“economic rent” explained (it is not what you think)
Varian talks about the notion of “economic rent”, using Tom Cruise’s movie salaries as an example (quoted below). Which reminded me of the insistence of some real estate commentators to talk about the “fundamentals” in the New York City apartment market (as in “the recent price run up could not be sustained because prices outstripped the fundamentals”).
cost vs. demand
Here is what Varian said about The Couch Raver’s salary:
David Ricardo, who lived from 1772 to 1823, developed the theory of economic rent in his essays opposing the 19th-century English Corn Laws. These were tariffs ostensibly intended to protect British farmers from cheap foreign grain.
Ricardo observed that the tariffs had two effects: the obvious effect of raising the price of grain and the more subtle effect of pushing up the rent of land suitable for growing grain.
From the viewpoint of an individual tenant farmer, the rent he paid to the aristocratic landlord was a cost of production. But for the system as a whole, the land rent did not really determine the price of grain. It was the other way around: the price of grain determined land rent. So the real beneficiaries of the Corn Laws were not the tenant farmers, but the aristocrats who owned the land.
And so it is with Mr. Cruise. His salary, as that of other Hollywood stars, depends on the fact that large numbers of people will pay to see his movies. If, in the future, these people spend more time on YouTube and less time going to movies, Mr. Cruise’s compensation will probably fall.
This is not true for other sorts of goods used to produce films. The movie business uses a lot of trucks — but the price of trucks won’t change if people go to movies less. Why? Because the price of trucks is determined primarily by their cost of production — the labor, steel, rubber and other materials that go into making them.
It’s quite different with star salaries. It’s not the cost of production that determines actors’ wages but the demand for the product that they produce.
What does this have to do with Manhattan apartment prices? Here is how I would turn Varian around to face my market:
Manhattan apartment prices depend on the fact that large numbers of people will pay to live in Manhattan. If, in the future, these people prefer to spend their money on suburban houses Manhattan apartment prices will probably fall.
Seems pretty simple and obvious, right?
I have often wondered about what fundamentals people are talking about when they talk about real estate. But here is why Real Estate Fundamentals don’t apply in Manhattan they way they may apply in, say, Houston.
My guess is that real estate prices in Houston – and in much of America -- are much more directly related to costs of production (buying land and building materials and paying someone to assemble those materials on that land) than here. If a buyer in Houston has a real opportunity to buy-and-build within a reasonable commuting distance to a job, the relative values of resale homes is limited in some significant way by that choice.
But in Manhattan, there is essentially no equivalent build-or-buy choice.
I wonder if there is any data that would help rank different US cities on the degree to which Costs Of Production are relevant to market prices.
Probably, Manhattan and San Francisco are examples of consistent demand being the market driver; “frothy” markets with a lot of investors (Las Vegas, south Florida?) probably swing in the degree to which demand is the driver; most of America is probably more weighted to costs of production. Not sure what the data would be, but I wonder if it is out there…
© Sandy Mattingly 2006
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