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Review Session 4 Land Markets

Review Session 4 Land Markets. Catalina Martinez c atalina.martinez@graduateinstitute.ch Office hours: Tuesdays 6-8pm Rigot 27 Economics and Development MDev 2012-2013 THE GRADUATE INSTITUTE | GENEVA. Agenda. Land markets: Risk tenancy contracts Marshallian inefficiency

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Review Session 4 Land Markets

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  1. Review Session 4Land Markets Catalina Martinez catalina.martinez@graduateinstitute.ch Office hours: Tuesdays 6-8pm Rigot 27 Economics and Development MDev 2012-2013 THE GRADUATE INSTITUTE | GENEVA

  2. Agenda • Land markets: • Risk tenancy contracts • Marshallian inefficiency • Your questions

  3. Introduction • Proper functioning of the land market is very important for the overall development of the economy. • Various concepts involved: • Asymmetric information: principal-agent (moral hazard: effort is difficult to monitor) • Risk: tenants tend to be more risk averse and this influences the tenancy agreement. • Efficiency: marshallian inefficiency • Complete markets: unmarketable inputs (management and supervision) • Inequality: distribution of land influences which tenancy agreement will prevail.

  4. Tenancy contracts • Sharecropping: • The tenant gets only a share of what is produced (usually half), but shares also the risk. • Fixed rent: • The tenant gets everything that is left over after paying the rent but bears all the risk. • Fixed wage: • The tenant gets a fixed income and the landlord bears all the risk.

  5. Risk and tenancy • Agricultural production is subject to random shocks: weather, biological diseases, etc. • We can consider a case in which only two levels of output are possible: • G (good) with probability p • B (bad). • We assume that a wealthy landlord is less risk-averse (thanks also to diversification of incomes) than his tenant.

  6. Risk and tenancy: the landlord • With a fixed-rent contract, the tenant will have to pay R (rent) regardless of the output generate by the plot of land, receiving: • G-R if things go well with probability p • B-R if things go bad • If we want the (risk-neutral) landlord to be indifferent between sharecropping and the fixed rent contract we must have: • This implies that the expected return from the fixed rent and sharecropping contracts are equal. • Therefore,

  7. Risk and tenancy: the tenant • The return in the good state under sharecropping is lower than with the fixed-rent contract. • However, the return in the bad state is higher in sharecropping. • The variance from the point of view of the tenant is higher under fixed income. • Since he is risk averse, he will choose sharecropping.

  8. Risk and tenancy: the tenant • Outcomes of good state for tenant: • Sharecropping: (1-s)G • Fixed rent: (G-R) • Difference between sharecropping and fixed rent is negative: the tenant would prefer fixed rent. • Outcomes of bad state for tenant: • Sharecropping: (1-s)B • Fixed rent: (B-R) • Difference between sharecropping and fixed rent is positive: the tenant would prefer sharecropping.  If the expected returns are identical and the tenant is risk-averse, he will prefer sharecropping, as it reduces the variability of his outcome.

  9. Risk and tenancy: the tenant • Expected return from sharecropping: • Expected return from fixed rent: • Even if the expected returns are identical and the tenant is risk-averse, he will prefer sharecropping, as it reduces the variability of his outcome.

  10. Example • Good state=500 with p=50% • Bad state=100 with 1-p=50% • Rent=200 • Share=50% • Expected return under sharecropping: 50%*(50%*500) + 50%*(50%*100) = 125-25 = 100 • Variance under sharecropping: 50%*(50%*500-100)2 + 50%*(50%*100-100)2 = 50%*(150)2 + 50%*(-50)2 =12,500 • Expected return under fixed rent: 50%*(500-200) + 50%*(100-200) = 100 • Variance under fixed rent: 50%*(500-200-100)2 + 50%*(100-200-100)2 = 50%*(200)2 + 50%*(-200)2 =40,000

  11. Risk averse tenants will prefer sharecropping • Sharecropping reduces the variability of the tenant income. • Since the tenant is risk averse, he will prefer sharecropping. • This will allow the less risk averse landlord to extract some additional rent (to increase the expected value of his returns) as a compensation for the risk he is bearing.

  12. Fixed wage • Under fixed wage, the landlord keeps all the output and pays a fixed wage to the tenant. • This makes the tenant have a constant income. • Why not transfer completely the risk on the landlord? • Landlords are not necessarily risk-neutral • Incentive problems (asymmetric info: imperfect monitoring) • It is difficult to monitor the effort of the tenant • It is costly • Moral hazard..

  13. MarshallianInefficiency • Sharecropping is seen as less efficient system than fixed-rent tenancy. • The argument dates back to Adam Smith and Alfred Marshall and is mainly based on the idea of the appropriate provision of incentives. • The effort of the tenant cannot be perfectly monitored and controlled by the landlord. • In the case of sharecropping the tenant has an incentive to undersupply his effort, as a fraction of the output produced is transferred to the landlord.

  14. Sharecropping B Production Function A Output, Costs The tenant maximizes his production given his costs If he could keep all the production, the optimal choice of labor is L* Under sharecropping the optimal choice is L’ C E Production Costs D L’ L* Labor

  15. Fixedrent B Production Function A The tenant maximizes his production given his costs If she could keep all the production, the optimal choice of labor is L* Under fixed rent the production function is shifted downwards, and the optimal choice is still L* Output, Costs Fixed rent C E Production Costs D L* Labor

  16. Why does sharecropping persist? • Risk aversion and lack of insurance • Unmarketable inputs (Eswaran and Kotwal) • One hour of the landlord’s time devoted to supervision is just a fraction of the tenant’s time: Tenants are better at supervising (monitoring) • One hour of the tenant’s time devoted to management is just a fraction of the landlord’s time: Landlords are better at managing (knowledge) • For low values of the gammas, sharecropping prevails. • These two inputs have to do with information. As it becomes more widely available (markets), sharecropping is less likely to persist.

  17. Why does sharecropping persist? • Land distribution (Eswaran and Kotwal) • To the extent that access to information is correlated with land ownership, a more equal distribution of land makes sharecropping less likely. • Land is also a collateral…allows peasants to be less risk averse…

  18. Questions

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