An introduction to economics - Lesson 5: Business and Land Prices

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Business and Land Prices

Consider two identical firms, ‘A’ and ‘B’.

They both engage in the same business using the same number of individuals who have an identical range and degree of skill and expertise. They both rent similar premises and use the same tools, equipment and materials in the production of identical goods for sale. The only difference between these two firms is their location.

Firm A is very conveniently located for easy access by staff, customers and suppliers.
Firm B is not so well located. Suitable staff have a difficult, long and expensive journey. There is little ‘passing traffic’ and face-to-face meetings with clients, customers, and suppliers is difficult since they are distributed over a wide area.

Getting the best deal, both in terms of delivery and price, can be a problem. Clearly, a given value of inputs by firm A will yield a larger output value than the same input by firm ‘B’. Looked at another way, for a similar value of output from both firms, firm A will require far less input than firm B. In short, firm B’s costs of production will be higher. If we suppose that firm ‘B’ is ‘marginal’ i.e. it is only just viable, we can see that Firm ‘A’ enjoys a surplus net revenue that is due entirely to its location.

The market however has shown that it could survive if it enjoyed only a net revenue equal to that of firm ‘B’. Put yourself now in the position of firm ‘A’s landlord faced with the question of how much rent he or she should charge for the business premises that firm ‘A’ occupies. We might assume that the landlord will be obliged to charge the same for the building itself as the landlord of firm ‘B’ must charge for his identical building. However, his overall rent charge will almost certainly be more. In fact he will almost certainly charge as much as he can and the upper limit will be set by what firm ‘A’ can afford to pay.

As we have seen firm ‘A’ enjoys a surplus revenue over and above that which he needs to stay in business equal to the surplus he receives compared with firm ‘B’. He can thus afford to pay that much extra to the landlord in rent compared with that which firm ‘B’ must pay.

We now need to consider the position of firm ‘B’s landlord. He will need to cover his costs and charge appropriately for the capital, maintenance and depreciation cost of the building itself but he will also seek a rent payment for the use of the site. It is after all valuable compared with all those other sites where no viable production can take place at all or where only production of a less valued kind than that which is the business of firms ‘A’ and ‘B’.

By less valued we might mean here production that requires less labour (quality or quantity), or which is less able to take advantage of advances in technology e.g. better plant and equipment – ‘capital’. His dilemma is to know just how much firm ‘B’ could afford to pay without with going bust, as that would oblige him to seek the tenancy of a firm engaged in some ‘lower’ form of economic activity. If he asks too much the site might stand empty for a while, yielding no rental income. If he asks too little, he may feel he is wasting his asset. Again, like the house owner, his attitude will be influenced by his need for revenue.

If he has a pressing need, he may be more tempted to accept a less than maximum revenue in order to avoid the risk of no revenue. If he has no pressing need for revenue, he may prefer to play a long game and hold out for a maximum rental, comforted by the prospect of a rising asset value as property/land values continue to rise.

We should note several features here:

  • All firms that rent the premises they use are obliged to operate at a level of business viability similar to that which prevails at the margin i.e. only just viable and are thus very vulnerable to even a small downturn in trade or increase in costs.
  • The level of business failure and the associated risks of unemployment are higher than they need be. · The firms earnings are reduced to less than the full value that their work produces by the land rent payment that is charged at the margin
  • The wages, salaries and profits that firms are able to pay out of earnings is correspondingly reduced.
  • Where a firm’s viability depends upon the profits available to non-working owners of the firm, and those profits are squeezed by rent payments, the risk of failure is even higher. (Sole traders and partnerships however may be able to tolerate a drop in wages during hard times).
  • Firms that do own the premises they use enjoy a surplus revenue that is really unpaid rent.
  • They therefore may not know if their business is viable or not.
  • They may not know if they are making best use of their land asset.
  • If they are not making best use of their land asset they will be vulnerable to take over as more astute observers realise their miscalculation.
  • Since even firms at the margin pay a land rent there must be other potential firms who would be viable if the land rent there were less or non existent.
  • Paying land rent at the margin thus represents a ‘barrier to entry’ for new firms.
  • Much land is held out of use in places that are suitable for all forms of economic activity i.e. in cities, towns, villages, and rural areas, while their owners hope for a capital gain in the longer run.
  • Much land is underused i.e. used for producing forms of wealth that do not make best use of their present location. Correspondingly much wealth is not produced where it might best be produced.
  • All this represents a large loss of economic potential to the nation.
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