Friday, April 22, 2011

Endangered Species and Markets

In an earlier post, I talked about the Great Hamster of Alsace. These hamsters thrive in fields of wheat and alfalfa.  Unfortunately for the hamsters, contemporary French farmers have switched to more profitable crops such as wine and corn.  These crops do not provide the shelter for the hamsters and the population of these creatures is plummeting.  In response, the French government is considering a policy to force farmers to return to the less lucrative uses of their land so that the hamsters will be protected.

If you are thinking that such interventions seem to be growing, you would be correct.  The Thursday April 21, 2011 edition of the New York Times carried the following story concerning U.S. experiences with endangered species.

The Fish and Wildlife Service is so overwhelmed by the explosion in requests to add species to the endangered list that it has told Congress it has become paralyzed and unable to perform its tasks. Adding to the mounting problem is a concurrent explosion in litigation against the Fish and Wildlife Service for missing multiple deadlines in each application, deadlines written into the Endangered Species Act passed in 1973.

The groups filing these numerous requests for intervention are trying to be the voice for the unrepresented species.  They ask for government intervention to restrict market outcomes, arguing that the socially optimal outcome demands incorporating the costs imposed on these species (how these "costs" are measured is a different and very complex issue).   Just two weeks ago, the April 13, 2011 issue of the New York Times ran a story about the recent efforts in Congress to remove a species from the endangered list.

This is notable because it is the first time Congress has directly intervened on the endangered species list.  Environmental groups are alarmed at this "political" intervention.   But, as the amount of economic activity impacted by the endangered list grows, you can expect to see more and more such congressional scrutiny.

Friday, April 15, 2011

Scarcity and the Proper Pricing of Water

Recall the famous diamond-water paradox.  While water is absolutely essential to human life, no one really needs a diamond to survive.  Yet, diamonds are many times more highly valued than water.  Of course, this seeming paradox is explained by the supply side.  Water is plentiful and diamonds are scarce.

This article appeared in the April 12th, 2011 issue of New York Times.  The article discusses the growing demands for water, especially in the southwest.

As we know, you cannot just wish away scarcity.  The existence of scarcity means that some system must be used for deciding allocation.  Normally, we rely on markets and prices to handle that.  But, there really are very few markets for water in the U.S.  The single biggest use of freshwater in the U.S. is irrigation and mostly in arid western states.  But the water for such uses is provided at no charge.  (Careful here:  people using irrigation do pay a price, but that is for access and delivery cost recovery.  The original grant of water into the irrigation system is generally not priced.)

The story indicates that water (more accurately, the scarcity of water) will become an increasingly important issue.  Of course, scarcity (and the handling of the resulting allocation problem) is not something new.  But, the combination of a very important item (water) facing an era where pricing will begin to reflect opportunity costs brings the potential for great disruptions in how we produce food as well as locate our communities.

Wednesday, April 6, 2011

The Fundamental Law of Demand

In considering the demand for, say, widgets, there are many things to consider.  And, we know that one of the key factors in the demand for widgets would be changes in prices of markets for goods economists call substitutes or complements.   Economic theory predicts that if the price of a substitute for widgets increases (decreases), the demand for widgets will increase (decrease).  And, of course, any changes in a complementary product's price will have the opposite effect on the demand for widgets.

The following story is from the March 29, 2011 business section of the New York Times.

Most travelers need to carry clothing and supplies to their destination, and there are substitute methods to accomplish this transport.  You can check your bag or you can take extra carry-on bags.  This story shows dramatically how the increase in the price of checking your bag has lead to a large increase in demand for a substitute to checking your bag: carry-ons.  And, if you were to read the story you would find examples of the negative externality effect of congestion.  Each person who increases his or her carry-ons is adding to an overall social cost of congestion, both at the TSA lines and in the nerve wracking boarding process where people try to fit bags seemingly twice their body size into the overhead compartments.

Tuesday, April 5, 2011

Pricing Assets In Perpetuity: the Case of Farmland

A recent article in The Progressive Farmer indicates that the price of farmland in the midwest is skyrocketing.

$11,000 per acre may seem to be pretty pricey for farmland. However, there is a way to understand the imputed market value of an acre of land.  First, recall that when we thought about the price of a share of stock of a company, we considered the present value (PV) of the long run stream of profits you could expect to earn as an owner of the company. Suppose you thought profits would be x0 this year, x1 next year, x2 the year after that, and so forth. The PV of this stream of returns over time out to time = T would be the sum of

PV = x0  +  x1/(1+r)  +  x2/((1+r)^2)  +  x3/((1+r)^3)  +  ...  +  xT/((1+r)^T)

Lets make things simple and assume for the moment that the returns in each period were some constant x (that is, we assume that x0 = x1 = x2 = x3 = ... = x).  Farmland is a special asset, one that is an "asset in perpetuity" since the owner can bequest it to her heirs, etc.  The good news is that we know for very large T, the equation simplifies to


In other words, if you expected to earn $100 per year forever, and the interest rate was .05, then the PV of that infinite series would be $100/.05  =  $2000.  That is the same thing as saying that "the discounted stream of an annual series of $100 annuities would be comparable to $2000 in the bank today" which is the same thing as saying "if you gave me $2000 today and I put it in the bank at a guaranteed annual rate of 5% forever, I could continue to take $100 out on Jan 1 of each year, forever...."

So back to our farmland story.  The same story cited above indicates that owners of farmland can simply rent the land (this is called "cash rent") for as much as $450 per acre in McLean county.  This is pure profit to the owner; the renter pays this for the right to use the land and that same renter incurs all production costs on top of this land cost and then keeps any and all profits after selling the corn.

We know the price of land ($11,000) represents the present value of the long run stream of annual profits ($450 per year) you could earn by simply keeping the land in your ownership.  Or, the $11,000 per acre today is what it would take to compensate you for giving up the $450 per acre into perpetuity.  Does that make sense?  Lets check:

Since we know the formula is:   PV = x/r   then we are asking does   $11,000 = $450/r

To make that equation work, we would need an interest rate, r, equal to 4 percent.  Is that reasonable? Well, if you look at the interest rate on long term bonds today, you see that the rate on 20 year bonds is about 4.3% which makes the $11,000 number quite reasonable.