

So we see that even on an unhampered market, there are reasons for resources to remain "idle." The process here is analogous to an unemployed person looking for a new job. There is a genuine search involved, where parties to a mutually advantageous trade need to first find each other.

For a different example, suppose that the government has declared a particular piece of land as a wetland, making it illegal to develop it commercially. Originally the land has a market price of $0. However, a few insiders catch wind that the incoming administration plans on removing the restriction. If that were to happen, then the marsh could be drained and a shopping mall could be built on the land, yielding fantastic revenues for the owners.

In this second scenario, insiders would purchase the land from its original owner, and would be willing to pay a hefty price for it, if necessary. Here too we would see land commanding a positive purchase price even though it would be earning zero rent.

Conclusion

The Austrian School is known for its contributions to the theory of capital and interest, as well as entrepreneurship. These issues all come together in the explanation of the market price of land. As usual, Rothbard's exposition in Man, Economy, and State is comprehensive and crystal clear. For those wanting a guided tour through his book, I welcome you to join our current Mises Academy class.