When you increase landowners' costs, the value of land goes down

Last week, the New Zealand Herald reported:

As of October 19, landowners and foresters who participate in the Emissions Trading Scheme (ETS) will be charged an additional annual fee of $30.25 per hectare in perpetuity.

A Ministry for Primary Industries (MPI) spokesperson says the $29.8m it costs each year to run the forestry ETS has been 100 per cent taxpayer-funded until now.

But from October 19, 63 per cent of those “administrative costs” will instead fall to ETS participants, with the remaining 37 per cent still funded by the taxpayer.

It seems fair enough to me that the landowners who benefit from the ETS should pay the costs of administering the system that they benefit from. However, what caught my eye in the article was this bit:

To cover that cost, [New Zealand Institute of Forestry president James] Treadwell says foresters will have to pass the problem on to farmers.

“I’ve got one farmer who is wanting to sell off about 120 hectares of their farm to cover their interest rates. I had to tell him the price has just dropped by $500 a hectare. He was pretty upset,” said Treadwell.

Why would a small charge of $30.25 per hectare per year lead to a $500 reduction in land values? It's because the value of the land is based on how profitable it is to own land. With the new annual fee, land is less profitable by $30.25 per hectare per year. And that translates into $500 in land value. The Efficient Markets Hypothesis suggests that new information is incorporated into the value of an asset immediately. And this appears to be what has happened here.

It's interesting to consider what that implies about the discount rate for landowners (or land buyers). Using the formula for the present value of an annuity, setting the value of the annuity to $500, and the value of the annual payment to $30.25, and solving for the discount rate R, I get an implied discount rate of 6.05 percent. [*]

That implied discount rate is interesting for a few reasons. First, it's very similar to current interest rates for farm loans. For example, ANZ currently has business term loans (including for farms) with a floating rate of 7.05 percent. At a discount rate of 7.05 percent, that $30.25 annual fee should reduce land prices by $429 per hectare. So, landowners (or land buyers) are reducing land prices by slightly more than expected given current interest rates. That may be because, while the annual fee is currently proposed to be $30.25, there is little stopping the government from increasing that fee later (at a rate that is higher than the rate of inflation), which would increase the amount of compensation, in terms of lower land prices, required now in order to offset the annual fee. So, perhaps that additional risk is being priced into land prices, and being picked up in the annuity calculation as a lower discount rate. [**]

Second, the discount rate is far higher than the social discount rate that is used in climate change (and many other) applications, which is often 3 percent (see here for more on this). If we applied the 3 percent social discount rate, the $30.25 annual fee should be reducing land values by $1008 per hectare. That suggests that landowners (and land buyers) are more focused on the present than the social discount rate implies, which is consistent with the idea of present bias from behavioural economics. Alternatively, we could interpret this as implying that society as a whole is much more focused on the future (as captured by the social discount rate) than individual landowners (or land buyers) are. Short-term profit motives strike again?

Finally, and perhaps most surprisingly to me, the implied discount rate is not wildly high (or low), implying that landowners (and land buyers) are not seriously overreacting to the introduction of this fee. Not only is the Efficient Markets Hypothesis working, but it appears that the landowners (and land buyers) have been relatively rational in terms of their response (as picked up in the change in land value). I guess it's not always the case that asset markets are crazy.

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[*] Ok, I admit that I didn't solve this by hand. It's not possible to do so easily. I used the 'solver' function in Excel, and set the number of periods to 10,000 (so, it's really a solution to the question: what is the discount rate that equalises an annual value of $30.25, paid every year for 10,000 years, and a one-time payment today of $500?

[**] If we used $30.25 per year for the first five years, then increasing to $37.25 for every year after that, then the implied discount rate that equates the annuity and the decrease in land values is 7.05 percent, the same as the ANZ farm loan rate. So, perhaps it is some calculation like that which explains the decrease in land values being higher than implied by current interest rates.

Drip pricing and quasi-rational behaviour

In an interesting article in The Conversation last month, Ralf Steinhauser (Australian National University) explains the idea of drip pricing:

You see a fantastic offer, like a hotel room. You decide to book. Then it turns out there is a service fee. Then a cleaning fee. Then a few other extra costs. By the time you pay the final price, it is no longer the fantastic offer you thought.

Welcome to the world of drip pricing – the practice of advertising something at an attractive headline price and then, once you’ve committed to the purchase process, hitting you with unavoidable extra fees that are incrementally disclosed, or “dripped”.

Drip pricing – a type of “junk fee” – is notorious in event and travel ticketing, and is creeping into other areas, such as movie tickets. My daughter, for example, was surprised to find her ticket to the Barbie movie had a “booking fee”, increasing the cost of her ticket by 13%.

Steinhauser then goes on to explain why consumers are susceptible to drip pricing, blaming present bias and loss aversion:

In the case of booking that hotel room, you could abandon the transaction and look for something cheaper once the extra charges become apparent. But there’s a good chance you won’t, due to the effort and time involved.

This is where the trap lies.

Resistance to the idea of starting the search all over again is not simply a matter of laziness or indecision. There’s a profound psychological mechanism at play here, called a present-bias preference – that we value things immediately in front of us more than things more distant in the future...

Beyond the challenge of starting over, there’s another subtle force at work when it comes to our spending decisions. Drip pricing doesn’t just capitalise on our desire for immediate rewards; it also plays on our innate fear of losing out.

This second psychological phenomenon that drip pricing exploits is known as loss aversion – that we feel more pain from losing something than pleasure from gaining the same thing...

Imagine you’re booking tickets for a show. Initially attracted by the observed headline price, you are now presented with different seating categories. Seeing the “VIP” are within your budget, you decide to splurge.

But then, during the checkout process, the drip of extra costs begins. You realise you could have opted for lower-category seats and stayed within your budget. But by this stage you’ve already changed your expectation and imagined yourself enjoying the show from those nice seats.

Going back and booking cheaper seats will feel like a loss.

In my view, Steinhauser is absolutely correct that drip pricing exploits consumers' quasi-rationality (that is, that consumers are subject to biases in their decision-making). However, he is not fully correct about the sources of the quasi-rational behaviour.

First, present bias would tend to work against drip pricing, because (using Steinhauser's example) consumers are weighing up the cost of the tickets (which they face now) against the benefit of the concert they will attend (which is in the future). If consumers weigh the present more heavily than the future, then the costs weigh more heavily than the benefits, which would work against the consumers paying the junk fees.

Second, Steinhauser is correct about loss aversion, but for the wrong reason. Nobel Prize winner Richard Thaler noted that people engage in mental accounting related to particular decisions. People like to keep their mental accounts in positive balances, and are reluctant to give up on something if the mental account has a negative balance, because that would result in 'booking a loss'. Since people are loss averse, they will only want to close mental accounts that have a positive balance.

What does that mean for a consumer buying a concert ticket? They have spent some time and effort selecting their seats and completing most of the booking process. That puts their mental account for the concert into a negative balance. So, facing a small additional fee seems like a good deal, when compared to closing the mental account with a loss. The consumer pays the fee. They don't necessarily feel happy about it, but it is better than the alternative. The only way to get their mental account for the concert into a positive balance is to attend the concert.

A related way of thinking about the process of buying concert tickets with junk fees is the concept of switching costs. Switching costs are the costs of switching from one seller to another, or from one good or service to another. In this case, for a quasi-rational consumer who is running a mental account for the concert, giving up on buying the ticket when they are faced with the junk fees creates a switching cost - the loss in their mental account. When consumers face high switching costs, they can become locked in to buying a product. The seller can then take advantage of their locked in consumers by increasing the price (which is what the junk fees effectively do).

If you are a strong believer in the tenets of neoclassical economics, then the consumer response to drip pricing seems somewhat at odds with rational behaviour. For a purely rational consumer, the time and effort spent on the booking process up to the time that they face the additional of the junk fees is a sunk cost. It shouldn't affect the decision about whether to proceed with buying the ticket or not, because that decision should depend only on the costs and benefits of attending the concert. If the junk fees increase the costs of attending the concert to such an extent that they are higher than the benefits of attending the concert, a purely rational consumer would stop the ticket-buying process at that point. However, a quasi-rational consumer, who is running a mental account for the concert, would be more likely to proceed with the purchase even when presented with the junk fees.

So, overall, drip pricing leads to more sales if consumers are quasi-rational than if consumers are purely rational. It's lucky (and very profitable) for the ticket sellers that so many of us are not purely rational consumers.

Gary Becker on human capital

In ECON110 this week, we've been covering the economics of education. In this topic we theorise that, from the perspective of the individual, education is an investment in human capital. This 'human capital theory' comes from the works of Jacob Mincer and from 1992 Nobel Prize winner Gary Becker, who sadly passed away in 2014 (although it was Arthur Pigou who much earlier coined the term human capital). So it is timely that the Economist has had two excellent articles on Gary Becker and human capital over the last couple of months. It was the second one, from The Economist Explains, that caught my attention this week, but I think the earlier article from August is better so I'll quote from that one:

...human capital refers to the abilities and qualities of people that make them productive. Knowledge is the most important of these, but other factors, from a sense of punctuality to the state of someone’s health, also matter. Investment in human capital thus mainly refers to education but it also includes other things—the inculcation of values by parents, say, or a healthy diet. Just as investing in physical capital—whether building a new factory or upgrading computers—can pay off for a company, so investments in human capital also pay off for people. The earnings of well-educated individuals are generally higher than those of the wider population...

Becker observed that people do acquire general human capital, but they often do so at their own expense, rather than that of employers. This is true of university, when students take on debts to pay for education before entering the workforce. It is also true of workers in almost all industries: interns, trainees and junior employees share in the cost of getting them up to speed by being paid less.

Becker made the assumption that people would be hard-headed in calculating how much to invest in their own human capital. They would compare expected future earnings from different career choices and consider the cost of acquiring the education to pursue these careers, including time spent in the classroom. He knew that reality was far messier, with decisions plagued by uncertainty and complicated motivations, but he described his model as an “economic way of looking at life”. His simplified assumptions about people being purposeful and rational in their decisions laid the groundwork for an elegant theory of human capital, which he expounded in several seminal articles and a book in the early 1960s.

His theory helped explain why younger generations spent more time in schooling than older ones: longer life expectancies raised the profitability of acquiring knowledge. It also helped explain the spread of education: advances in technology made it more profitable to have skills, which in turn raised the demand for education. It showed that under-investment in human capital was a constant risk: young people can be short-sighted given the long payback period for education; and lenders are wary of supporting them because of their lack of collateral (attributes such as knowledge always stay with the borrower, whereas a borrower’s physical assets can be seized).

So many of the things we covered in class this week are found there, including the decision about private investment in education, the credit constraints that low income students face in borrowing towards their education costs (which is part of the rationale for a system of student loans), and one of the rationales for government involvement (that students would under-invest in their own education). Even though, as the article notes, behavioural economics has been used to attack the foundations of Becker's theories, on that last point I think behavioural economics actually makes the case stronger. One of the biases that behavioural economics has identified is present bias - quasi-rational decision-makers heavily discount the future (much more so that a standard time-value-of-money treatment would). Since the benefits of education happen in the future, those benefits are discounted greatly compared with the costs of education that occur in the present. So, quasi-rational people would tend to under-invest in education because they under-weight the value of the future benefits relative to the current costs.

The whole article (or both articles) is a good introduction to Becker's work on human capital. For a broader perspective on Becker's work, from the man himself, I highly recommend his 1992 Nobel lecture.

Incentives and the loss of the Kiwisaver kick-start

Sometimes I wonder. Do politicians really not understand the role of incentives? Or are they deliberately ignoring them. Exhibit A is the daft statement by John Key about removing the $1000 Kiwisaver kick-start in last year's Budget: the change will "...not make a blind bit of difference to the number of people who join." Well, it turns out the change did make a blind bit of difference, as this New Zealand Herald article notes:

The number of people signing up to KiwiSaver has slowed significantly since the removal of the $1000 kick-start...

Analysis by the Herald shows the average number of people signing up to KiwiSaver per month was 15,029 in the year to June 2015 and 16,976 in the year to June 2014.

But since finance minister Bill English scrapped the kick-start incentive in last year's May Budget sign-ups have fallen to an average of 8996 per month with the lowest sign-up level, in October, below 8000.

None of this should be a surprise. Rational (and quasi-rational) decision-makers weigh up the costs and benefits of their decisions. If you remove the $1000 kick-start from Kiwisaver, then this reduces the benefits of joining, while the costs remain the same (lower consumption today), and at the margin at least some people will choose not to join. It turns out that 'some' people is actually quite a lot of people - nearly half of those who would have joined. [*]

Moreover, quasi-rational decision-makers are affected by present bias - they weight costs and benefits that occur now much more heavily (compared with costs and benefits that occur in the future) than they should (e.g. what economists refer to as hyperbolic discounting). So, that $1000 lost benefit carries much more weight in the decision about joining Kiwisaver (or not) than it should. The benefit is still lower and highly salient even if you point out that there are significant other benefits of joining Kiwisaver. For example, from the same article:

Matthews said the trend was disappointing but not a surprise given human behaviour.

"To me what that signals clearly is a lack of financial literacy because within two years you have $1000 from the government in terms of the member tax credit.

"Over the life of KiwiSaver, $1000 is insignificant."

Those other benefits were present before the kick-start was removed, and are present after. So, nothing has changed in that respect. So if a person hadn't already joined Kiwisaver, they probably aren't going to change their minds in a hurry as a result of benefits that were already present. What changed was the kick-start benefit was lost, and as the data show pretty clearly, the numbers signing up for Kiwisaver declined substantially. Incentives matter!

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[*] Now, a reduction in signups could be expected because as a higher proportion of the population join Kiwisaver, there are fewer non-members left in the population to sign up. But, it's unlikely to have had that dramatic and sudden an effect!