BUSI 300 Lesson 7 Flashcards
Briefly explain what the terms “myopia” and “perfect foresight” mean, in terms of economics
In economics, these terms are used to describe expectations about the future. If a person is “myopic”
in this context, it means that he or she cannot see into the future, and assumes that current economic
conditions will persist forever. In contrast, a person who has “perfect foresight” knows the future with
certainty and uses this information when deciding on a course of action.
In the model of incremental growth presented in the text (with durable capital and myopic landowners), the city grows by adding a small amount of new development at the edge of the city in each time period. The amount of new development is just sufficient to accommodate that period’s population growth, and the density of new development is determined by economic conditions in that time period.
(a) What are the two basic economic factors that influence the density of new development in this model?
(b) Briefly describe the “sawtooth” population density function that occurs in this model and why this pattern occurs.
(c) Is it possible for population density to rise with distance in this case? Explain.
(a) From Equation 8.2, the basic economic factors are incomes and transportation costs.
(b) In this model the city grows by adding a bit of new development in each time period where the
density of new development is determined by current economic conditions. If economic conditions change between time periods, then the density of new development will “jump” at the borders between the time periods, giving the sawtooth pattern shown in Figure 8.4.
(c) Yes, if economic conditions change so that the optimal density in a later time period is higher, then population density may rise with distance. For example, if incomes fall over time, then individuals will demand higher density housing in each new area of development at the edge
of the city.
State the rule that governs when a property should be redeveloped. What types of properties are good candidates for redevelopment?
“Redevelopment should occur when the value of a new property (with its currently optimal lot size and
structure) exceeds the value of the existing property on a parcel (with its historical lot size and structure)
by more than the cost of demolition.” Properties that are good candidates for redevelopment are thus
properties where historical development is far below the level or standard of development that would
be optimal today, and where demolition costs are small. The standard example is an older residential
structure that may be thoroughly depreciated, out of date, or simply too small for today’s market.
Describe the relationship between house prices, city size, and the rate of population growth. Why are average prices higher in larger cities? Why are average prices higher in cities that are growing more quickly?
Prices are higher in larger cities because accessible locations are scarce there. Location premiums are
larger in big cities than in small ones. Prices are higher in growing cities because future rents are
expected to be higher there, and these expected future rent increases are compounded into current land
and housing prices.
Suppose you own a parcel of land that has a highest best use today for single family housing. If you develop the parcel in this use today, you will receive $10,000 in net rent this period and $15,000 in net rent next period. If you delay development until period 2, the highest and best use of the land changes to condominiums, in which the land generates a net rent of $30,000. Assume that rents are paid at the beginning of each period, that there are only two time periods to consider, and that the discount rate is 8%. Support your answers with calculations.
(a) What is your optimal development strategy? Explain your reasoning.
(b) How does your answer to part (a) change if the discount rate is 50%?
(c) Suppose that the rent that the land earns if optimally developed in period 2 is $25,000 instead of $30,000. Would it ever be desirable to delay development in this case? Explain.
(a) The present value of the rent stream if you develop today is 10,000 + 15,000/(1.08) = $23,889.
The present value of delaying development is 30,000/(1.08)= $27,778. Therefore, your optimal strategy is to delay development.
(b) The value of current development is now 10,000 + 15,000/(1.5) = $20,000. The value of delaying development is now 30,000/(1.5) = $20,000. Thus, you are indifferent between developing now and delaying development under these conditions.
(c) No. The present value of current development is always higher in this case, no matter what the discount rate is. The two development strategies give the same total earnings, but delaying development places more of the income in the future, which makes it less valuable.
If a person is/has _________, it means that he or she cannot see into the future, and assumes that current economic conditions will persist forever.
(1) perfect expectations
(2) perfect foresight
(3) myopia
(4) All of the above answers are correct.
Answer: (3) If a person is “myopic,” it means that he of she cannot see into the future and they base their decisions only on economic conditions as they are today.
The economic conditions in period 0 are U* = 7, Y = 120 and t = 6.
What is the equilibrium land rent for new development in period 0 at a distance of 5 kilometres?
1) $3.21
2) $41.33
3) $4.59
4) $61.73
Answer: (2) The equilibrium land rent function for new development in period 0 is ro(d) = 1/(4U0*^2) × (Yo - to × d)^2, which equals 1/(4 × 7^2) × (120 - (6 × 5))^2 = (1/196)(120 - 30)^2 = (1/196)(8,100) = 41.3265306122.
The economic conditions in period 0 are U* = 7, Y = 120 and t = 6
What is the equilibrium population density on newly developed land in period 0 at a distance of 2 kilometres?
(1) 1.1020 persons per square kilometre.
(2) 3.8571 persons per square kilometre.
(3) 83.8367 persons per square kilometre.
(4) 120 persons per square kilometre.
Answer: (1) The equilibrium density function for new development in period 0 is Do(d) = 1/(2Uo*^2) × (Y - to× d), which equals 1/(2 2 7^2) × (120 - (6 × 2)) = 1/98 (120 - 12) = (1/98) (108) = 1.10204081633 persons per square kilometre.
The income in Red Deer is higher this year compared to last year, yet all other factors are the same. What does this increase in income do to Red Deer’s land rent and the population density functions?
1) An increase in income causes the land rent function to shift downward and density function to shift upward.
2) An increase in income causes both the land rent and population density functions to shift downward.
3) An increase in income causes the land rent function to shift upward and the density function to shift downward.
4) An increase in income causes both the land rent and population density functions to shift upward.
Answer: (4) An increase in income causes both the land rent and population density functions to shift upward.
If income is rising and a city has expanded over the last year from b to b , where does the new o1 development take place? (Assume land is frozen in its historical land use.)
1) New development only occurs in the interval between the old border b0 and the new border b1.
2) New development will occur anywhere inside the new border, b1
3) New development only occurs inside the old border, b0
4) This question cannot be answered without more information.
Answer: (1) Because development is durable, in the sense that lot sizes inside bo are given by their historical values from period 0, new development only occurs in the interval between the old border bo and the new border b1 . In other words, the city grows by adding a bit of new development at its edge. Inside bo, nothing changes.
What is the rule that governs when a property should be redeveloped?
1) Redevelopment should occur when the value of a new property exceeds the value of the existing property on a parcel.
2) Redevelopment should occur when the expected value of the new property is equal to or higher than residential standards.
3) Redevelopment should occur when the utility achieved by the new building is higher than the utility achieved by the old building.
4) Redevelopment should occur when the value of the new property exceeds the value of the existing property by more than the cost of demolition
Answer: (4) Redevelopment should occur when the value of a new property (with its currently optimal lot size and structure) exceeds the value of the existing property on a parcel (with its historical lot size and structure) by more than the cost of demolition.
Which of the following statements best describes the “sawtooth” population density function that occurs in the model of incremental growth presented in the text? (Assume that incomes continue to rise over time.)
1) The population density function rises and then falls over every period. This occurs because at the beginning of every period, land is in high demand and people purchase smaller lots of land. As the period goes on, the demand for the land decreases, resulting in a falling population density function.
2) The population density function has a sawtooth like design because as each period passes, new economic conditions apply. New development will always be added within the new border and this new development will always contain higher density structures because more people will be living in the same area.
3) In the incremental growth model, the city grows by adding a bit of new development in each time period where the density of new development is determined by current economic conditions. If economic conditions change between time periods, then the density of new development will “jump” at the borders between the time periods, giving the sawtooth pattern.
4) In the incremental growth model the city is growing. Land near the border after each period has a higher demand than land just past the border. Therefore, the land at the border will have a higher population density and the result will be a sawtooth like population density function
Answer: (3) If incomes continue to rise over time, as the city expands population density will follow a sawtooth pattern. In this model, the city grows by adding a bit of new development in each time period where the density of new development is determined by current economic conditions. If economic conditions change between time periods, then the density of new development will “jump” at the borders between the time periods, giving the sawtooth pattern.
Which of the following statements is an example of a landowner with perfect foresight?
1) For the next five years, my property will make the most money being used as agricultural land. In five years, I will then convert it into residential land because a shift in the land market will make it more profitable for me to rent to residential users than agricultural users.
2) Based on present economic conditions, my property will be rented in the residential land market because this market will offer me the most money for my land. I am going to leave my property empty for the time being, then I plan to build a duplex on it.
3) It would cost me more to build on it now and then tear it down than to just leave it empty for awhile. Depending on how the market changes, I plan to build the duplex within the next ten years.
4) Options (1) and (3) are correct.
Answer: (1)
A landowner with perfect foresight chooses the date and form current development and future
redevelopment to maximize the present value of future land rents. This might involve different land
uses at different points in time. For example, it might be best to initially develop a parcel as housing
and then later convert it into a commercial use. In Option (1), the landowner knows which development
and future redevelopment will maximize the present value of his or her future land rents. Option (3)
is incorrect because this landowner does not have perfect foresight. A person who has “perfect
foresight” knows the future with certainty and uses this information when deciding on a course of
action. The landowner in Option (3) does not have perfect foresight; they are taking a guess on what
is going to happen in the future. Option (2) is incorrect because a landowner with perfect foresight will
not base his or her investments on current economic conditions. The investor will base it on current
and future conditions because he or she will know exactly what is going to happen and what will make
the investor the most money.
Based on the information provided in Figure 8.6 in the Urban and Real Estate Economics text, which of the following items positively impact inter-metropolitan differences in land prices?
1) Increased crime and increased size.
2) Population growth and size.
3) Decreased crime and land prices.
4) Land prices and population growth
Answer: (2)
The data suggests that population growth, in addition to size, has an impact on inter-metropolitian
differences in land prices.
Assuming an investor has perfect foresight and the city will continue to grow, how much would he or she be willing to pay for an agricultural parcel of land one kilometre outside of the city boundary?
1) The investor would be willing to pay an amount equal to the agricultural land rent.
2) The investor would be willing to pay less than the agricultural land rent because the land is not right next to the city boundary. As you move away from the city boundary, land rent decreases.
3) The investor would be willing to pay more than the agricultural land rent because the present value of the future land rent is higher than the present agricultural land rent.
4) This question cannot be answered without more information.
Answer: (3)
Agricultural land near the city border of a growing city sells for a price in excess of the present value
of the agricultural land rent. The growth premium declines as one moves out farther away from the city
boundary because the expected conversion date (from agricultural to residential) moves further into the
future; future rent increases on these parcels are discounted more heavily. The growth premium
becomes larger as the expected rate of population growth increases.
