Paying landowners to change land use

Economists recognise that people respond to incentives. If you increase the cost of doing something, on average people will do less of it. On the other hand, if you increase the benefits of doing something, people will do more of it. So, economists are less surprised than 'normal people' about things like this, as reported in the New York Times at the end of last year:

In environments as different as North America and Africa, new programs are preserving land through short- and-long-term deals that pay people to protect nature on their own land. The innovation makes it possible to transform a binary approach to land use — either devoting it to private development or turning it into a nature reserve — into something in between.

Consider how Airbnb works. Think of Minneapolis during the coming Super Bowl, when hotel rooms are scarce and residents will be enticed to rent their homes to football fans. Something like that happens in the environmental realm, too: There is a surge in demand for protected land when migratory birds are passing through an area or a threatened species is breeding.

In the United States, the nonprofit Nature Conservancy has been a pioneer in bringing the “sharing economy” business model to conservation. It has been temporarily expanding wetlands for migratory birds in California’s Sacramento Valley since 2014. In early fall, when birds head south for the winter, and again in early spring on their return journey, birds need larger protected areas than the current mix of parks and nature preserves allows, as the website Howstuffworks reported in August.

The big insight was realizing “we could use a rent rather than buy model,” said Mark Reynolds, an ecologist with the Nature Conservancy, which pays rice farmers to flood their fields for the few crucial weeks each fall and spring. Rice growers routinely flood their fields for irrigation and to decompose crop residue after harvest; through the conservation program, named BirdReturns, they do so during periods when the fields would have been dry.

So often, activists and environmental campaigners settle on a 'command and control' model as their preferred policy to ensure positive environmental outcomes ('command and control' policies are policies that say you 'must do' some things, or 'must not do' other things). As the New York Times article makes clear, a market-based approach can be just as effective, if not more effective, in some circumstances. A market-based approach doesn't rely on compelling people to obey, it relies on changing the incentives.

In this case, if you offer landowners a payment for changing their land use for part of the year (e.g. flooding their fields to make wetlands), then landowners can choose whether they want to do so. Landowners who face a low cost of changing their land use (maybe because their land is not highly productive so they won't be giving up much production) will be more likely to do so (because the payment will exceed the costs of land use change). Economists refer to the value of the foregone production for these landowners as an opportunity cost - it is the cost (to those landowners) of choosing to change land use. In contrast, landowners who face a higher cost of changing their land use (maybe their land is more productive, so they would be giving up more production) will be less likely to do so. For these landowners, there is an opportunity cost of not changing their land use - they are giving up the payment they would have received from the environmental group.

How do you work out how much to pay the farmers to get the right number of them to change land use? The article explains:

A team of ecologists and economists figured out how much to compensate the farmers for this change. They ran “reverse auctions” in which landowners specified the lowest payment that would entice them to flood their fields for a given four- to eight-week period.

This auction system adjusts payments to farmers’ costs. For example, flooding during the end of the spring migration season is trickier to fit into an annual rice-growing schedule, so bids — and payments — are higher then. The auction model is also flexible when the weather fluctuates. The early years of the program occurred during California’s prolonged drought, but abundant rainfall in 2017 meant that BirdReturns could dial back the amount of pop-up wetland it procured this year.

Note that the reverse auction is a good way for the environmental group to ensure that they can achieve their desired change in land use at the lowest cost, provided the landowners are genuine in specifying their opportunity cost for changing land use as the lowest payment they would accept. The italicised bit in the last sentence is important. You don't want landowners to simply hold out for higher payments. One way to avoid that problem is to ensure that you invite more landowners (with more land) than would be necessary to achieve your desired amount of land use change.

Finally, it is worth noting that this type of market-based system can't make farmers worse off. Since farmers are not compelled to participate, they will only do so if the benefits to them outweigh the costs. Markets aren't a perfect solution for every problem, but sometimes they can solve problems in a surprisingly simple way.

The winner's curse and the Auckland housing bubble

The New Zealand Herald ran a couple of stories on house auctions in Auckland this week. In the first, Ray White Mission Bay owner Wayne Maguire gave his tips on how to win an auction:

Last week Mr Maguire staged a How to Bid and Buy at Auctions seminar for more than 130 house hunters, providing tips on the auction process designed to make bidders more competitive and help blow rivals out of the water.

Auckland property sales are dominated by auctions, with nearly half the region's May transactions done under the hammer.

Mr Maguire said competition for scarce property listings was cut-throat and serious buyers needed to turn up mentally focused and ready to perform...

Mr Maguire said it was important to have a financial plan and know your limit.

Buyers should jot down a running list of price thresholds - starting from the likely opening bid (usually around CV) and ending with the final price limit they are prepared to pay.

"You've got to stop when you hit your limit."

In the second article, Lane Nichols reported on a subsequent auction, and quoted one bidder:

Ms Flavell-Neville agrees the auction process pits buyers against each other, with the potential to induce reckless spending.

"You want to be the winner. I think I would have kept going for a bit longer just to win. But you have to have a hard limit.

"From what we've seen it seems the less people who are bidding the better because they just egg each other on."

The standard English auction really is a suckers' game. They're great for sellers, but not so much for buyers. Why? Because of the winner's curse.

Consider a group of potential buyers for a particular house. Rational buyers with the same preferences would all have the same valuations (or willingness-to-pay) for the house. However, not all potential buyers have the same preferences, and the potential buyers may make random errors in determining their valuations for the house, so all of the potential buyers will have different willingness-to-pay for the house. For buyers with similar preferences, these differences in willingness-to-pay arise randomly - some will overestimate the quality (and value) of the house, and some will underestimate. Probably, if we believe in the wisdom of crowds, the 'true' value of the house will be close to the average willingness-to-pay of all of the potential buyers.

Now take this group of potential buyers and subject them to an English auction for the house. In the English auction format, bids start low and each subsequent bid increases the price that the house would be sold for. The buyers who have underestimated the quality (and value) of the house will quickly drop out of the auction, because the bids will soon exceed their willingness-to-pay for the house. However, the buyers who have overestimated the quality (and value) of the house have an incentive to remain in the auction longer, since higher prices will remain below their willingness-to-pay. The chances are high that, if there are enough potential buyers bidding in the auction, the eventual winner will have overestimated the quality (and value) of the house, and hence will pay too much for their house relative to its 'true' value, making them worse off. In other words, as the bidder above is quote, when there are more bidders it is more likely that some of them have overestimated the value of the house, and they will egg each other on to higher prices - not good for the eventual winner.

The solution is to add one further tip to Wayne Maguire's set of tips - in your list of price thresholds, your final price limit you should be prepared to pay should be somewhat less than the maximum you are willing to pay for the house (engaging in what is termed 'bid shading'). This would help ensure you aren't cursed as a winner.

One final important point - if (as stated in one of the articles) around half of Auckland houses are being sold at auction, and auctions are well-attended with many bidders, then many Auckland houses are being sold subject to the winner's curse. So their selling price of many houses will be above their 'true' value. That means that conventional measures of the value of Auckland housing, such as the median house price, will be based on house sales that include all of these 'cursed' homes. Thus the median house price will most likely tend to overstate the value of houses in Auckland.

That's not the end of this story though. Rational buyers have complete information about the house they are buying and will make their assessment of its value (and their willingness-to-pay) based solely on the house's characteristics (location, construction quality, number of bedrooms and bathrooms, land area, views, etc.). However, most of us are subject to an anchoring bias when valuing things we want to buy - they first price we see will tend to affect our valuation (and our willingness-to-pay). Chances are that potential house buyers will have the median house price for an area (or for Auckland as a whole) in mind when they evaluate their willingness-to-pay for houses they are looking at (it would be hard not to - the median house price is probably the most widely reported measure of housing value, and if you're a house hunter it would be hard to avoid seeing the median house price). So future buyers are likely anchoring their valuations on over-estimated median house prices. Some of them will further over-estimate, win the subsequent auction (with associated winner's curse), and boost the median house price further. Rinse and repeat. Could the winner's curse and subsequent anchoring of willingness-to-pay explain part of the housing price bubble in Auckland?