Tuesday, 25 July 2017

Sunshine, the value of housing and compensation for externalities

In ECON110 today, we discussed hedonic demand theory (or hedonic pricing). Hedonic pricing recognises that when you buy some (or most?) goods you aren't so much buying a single item but really a bundle of characteristics, and each of those characteristics has value. The value of the whole product is the sum of the value of the characteristics that make it up. For example, when you buy a house, you are buying its characteristics (number of bedrooms, number of bathrooms, floor area, land area, location, etc.). When you buy land, you are buying land area, soil quality, slope, location and access to amenities, etc.

In a new Motu working paper, David Fleming, Arthur Grimes, Laurent Lebreton, Dave Maré, and Peter Nunns show that sunshine is one of the important characteristics that contributes to house values. The New Zealand Herald reported a couple of weeks ago:
Motu Economic and Public Policy Research Trust has released what it calls the first research carried out anywhere in the world to specifically evaluate the extra value house buyers put on extra sunshine hours.
Arthur Grimes, a senior fellow at Motu and co-author of the study, said there was a direct correlation between more sunshine and higher values and the study was precise about how much extra value is added.
"Direct sunlight exposure is a valued attribute for residential property buyers, perhaps especially in a cool-climate city such as Wellington. However, natural and man-made features may block sunlight for some houses, leading to a loss in value for those dwellings," the study said.
The effect is quite large. Quoting from the paper:
...each additional hour of direct sunlight exposure for a house per day (on average across the year) adds 2.4% to a dwelling’s market value.
The paper also has some interesting implications in terms of negative externalities. If a high-rise apartment development will block the sunlight from nearby houses, then it will reduce the value of those houses. This constitutes a negative externality imposed on the affected homeowners. Fleming et al. note that these externalities could be dealt with through compensation:
At a policy level, our estimates may be used to facilitate price-based instruments rather than regulatory restrictions to deal with overshadowing caused by new developments. For instance, consider a new multi-storey development that will block three hours of direct sunlight exposure per day (on average across the year) on two houses, each valued at $1,000,000. The resulting loss in value to the house owners is in the order of $144,000. Instead of regulating building heights or the site envelope for the new development, the developer could be required to reimburse each house owner $72,000. In return, the developer would be otherwise unrestricted (for sunlight purposes) in the nature of development. If the development cannot bear the $144,000 then the efficient outcome is that the development does not proceed. Conversely, if the development can bear that sum, then the socially optimal outcome is for the development to occur and, from an equity perspective, the neighbours are compensated for their loss of sunlight exposure.
The idea that compensation can be used to deal with externalities relies on the Coase Theorem - the idea that, if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own (i.e. without government intervention). In the case of a bargaining solution to an externality based on the Coase Theorem, the solution depends crucially on the distribution of entitlements (property rights and liability rules). In this case, the homeowners have existing rights to sunlight and because an apartment development would infringe on those rights, the developer would be expected to pay compensation to the affected homeowners. This will only be viable if the total amount of compensation paid to affected homeowners is not so great that it makes the development unprofitable.

The study was based on data from Wellington. Given that development in Auckland is happening faster and involves increasing density and greater numbers of taller mixed-use buildings, it would be interesting to see if the results hold there as well. As noted in the New Zealand Herald story:
"For places other than Wellington, the value of sunshine hours may be higher or lower depending on factors such as climate, topography, city size and incomes. Nevertheless, our approach can be replicated in studies for other cities to help price the value of sunlight in those settings," Grimes said. 
So the approach is transferable, even if the results are not. It's almost certainly extendable to considering the value of volcanic viewshafts in Auckland, and hopefully someone is already thinking about undertaking that work.

Monday, 24 July 2017

Reason to be wary if a job in Taumarunui offers an Auckland salary

The New Zealand Herald reported last week:
If you fancy getting away from the rat-race and settling in small-town New Zealand, the perfect role just came up.
Forgotten World Adventures are advertising for a general manager to be based in Taumarunui while receiving an "Auckland salary" - over $150,000 for the "right" candidate...
The advertisement says candidates don't need tourism experience but will "need to be a true leader".
"We are looking for someone who is excited about doubling our revenue over the next three years, passionate about securing our position as a 'bucket list' experience for our target market, and focused on developing our reputation as an industry leader," the advertisement reads.
If you're wondering why a business in Taumarunui is offering an 'Auckland salary', you're right to wonder. That should be a great big red flag. It screams out "compensating differentials!".

Economists recognise that wages may differ for the same job in different firms or locations. Consider the same job in two different locations. If the job in the first location has attractive non-monetary characteristics (e.g. it is in an area that has high amenity value, where people like to live) then more people will be willing to do that job. This leads the supply of labour to be higher, which leads to lower equilibrium wages. In contrast, if the job in the second area has negative non-monetary characteristics (e.g. it is in an area with lower amenity value, where fewer people like to live) then fewer people will be willing to do that job. This leads the supply of labour to be lower, which leads to higher equilibrium wages. The difference in wages between the attractive job that lots of people want to do and the dangerous job that fewer people want to do is called a compensating differential.

So, coming back to the Taumarunui job with an Auckland salary, you really have to ask yourself what is so bad about the job that it requires a high salary to attract someone to work there? Perhaps the business is struggling (but nonetheless trying to double their revenue over the next three years)? Or maybe the owners or co-workers aren't easy to get along with? Or, maybe living in Taumarunui is truly awful? They're almost certainly compensating for some undesirable characteristic of the job.

Whatever it is, I'd be wary of applying. Is there a prospective employee equivalent to caveat emptor?

Read more:

Sunday, 23 July 2017

Are house prices a self-fulfilling prophecy?

Possibly. But let's start from the beginning, which was neatly summarised in this New Zealand Herald article from a couple of weeks ago:
An economist from one of New Zealand's biggest banks has questioned the role of the media in reporting on Auckland's housing market, asking if significant coverage of Auckland house price declines could be "a self-fulfilling" prophecy.
BNZ senior economist Craig Ebert was writing ahead of tomorrow's release of Real Estate Institute data for June and posed a question about the effect of the media's role in the market.
He referred to other recent data that showed prices dropping in some Auckland areas.
"The recent decline in Auckland house prices is now getting significant media coverage. This can be self-fulfilling to the extent that folk fearful that a market might correct are more likely to withdraw from it - buyers that is - and sellers will either delist their properties, simply not sell or, if under pressure, accept lower prices than might otherwise be the case," Ebert wrote.
One of the factors that affects the current demand in a market is expectations about future prices, which may be affected by media coverage. If a consumer (in this case, a home buyer) believes that the price of a good (in this case, a house) will be lower in the future, then they may hold off on purchasing now and wait for the lower future price. This lowers current demand for the good (houses). As shown in the diagram below, demand falls from D0 to D1, and the effect of that is that the equilibrium price falls from P0 to P1 (and the quantity of houses traded falls from Q0 to Q1). So the price falls, which is exactly what the consumer expected. Hence, this becomes a self-fulfilling prophecy.

But wait, there's more. If potential sellers expect prices to fall in the future, they may choose to sell their houses now, which increases the current supply of houses. As shown in the diagram below, this combination of decreased demand (from D0 to D1) and increased supply (from S0 to S2) leads to an even greater drop in prices, to P2. Note that the change in quantity becomes ambiguous - quantity of houses traded could increase (if the increase in supply is greater than the decrease in demand), decrease (if the increase in supply is less than the decrease in demand), or least likely of all the quantity could stay the same (if the increase in supply exactly offsets the decrease in demand).

But maybe sellers aren't that dumb - maybe they recognise that they can hold onto their houses for now instead (and rent them out), and then sell them at some point in the future once prices have recovered. In this case, the supply of houses for sale would decrease rather than increase. As shown in the diagram below, this combination of decreased demand (from D0 to D1) and decreased supply (from S0 to S3) leads to a certain decrease in quantity (to Q3), but an ambiguous change in prices. House prices could increase (if the decrease in supply is greater than the decrease in demand), decrease (if the decrease in supply is less than the decrease in demand), or least likely of all the price could stay the same (if the decrease in supply exactly offsets the decrease in demand).

So, are house prices a self-fulfilling prophecy? It really depends on the reaction of sellers. If sellers choose to cash out before prices start to fall (which I would suggest is probably the case for short-term speculators) then yes. However, if sellers choose to hold onto houses and wait out the downturn (which is more likely the case for owner-occupiers, landlords and long-term investors), then possibly not. At that point, it becomes an empirical question - if the quantity of houses changing hands falls significantly and house prices hold up, then the latter of those two explanations is probably having the greater effect.

Saturday, 22 July 2017

Surge pricing is coming to a supermarket near you

When demand increases, the standard economic model of supply and demand tells us that the price will increase. However, most businesses don't dynamically adjust prices in this way. For instance, ice cream stores don't raise prices on hot days, and umbrellas don't go up in price when it rains.

There are a few reasons that sellers don't automatically adjust prices in response to changes in demand. The first reason is menu costs - it might be costly to change prices (they're called menu costs because if a restaurant wants to change its prices, it needs to print all new menus, and that is costly). The second reason is that changing prices creates uncertainty for consumers, and if they are uncertain what the price will be on a given day, perhaps they choose not to purchase (in other words, the cost of price discovery for consumers makes it not worth their while to find out the price). The third reason is fairness. Research by Nobel Prize winner Daniel Kahneman (and described in his book Thinking, Fast and Slow) shows that consumers are willing to pay higher prices when sellers face higher costs (consumers are willing to share the burden), but consumers are unwilling to pay higher prices when they result from higher demand - they see those price increases as unfair.

Despite this, there are examples of sellers dynamically adjusting prices. For example, Alvin Roth's book Who Gets What - And Why (which I reviewed here) relates a story about how Coke ran a short-lived experiment, where their vending machines increased prices in hot weather. And many of us will be familiar with Uber's surge pricing (which, as noted in this post, is used to manage excess demand).

It seems that soon Uber may not be the only local example that we will see of this. The New Zealand Herald reported a couple of weeks ago:
On demand surge-pricing is making its way to New Zealand.
The country could soon be in the same boat as the UK, Europe and America, with stores and supermarkets adopting digital e-pricing - prices that change hour to hour, based on demand.
Retail First managing director Chris Wilkinson said variants of surge-pricing had already hit New Zealand, particularly around the Lions tour, with accommodation and campsites prices soaring.
While on demand surge-pricing is not a new phenomenon, Wilkinson said the way it was being administered, overseas, was.
"What is new is the ability to manage on-shelf pricing dynamically and tie this to key commercial opportunities - such as busy times, events, weather or other responsive opportunities," he said.
Asked if he thought it would become standard practice in New Zealand supermarkets and on shelves anytime soon, Wilkinson said it would likely hit service stations first.
"We'll likely see this in service stations first, as they will be able to maximise potential around higher margin products such as hot drinks, bakery and other convenience items," he said.
I'd be interested to know how a supermarket would deal with a customer who picks up an item observing one price at the shelf, but then finds that the price has changed by the time they get to the checkout. Would that breach the Fair Trading Act? As Consumer notes here:
In the past, a supermarket has been convicted and fined for charging higher prices at the checkout than were on display.
Despite that particular problem, surge pricing is coming. When you see the traditional price sticker replaced by a small LCD or LED display, you'll know it has probably arrived.