Land and Natural Resources Part Two – Trade and Exchange

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In part one of this two-part series of essays we explored the utility, value, profits and losses that are associated with a single human’s action in relation to land and natural resources. In this second part we will now turn to a consideration of the same in a world where there are multiple humans and the economy is a complex one of trade and exchange of these resources.

Land Settlement in the Complex Economy

Where we have a world of many humans each of them are, at birth, in the same position as our lone human at his birth. They are gifted their own bodies, their standing room and a set of free goods that they do not need to make the object of their action in order to derive utility from. Every action thereafter will be taken at a cost with the object of receiving a gain that will outweigh that cost. To reiterate again these costs and gains must be estimated in advance and so every action is only speculative; there is no certainty that an action will, in fact, yield a gain. In a world of trade and exchange land and its product will trade for money and so these gains and costs will, likewise, be estimated not in terms of land’s physical product but in terms of the money that they will fetch in exchange. Now, therefore, leaving aside mental appreciations such as aesthetics or personal value attached to specific areas of land such as one’s home, we are not talking about merely psychic profits and losses but the actual revenue and outflow of money from operations with natural resources. In other words, how can one make money from using natural resources and how can we categorise the components of this income?

The first, if seemingly trite, observation concerning an unsettled plot of land is that no one has estimated the land as being valuable. In other words no one yet believes that the revenue to be gained from settling this land will outweigh the cost of doing so. Existing settlements or other prospects are deemed to be more valuable than settling the plot in question. The prices of the scarce resources that will be devoted towards settling the plot are being bid up by other potential uses and people estimate that the yield from the land will not be sufficient to cover these costs. Where, therefore, one human decides to settle land it will be because he, uniquely, decides that this land will, in fact, yield a definite gain and that everyone else is in error in leaving the land fallow. Let us again take the example of Plot A, demonstrating now the gains and costs not in terms of physical product but in terms of money. There are only three possibilities:

  1. Plot A will make a profit;
  2. Plot A will break even;
  3. Plot A will make a loss.

Let us examine each of these possibilities in turn, assuming again that the prevailing rate of interest will apply a 10% discount to the gross yield in each year. In scenario 1, we will take the gross yield to be £200K per year with the costs amounting to £100K per year. We can illustrate the net gain as follows in Figure A:

Figure A

Year      Gross Yield        Costs                Gross Gain        (Discount)          Net

1          £200K               £100K               £100K               (£10K)              £90K

2          £200K               £100K               £100K               (£20K)              £80K

3          £200K               £100K               £100K               (£30K)              £70K

4          £200K               £100K               £100K               (£40K)              £60K

5          £200K               £100K               £100K               (£50K)              £50K

6          £200K               £100K               £100K               (£60K)              £40K

7          £200K               £100K               £100K               (£70K)              £30K

8          £200K               £100K               £100K               (£80K)              £20K

9          £200K               £100K               £100K               (£90K)              £10K

10         £200K               £100K               £100K               (£100K)            £0K

The result of this has been a net profit for the land settlor. The land has actually turned out to yield more monetary income than was estimated by everyone else. In other words, everybody else was incorrect in estimating that the land would not produce an end that is more highly valued than some alternative. Rather, the product of the land is more highly valued than other ends to which the scarce factors of production could have been allocated and this value will be imputed back to the land itself so we can say that the land will have a capitalised value equal to the sum of the final column which, in this instance, is £450K. We will return to this again shortly but before that we shall examine scenarios two and three. In the former, it should be obvious that there will be no net gain at all. Let us illustrate this by assuming that the land will still yield £200K per year but now costs have risen to an equal amount:

Figure B

Year      Gross Yield        Costs                Gross Gain        (Discount)          Net

1          £200K               £200K               £0K                   (£0K)                £0K

2          £200K               £200K               £0K                   (£0K)                £0K

3          £200K               £200K               £0K                   (£0K)                £0K

4          £200K               £200K               £0K                   (£0K)                £0K

5          £200K               £200K               £0K                   (£0K)                £0K

6          £200K               £200K               £0K                   (£0K)                £0K

7          £200K               £200K               £0K                   (£0K)                £0K

8          £200K               £200K               £0K                   (£0K)                £0K

9          £200K               £200K               £0K                   (£0K)                £0K

10         £200K               £200K               £0K                   (£0K)               £0K

In this instance what is produced is exactly what is paid out in costs and there was, therefore, absolutely no point in settling the land. While there has not been a loss and the settlor is not in any worse position than he was before, there has also been no gain and the entire operation has been pointless. What about scenario three? Now let’s assume that costs remain at £200K but that now the land only yields £100K of gross income:

Figure C

Year      Gross Yield        Costs                Gross Gain        (Discount)          Net

1          £100K               £200K               (£100K)             £10K                 (£90K)

2          £100K               £200K               (£100K)             £20K                 (£80K)

3          £100K               £200K               (£100K)             £30K                 (£70K)

4          £100K               £200K               (£100K)             £40K                 (£60K)

5          £100K               £200K               (£100K)             £50K                 (£50K)

6          £100K               £200K               (£100K)             £60K                 (£40K)

7          £100K               £200K               (£100K)             £70K                 (£30K)

8          £100K               £200K               (£100K)             £80K                 (£20K)

9          £100K               £200K               (£100K)             £90K                 (£10K)

10         £100K               £200K               (£100K)             £100K              (£0K)

Here the settlement was entirely erroneous and will result in year after year of net losses for the settlor. He estimated incorrectly that the yield from the land would be sufficient to cover the costs and, in fact, there were more valuable uses to which these costs could have been devoted. The entire operation has been a waste and the land will simply be abandoned1.

Let us now turn back to scenario one where the land yielded a profit. We noted that the settlor realises a gain upon the realisation that the land will produce a yield the value of which exceeds that of its costs. Once again, as in part one, we must emphasise that this gain is earned not by the “productivity of the land” or its “natural powers”. The land was only doing that which it is under the orders of the laws of physics to do. Rather the earnings, the net income, are wholly the reward of the decision of the settlor to turn that land into productive use, a decision that resulted from his judgment that the land would yield more than its costs, an outcome that was, furthermore, clouded with uncertainty. Everyone else was free to make the same decision and to settle the land first but nobody did. To the extent, therefore, that a person earns a net income from productive use on the land it is only because this person, uniquely, has realised that devoting scarce resources to its settlement and use will yield a stream of utility that is more valuable to consumers than that which existed before. It was his decision that created the increase in value with the resulting flow of productive services, and it is to this aspect that the net income flows.

If this is doubted then we should consider the situation of the evenly rotating economy where all revenues equal cost. In other words there is trade and activity but all the utility of what is received from an action equals exactly the utility of that which is foregone. So if the produce of land yields £200K per year then the landowner will have to pay precisely £200K per year in costs2. If this was the way the world worked then it should be clear that there is no room at all for uncertainty and for decision making. If it is certain that there is no realisation of value, that nothing could ever be made better, then there is no premium to be put on the making of judgments that results in decisions. Net income disappears precisely because there is no need for these aspects. It is only because we live in a world where things can be made better and that this betterment is shrouded in uncertainty that a judgment must be exercised in order to realise it. Good judgments that direct the scarce resources available to a stream of utility that is more preferable than that given up are rewarded with net income. Bad judgments which waste those resources on ends that are not preferred are penalised with losses.

What about, for the sake of completion, a world where things could be made better but that the improvement is certain? That if we made a decision we would know for sure that the outcome would exactly be as intended so that, in other words, everyone’s judgment would exactly predict what would happen. If this was so then everyone’s judgment and everyone’s decisions would be exactly the same. A person can only profit from a decision because everyone else has underestimated the value of the yield from a productive activity, this underestimation resulting in an underbidding for the productive resources that are devoted to that activity. If, however, everyone knew the outcome then there would be no underbidding at all and all costs of production would be bid up fully to the height of the revenue of the resulting product. Hence, there would be no net income.

Therefore our conclusion can only be that the realisation of value is a product of superior human judgment.

Going back to our landowner does he now realise a constant, year on year net income from his ownership of the land? Unfortunately for him he does not. For the £450K worth of net income, representing the capitalised value of the land, is was he earns now and correspondingly takes its place in his rank of values now. It must therefore be ranked alongside other actions which could be more or less valuable now and while he hangs onto the land he always bears the opportunity cost of foregoing other actions. In the case of our lone human in part one this was the result of having to decide whether to continue to produce on the current plot of land or whether to stop and move to an alternative piece of land. In the complex economy, however, the decision that must constantly be assessed and remade is whether to hang onto the land or to sell it to a purchaser. Let us examine the ramifications of this necessity.

Trade of Land

In the first place, let us assume that the net present value of the land – £450K – is not only correct but that also all entrepreneurs know that it is correct and that this is certain. In other words the precise yields from and costs of production on the land are as they are in Figure A above and everyone knows that there will be no deviation from this schedule. What this means is that the purchase price will be bid up to exactly this net present value – £450K – with all potential suitors offering not a penny more and not a penny less. The decision for the landowner is a very simple one – to carry on with production of the land and wait for the fruits of its productivity; or to sell and to accept the present value of this future yield now in cash. The result of this is to impose upon our landowner an opportunity cost that completely wipes out any continuing net gains in income. As he can take the present value of the yield in cash the foregoing of this opportunity through holding onto the land will leave him only with interest from the future yields, i.e. the difference in value of the future yields when they mature and the capitalised value of the land now.

In reality, however, the situation is much different. Rather than everyone knowing the future yields of land they constantly have to be estimated. As we said in part one there are at least four factors that affect this:

a)     Direct costs of farming a plot will change from year after year and must be estimated in advance of their occurrence;

b)     Opportunity costs will change from year after year and, likewise, must be estimated;

c)      The gross yield of a plot of land is not certain in advance; rather, factors such as the weather, seed quality and soil deterioration will intervene;

d)     The discount to be applied to future gains is dependent upon the individual’s time preference rate which is subject to change.

To this we may add one more:

e)     The precise end to which the land is devoted also has to be decided. Should it be used for farming, for the building of a factory, or for building houses? Which of these streams of utility is most valuable to the customers who will provide the revenue?

Every entrepreneur, therefore, including the present land owner must constantly assess and estimate the effect on the productivity of the land by these aspects and this list is not necessarily exhaustive. Having estimated the future yield, each entrepreneur will discount it to a net present value resulting in a price that he is willing to pay for the land now3. Let us look at the mechanics of this fact in situations that lead to a profitable outcome for our landowner. Let’s say that there are three entrepreneurs, A, B and C, of whom our current landowner is entrepreneur A. Each engages in his estimation and calculates the following net present values of the land:

A        £450K

B        £350K

C        £250K

In this instance every other entrepreneur estimates the net present value of the land as being lower than the estimate of A. As A estimates that there is more to be gained from holding onto the land and selling its produce at a later period in time than from selling the land now then he will refuse to sell the land to the highest bidder which is B. If A is correct and the land yields a produce that is more than the estimate of the next highest bidding entrepreneur (let’s say that A’s estimate is precisely correct) then what is the analysis of A’s income? As his opportunity cost was to sell the land for £350K and earn interest on this sum, his actual outcome has been to hold onto the land and earn interest on a sum of £450K. The difference between these two will therefore form a net income – an income that A received solely because he estimated the produce of the land as being higher than that of rival entrepreneurs. Examining each of our criteria a) through to e) above he could have done this a number of ways and, in practice, a combination of them will always be active:

a)     A more accurately estimated the costs of farming the land as being lower than the estimates of B or C; or the methods that A chose in farming the land were less costly than those that B or C would have employed. A’s economy therefore conserved scarce resources to be released for employment towards the fulfilment of other ends.

b)     A accurately estimated that the other opportunities available to him would yield a lower (if any) net income than holding onto the land;

c)      A more accurately predicted the conditions of farming than B or C; the latter might have erroneously predicted more unfavourable farming conditions which led to their lower estimates;

d)     This is a little more complex and will be examined when we discuss land hoarding and speculation (below). Suffice it to say that A may have more accurately estimated the future societal rate of time preference than B or C and hence the discount to be applied to the future yields;

e)     And finally, A might have devoted the land to an end that is more valuable in the eyes of consumers than B or C would have done and thus the consumers were willing to pay a higher amount for its produce than for the produce that B or C might have churned out from the same land4.

Let us say that having witnessed A’s burst of productivity, B and C revise their estimations of the land’s capabilities. For argument’s sake, A maintains his estimate at the previous level:

A        £450K

B        £550K

C        £350K

Here what should be clear is that A now has the opportunity to sell the land for a net present value that is greater than his estimate of the same. He believes that B has overestimated its productivity and will incur a loss if he purchases for that sum. A therefore cashes in by selling to B and earns interest on the sum of £550K. To his horror, however, B finds that the land only yields a present value of £450K and hence he earns interest on this lower sum. It would have been better for B to have foregone the purchase and held onto the cash, earning interest on £550K instead of £450K. The difference between these two therefore represents B’s loss and A’s profit. The loss of B has accrued to a bad decision, a decision to devote the scarce resources available to an end that was less productive than that estimated. The reader can examine our criteria a) – e) above in order to speculate upon the source of B’s error, but the important point is this: where there is a net income it results from diverting the scarce resources to an end more highly valued than that estimated by other entrepreneurs. A loss is made when resources are devoted to an end that is less highly valued than that estimated by the same. Good decisions and beneficial use of scarce resources therefore yield a reward – a net income, a profit. Bad decisions and the waste of resources are punished with losses. Net income therefore flows to good decision-making ability and it is this ability alone – not any productive power of the land or any virtue of its ownership – that commands a premium in the marketplace5.

Now we shall turn to situations in which A’s decisions make a loss. Let us return to the first set of estimations:

A        £450K

B        £350K

C        £250K

A, obviously, will again choose to hold onto the land. But let’s say that in this scenario the land only yields £300K’s worth of income. It would have been better to have sold to B and made a presently valued profit of £50K rather than hold onto to the land and lose that opportunity. A’s decision was erroneous and this error was met with a loss. What about the second set of valuations?

A        £450K

B        £550K

C        £350K

Again A will sell to B in this scenario. A thinks that B is a fool in this scenario for thinking that he (B) can ever ring out £550K’s worth of productivity from the land and A congratulates himself for having made a handsome profit. But what if the land actually yields a presently valued income of £650K? In this instance, therefore, it would have been better for A to have held onto the land and carried on production. Instead he sold it and the passing up of this opportunity imposes a loss upon him.

What we realise, therefore, is that all present and prospective landowners constantly bear the burden of having to assess the future income from land. Present landowners have to determine whether the future income will outweigh the purchase prices offered by prospective buyers. The latter have to determine whether they can offer a purchase price that is outweighed by the future income. Those that make the most accurate decisions in this challenge are those that devote the scarce resources available to their most highly valued ends. They took the decision to direct their resources in this way in the face of uncertainty while nobody else did. The result is a net profit.

We should also add here that good decisions and good decision-making ability are determined relatively not absolutely – the profitable entrepreneur only has to be more accurate than the next entrepreneur. For example, let’s say that the land would yield a net present income of £650K and the following entrepreneurs estimate it as follows:

A        £450K

B        £350K

C        £250K

In this case it is obvious that A will hold onto the land and earn a net income when the yield of the land turns out to be worth a present value of £650K. But what if the estimations were as follows?

A        £450K (same as before)

B        £550K

C        £250K (same as before)

Here A will make the choice to sell to B. Yet even though his choice was derived from the same estimation as in the previous scenario, he now incurs a loss as it would have been better for him to have held onto the land and earn interest on £650K than to have taken £550K in cash. Looking at that same scenario from the buyer’s perspective, B now earns the profit. But what if there was a third set of valuations as follows?

A        £450K (same as before)

B        £550K (same as before)

C        £600K

Now, the profit maker is C. Therefore, even though the judgments that underpinned the decisions of A and B remained constant, the entry of a more accurate entrepreneur meant that the latter earned the profit and they did not. It is, therefore, the most relatively accurate decision in directing scarce resources to their ends that is rewarded. Clearly the same will also be true from the loss-maker’s point of view – a judgment that once was loss-making will become profitable if other entrepreneurs lose their accurate foresight.

Profit, therefore, can only be made when a person renders a valuable service that no one else is able to do. If entrepreneurial foresight becomes more prevalent and accurate its supply increases and, just like any other good, as supply increases then, all else being equal, the price it can command must diminish. If a piece of land yields £650K per year and the most accurate prospective purchaser bids £450K for it that he will earn a net present income of £200K. If, however, the market is suddenly flooded with entrepreneurial talent then each entrepreneur will bid up the land successively towards its mark of £650K. If an entrepreneur would bid £630K for the land then there is a chance for another, more accurate one, to bid, say, £640K. But the entry of a further, still more accurate entrepreneur could raise the purchase price to £645K with profit diminishing to a mere £5K. The extension of this situation would obviously be where every entrepreneur values the land exactly correctly and everyone would bid precisely £650K for it, with any chance of net income disappearing entirely. The existence of net income is therefore negatively correlated with the prevalence of good decision-making ability and as soon as the latter is abundant it ceases to command a high premium and profit comes close to disappearing.

In part one we questioned whether it was possible for luck to influence a person’s net gain. Could, for example, one buy or sell a piece of land having absolutely no idea whether it will yield a net income ahead of the purchase price? Or, alternatively, could one sell a piece of land without a single clue as to whether he is selling it for more than it is worth? In other words couldn’t someone just yield a profit by gambling rather than through any special entrepreneurial talent? If one makes a net income on these occasions then it states one of two things. First, as we said in part one, to consign one’s fate to luck is itself a decision and to the extent that it is more profitable than a carefully considered decision then it is the best decision. Secondly, if one makes a profit from gambling then it is still the case that resources were directed to an end that was more highly valued by consumers than that estimated by other entrepreneurs. In short, the gambler’s guess was better than anyone else’s decision and in its absence the economy would be worse off. It is the realisation of value that is rewarded, whatever the method through which it is achieved. It is just that in our world luck plays a very minor role in reaching this goal whereas good decision-making ability is most often needed.

Speculation and Hoarding

With all of this in mind let us now turn our attention to the speculation and hoarding of land. Land owners are often accused of sitting on fallow land and earning year on year profits while this land could be used for the fulfilment of vitally needed ends6. Can we square these facts?

The first question we have to address is why does fallow land have any capitalised value at all? If it isn’t being used for anything then how is it generating any value whatsoever? The answer to this can only be that, in the estimations of entrepreneurs, the land will not yield any valuable utility from a stream of production now but will, rather, yield the same from production that is begun in the future. Say, for example, that if entrepreneurs estimate that additional housing capacity is not required now but will be required in, say, ten years then the land’s ability to meet this end at that point in the future will be imputed back to the land itself and it will trade for a capitalised value. Obviously the discount applied to a utility only taking effect at such a far off point will impose a cumulatively heavy toll, but there would still be a capitalised value. Entrepreneurs therefore have to decide not only what to devote land towards but precisely when to do it and it is the differences of these estimations that permit one to earn a net income from the hoarding of land.

Let us say that A purchases a plot of land now with the intention to hold onto it without development and is able to earn a net income on this operation. There are two aspects to the explanation of this outcome. First, if all entrepreneurs are agreed as to when is the most suitable time to develop the land is then A can only make a profit if he more accurately estimates the value of the yields that result once this time is reached and the land is developed. This is essentially no different from what we discussed above – the only difference is that the first act of production will not be now but at some point in the future. But secondly, if entrepreneurs are not in agreement over when the most suitable time to develop the land is then A can make a profit by more accurately estimating this suitable time. Let’s say, for example, that the five entrepreneurs would develop the land after the respective intervals have elapsed following purchase and their estimations of the present value of the yields are as follows. Let us also assume, for simplicity’s sake, that each is correct in the estimation of what the land would yield after these intervals:

A        5 years         £600K

B        4 years         £500K

C        3 years         £450K

D        2 years         £210K

E        1 year           £130K

What this means is that E believes that the most productive use of the land will arrive after only one year and that he won’t, therefore, gain more than a present value of £130K by waiting either longer or shorter. D believes that two years is the correct period to wait and any longer or shorter will never achieve as high an income as £210K, presently valued. And so on for C, B and A. The latter, however, is the most accurate and he is the one who will purchase the land (in this case, offering only slightly more than the discounted value of B’s estimate in order to price B out of the market) and he will earn a profit. The effect of A’s action is to withhold the land from development that would otherwise occur too early and thus its direction to an end that is less valuable to consumers is prevented; rather the land is released for development right at the precise time when it is needed for fulfilling the most pressing end. A of course might be “incorrect” in an absolute sense – perhaps had he waited another year still (so six years in total) the land might have yielded a present value of £700K. But as the relatively most accurate entrepreneur he is the one who yielded the profit. Had another person, F, come along and bid £650K then A would not have earned that profit.

Related to this is the height of the societal time preference rate which determines the interest rate. As we said earlier, all future utility from land is discounted according to the prevailing rate of interest. But this too is subject to fluctuation and must be estimated, a point we noted earlier. If time preference lowers then the discount to be applied to future yields of land will diminish and hence the capitalised value of land will rise. On the other hand if time preference rises then the discount will be increased and the capitalised value of land will fall, its promise of future utility being less valuable to consumers. In practice this phenomenon tends to go hand in hand with the fact that land may yield its most valuable end not now but sometime in the future. For land is the ultimate remote good out of which capital goods must be furnished and increased demand for it is almost synonymous with a lowering of the societal time preference rate and a desire to engage in more roundabout methods of production and the creation of economic growth. The estimation, therefore, by entrepreneurs that land will yield a more valuable use not now but in the future also translates into estimating that the societal rate of time preference will be lower.

The allocation of resources across time is also one of the most difficult activities which must be faced by the present landowner, let alone a prospective purchaser. A failure to estimate how much to produce and when to do so has the potential to cause serious losses. The capitalised value of a copper mine, for example, will, as we know, represent the discounted value of all of the future copper that will be extracted from that mine. The choice of how much copper to mine this year is made not only in the face of current costs such as labour, equipment etc. but also the mine owner must consider the fact that any extraction of copper now will mean that there is less copper to be had in the future. If the mine owner extracts copper now then this will cause a write down in the capitalised value of the land as, the copper having been extracted, a portion of it is no longer there to provide for future utility. Whether or not the mine owner successfully allocates copper to the present or to the future depends on the relationship of the revenue from selling copper now on the one hand to the height of the write down on the other. If, having accounted for all other costs, the revenue he receives from selling a portion of the copper today is higher than the write down then this means that the present value of copper sold has a higher value than the same copper would have done had it been left under the ground. Therefore the quantity of copper that the mine owner brought to market was in line with the preferences of consumers and copper was not wasted by being mined too soon. On the other hand, if the value of the write down is higher than the revenue that is received then this means that the copper that is brought to market would have had a higher present value had it been left under the ground to be preserved for a future use. The copper was brought to market and supplied too early and consumers were not willing to devote it to an end today that is more valuable than an end at some point in the future. In short, the copper has been wasted and the resulting loss will penalise the mine owner for this oversight. It is for this reason why capitalism and free exchange provides the best method of conserving resources as the profit and loss system entices entrepreneurs to deploy them precisely when they can meet their most valuable ends.

Taxation of Land

It follows from the analysis in both parts of this series of essays that any attempt by the government to tax the proceeds from land must fall upon one of the three streams of income:

  1. Costs;
  2. Interest;
  3. Entrepreneurial Profit and Loss.

If costs are the target then clearly this just raises the cost per unit of productivity from the land. Within this category will fall all taxes on labour, direct taxes on the costs such as sales taxes, and the taxes that must be borne by suppliers. If, though, interest is the target then this has the effect of increasing the discount from future yields of land. The relative attractiveness of future goods will therefore decline and so too will any engagement in roundabout methods of production that lead to economic growth. Finally, a tax on entrepreneurial profit and loss will penalise the decision-making ability that directs resources to their most highly valued ends. There will, therefore be relatively less inclination to seek out the most valuable ends coupled with relatively more wasting of land as the lack of scrupulousness means that the land ends up being devoted to less urgent ends7.

All taxation on land will simply magnify the costs and reduce the gains. But it is important to stress its effect on our third category of income above, which relates to the entrepreneurial aspect of land ownership. The purpose of the analysis in these two essays has been to demonstrate that regardless of any natural qualities of the land or resource in question every decision and every action – even just holding onto the land – entails a cost that may outweigh its gain. Net gains from land ownership can only be had by demonstrating a relative entrepreneurial talent. They cannot be gained simply by owning land and sitting on one’s backside – there is no category of “unearned” or free income from land ownership that is ripe for taxation and there is no form of taxation that will be neutral on productivity.

At the beginning of part one, we stated that every action has a cost and a gain, the magnitude of each being uncertain. The only free or unearned “income” that a person ever has is his own body and standing room at the moment that he is born. Not only did we indicate in part one that these cannot be considered as “gains” as such but if one is adamant that unearned income should be taxed away then it follows that the only logical proposal to enact that policy is to tax birth. Is any advocate of the taxation of unearned income expecting to be able to propose such levy and, at the same time, to be taken seriously?

Conclusion

What we have sought to demonstrate in this two part series of essays is how an acting human can realise utility, gains, benefits, profits, losses and value from his actions in relation to land, including its use and its trade. We have concluded that the gross yield is directed to three sources – compensation for costs, interest, and entrepreneurial profit and loss. Finally we concluded that attempt to levy a tax on any one of these must have the effect of raising costs and decreasing gains, leading to a relative wasting of land.

View the video version of this essay.

1Alternatively, if the landowner was locked into the operation and had to suffer the repeated losses, the only way he could escape would be to transfer the land to someone else. But who would want to do this? Who would want to take on the burden of a loss-bearing piece of land? The only way that it could happen is if the current land owner was to compensate the purchaser for the future losses – in other words he would have to pay someone the net present value of each year’s loss, the sum of which is that of the last column in figure C – £450K. The interest earned on this sum will compensate the new landowner for the maturity value of the losses (£100K) as each year comes round. This situation is not unusual if you consider the possibility of an enthusiastic entrepreneur taking on burdensome and lengthy obligations to third parties in relation to the operation on the land.

2In most descriptions of the evenly rotating economy there would still be discounting as the costs are incurred at a period of time before the vending of the final product. Indeed one of the advantages of this imaginary construction is that it is able to explain the phenomenon of interest as being distinct from entrepreneurial profit and loss. If the land yields £200K then, applying a discount rate of 10% per annum, costs that are incurred one year earlier will amount to £180K.

3For the sake of simplicity we will ignore the effects upon price of bartering and assume that each purchaser would pay a purchase price equal to his valuation of the land.

4It might also be the case, of course, that A is simply a more productive labourer than B or C and can farm more produce per acre. But any gain in income from this aspect accrues not to A’s entrepreneurial decision-making ability but rather to the remuneration for his labour and this additional income would be categorised in the “costs” column of an analysis of the gross income from the land rather than in the “net income” column.

5We are not intending the words “good”, “bad”, “reward” and “punishment” to imply any moral evaluation of an entrepreneur’s actions; rather, the terms should be appreciated only to the extent that people prefer making profits to losses.

6The recent accusations of the leader of the UK Labour Party, Ed Miliband, were of precisely that.

7In practice, taxes on interest and profit and loss amount to the same thing as it is not possible to separate them from an accounting point of view.

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Land and Natural Resources, Part One – Human Action, Profits and Losses

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NOTE: The tables in this essay will be updated in due course so that they fit onto the page! Apologies for any difficulties in comprehension.

The economics of natural resources can be a complex and often controversial topic. It is not, in the end, a particularly difficult one and this set of two essays will lay out clearly how humans derive utility, value, profits and losses from the Earth around them. Part one will examine this in the “Crusoe” situation of a single, lone human, while part two will explore the implications arising from trade and exchange in a complex economy.

The Gifts of Birth

At birth, a human being is gifted two things by nature1 – his own body; and then a vast array of natural resources that are external to his body. A person does not come into existence without the physical manifestation of his body and this body’s uniqueness is resides in the fact that it is the only gift of nature that is intimately bound to his own will and is directly controllable. The second gift, viz. the remainder of all resources, consists, from the core of the Earth to the top of the atmosphere (and even further if we consider the possibility of space exploration), of densely packed atoms in various configurations as chemical elements and compounds. Here we have the essence of the two ingredients of all economising action – labour, the effort expended in the use of one’s own body, and land, the matter external to the body in the condition upon which a human discovers it. Part of the land will be used by the body after the first moment of birth, for the body cannot exist without three dimensional space; because of the nature of gravity this space will always take effect as a piece of physical land plus the air space above it necessary to accommodate the volume of the body, all of which we will summarise under the term “standing room”. At birth, therefore, the gifts that are immediately utilisable to a person are his body and his standing room.

To the extent that a person prefers being alive to being unborn we can say that the gifts of a person’s body and the land he uses as standing room are “gains” to him, that he has achieved something “better” than what he had before. However, given that a human is not consciously aware of any existence prior to birth means that it is far more convincing to state that his body and standing room are not gains but are, rather, the base line from which he begins. He cannot compare any mode of existence without having his body and standing room as a prior condition. The utility he derives from them, therefore, while being a gift, does not represent any conscious benefit or gain. He is merely at the zero point, the starting line of the remainder of his life.

What about the remainder of the land, that which does not form part of the standing room? In the absence of any human being, all of this “stuff” in the universe is precisely that – just stuff. Regardless of whether it is manifest as iron, oxygen, trees, animals, or as anything else, all matter is basically just a variety of atomic configurations. It yields no utility, no value, no ends, no satisfactions or anything. It is dead and inert, subject only to the physical laws of the universe and any condition in which it finds itself yields no service. When a human being comes along, however, all of the resources of the universe may yield to him utility – that is some kind of service or facility that contributes to his welfare2.

Let us assume that the human being remains in the position of his original standing room. In this situation, another resource will do one of two things; first, it may deliver him utility if it contributes to his general welfare but does not have to be consciously made the subject of his action in order to gain this welfare. The almost clichéd example is air – it is immediately available, served by nature in the form in which its qualities can be utilised by human beings, and this utility is available for all of time. Similarly, we may say the same thing of a beautiful view. The landscape does not have to be worked into a configuration to produce the view and it is, furthermore, everlasting. It is a gift of nature that will yield perpetual utility. Secondly, a resource might deliver him no utility whatsoever. Iron ore buried deep below the ground, for example, or trees on the other side of the world yield no service to our human and his condition or welfare would be the same without their existence3. In both of these two instances a resource is said to be non-scarce. Non-scarcity is determined when the quantity of an available resource exceeds the services (present and future) that it contributes towards human welfare4. With resources that simply produce no welfare whatsoever this is obvious, but this truth is less clear with resources that do provide welfare but nevertheless are so abundant that they still possess a non-scarce quality.

There are three important and directly related aspects to stress when understanding the qualities of the latter type of non-scarce resource. First, the resource must be in a condition in which one’s labour does not have to be directed from one end to another in order to utilise it. This is determined praxeologically and not physically. It is true, for example, that the body has to utilise energy to draw air into the lungs and then to exhale and that this energy could serve another purpose. Or, with the beautiful view, it is true that light waves have to reflect off the landscape into the viewer’s eye and that these waves must, in turn, be processed by the brain. But this physical exertion has no praxeological effect. For in order to qualify as the latter these physical aspects have to be appreciated by a human being. As long as a human inhales and exhales without any conscious thought or appreciation of the physical mechanics involved and as long as the sight of the beautiful view can be enjoyed without conscious knowledge of his body’s physical effort to produce that enjoyment then these purely physical matters are without substance in the realm of economics. Directly related to this is the second aspect which is that while a resource in its entirety may possess the same physical uniformity this does not mean that it is in a condition in which it is immediately utilisable without the intervention of labour. In other words, not all portions of a physically homogenous resource have equal serviceability to a human being. Water that is right next to me, for example, is physically the same resource as water that is twenty miles away, but praxeologically, i.e. in terms of the utility they each provide me, they are not the same resource but different resources as only the former may be enjoyed without my labour. Therefore, in order for a resource to be non-scarce, the portion of the total quantity of it that is physically homogenous and with which labour does not need to be mixed so that the resource’s utility may be received must be in a quantity that exceeds the needs of a human. In order to clarify this we will, hereafter, refer to a “resource” when we mean physical homogeneity (i.e. water), and to a “good” when we mean praxeological homogeneity (water next to me, water twenty miles away, water in the sea, etc.). Different goods, therefore, may have the same physical qualities but what determines their difference is their serviceability to a human being so, praxeologically, this difference makes a good a separate and distinct good from other portions of the same, physically homogenous resource5. Thirdly, the contribution to human welfare of a particular good is made by specific units of that good and not by the whole quantity of the good itself. Humans have no relation to categories of goods in their entirety, such as all of the air in the world or all of the gold, iron, wood, water, and so on, even if this is all available for their immediate use without the need to labour. Rather we only use these things in single, concrete portions to yield a particular service and hence, when we say that a good is non-scarce we mean that any individual unit is not consciously appreciated by a human. A single breath of air, for example, can be easily replaced by another breath, and there are enough units of air to satisfy a human’s need for it immediately and into the future of his life. Similarly, with the beautiful view, we may consider units of this view as being slices of time in which the view can be enjoyed. One unit of this view is just the same as any other and, from the point of view of the individual’s life, further units present themselves perpetually (this would be different, of course, if we knew that the view was going to be destroyed tomorrow). So, summing all this up, as long as the total quantity of units of a good that do not require the intervention of labour outweigh the needs of a human being then any individual unit will be unappreciated by that human and the good can be said to be non-scarce.

What do we mean when we say that being able to utilise a non-scarce unit of a good means that any human appreciation of this particular unit is absent? First of all, it means that the human experiences no gain. For there to be a gain then a previous set of circumstances must be replaced by a better (in his view), following set of circumstances. However, with a unit of a free good the circumstances are continuous – one unit of the good can only replace another unit of the same good. Similarly there is no conscious loss to a human if one unit should disappear as it can be replaced without effort by another. Hence an equally serviceable unit of the good is always available to be utilised – there is no transition from a period of being without to a period of being with. Similarly we can say that there is no benefit from utilising a single unit of a good. For a benefit implies some advantage, something “better”, but there is no benefit from utilising one unit of air – the condition of air’s presence and utility is on-going, so one particular unit provides nothing that was not already available. And finally there is no cost or burden associated with the utility of a unit of air – nothing has to be given up by the human in order to “enjoy” this utility. Crucially, what all of this means is that any single unit of air – and any single unit of all non-scarce goods – has no value. For all of these concepts – gains, costs, benefits, etc. – are all tied to the concept of valuation. For valuation is the comparison of one stream of utility against another – it is to prefer one to the other, i.e. to recognise a gain when one is achieved at the cost of losing another. None of this exists with units of non-scarce goods and so the utilisation of a unit of air, requiring no cost and achieving no gain, has no value. The very circumstances of air’s abundance, i.e. its complete non-scarcity, prevent the necessity of any kind of valuation. Again, without meaning to labour the point, all of these concepts – gains, benefits, costs, etc. – are to be understood praxeologically and not physically. Obviously air gives one a physical benefit and comes at the expense of physical costs but as long as there is no conscious gain and no conscious cost then these physical matters are irrelevant.

A unit of a non-scarce good, therefore, may yield unvalued utility – that the utility from the unit, a stream of service, is present, but it is not valued by the human. For the very essence of valuation is to desire, to prefer, to want or to need a certain stream of utility. But there is nothing about the relation of a human to a unit of a free good that demonstrates this. He reveals nothing about whether he prefers either the utility stream’s continuance or its cessation. Again, we must stress that this is only in relation to any particular unit of the good. We are not facetiously claiming that a person would not care if he was to lose all of his air and would not mind suffocating to death. We are only asserting that he does not care whether the utility rendered by one particular unit of air continues6.

In all cases, therefore, the condition of non-scarcity is dependent upon a quantity of immediately utilisable units of a good being sufficient to outweigh all of a human’s needs that can be serviced by that good. The utility present at a human’s birth, then, derives from his own body, his standing room and from non-scarce goods such as air. As we said above, this condition cannot be said to be “better” than anything else as there is no other condition from which the human has consciously been aware of departing from in order to arrive at it. Let us now, therefore, explore the condition when the human encounters scarcity, viz. when the quantity of an immediately utilisable good is not sufficient to outweigh all of a human’s needs that it can service.

Scarce Goods

Let us begin by positing a change in the condition at the “starting line” of a person’s birth. Let’s say the supply of immediately utilisable air was to diminish drastically to the point where further loss would cause a human to suffocate. The quantity of units of this good is now not sufficient to command all of a human’s needs. Air cannot be enjoyed as it once was as now each individual unit is not replaceable by another unit. The loss of one unit now very much entails a loss of service, a loss that wouldn’t have been experienced when air was available in abundant quantities. The result, therefore, is that the human is now confronted with a choice. With restricted air the choice is between whether to enjoy air now and risk suffocation in the future, or to restrict one’s consumption of it now in order to store it and preserve it for the future. To bring about the substance of his choice the human has to act in relation to the good, i.e. he has to make it the object of his action (or “mix his labour” with it). The result of the action is to divert the good from providing one stream of utility to another. So if I work to capture a unit of air in a glass bottle where it can be stored for the future I have ceased its service to my present respiratory needs and reserved it for my future respiratory needs. The result of this choice brought about through action in relation to the good is, therefore, the demonstration of a value. For I have now valued one stream of utility – present air – against another – future air and this valuation is imputed back to the good in question. My act of preference has been to set aside or to incur a loss or a cost of one stream of utility at the gain or profit of another stream of utility. Value, then, springs from the choice, the decision, of a human to set aside one utility for another, the resulting gain in utility being wholly rewarded to this choice or decision. It is these qualities – value, gains, profits, costs and losses – in relation to natural resources that will be the focus of this essay7.

The realisation of value, then, is to achieve something better than what existed before through human action. What, therefore, are the elements of valuation that occur with a human act? A human, in the condition that he finds himself after birth, must recognise that the potential stream of utility from a unit of a good is preferable to that which exists already. There must, therefore, regardless of the body he has, the standing room on which it is place, and the free goods which contribute to his general welfare, be some kind of uneasiness or dissatisfaction. He believes that the external resources available to him will offer him a stream of utility that is better than what he receives already. Let us posit something simple; his current standing room is position A whereas he would prefer to stand in position B because the ground is firmer and the human believes it will feel more comfortable to stand on. What elements are involved in this choice? First of all, there is the fact that while positions A and B both qualify as the resource of standing room in a physical sense they are different, heterogeneous goods in a praxeological sense. Position A is un-firm ground and position B is firm ground as judged by the human. The quantity of firm ground available for immediate utilisation is outweighed by the needs of a human’s welfare and hence firm ground is a scarce good8. Secondly, we can now say that a human has a conscious end – to derive the utility stream that is offered by firm ground. Thirdly, he has means, the tools he uses to achieve the end – his labour and position B. Fourthly, there is now a definite cost for the human cannot experience the utility of position A and position B at the same time. The achievement of standing in position B therefore requires the foregoing of position A and everything it has to offer for his welfare. Further, it requires him to experience the disutility of labour. Fifthly there is the element of uncertainty, which is pervasive through all action. Uncertainty falls into two categories – the uncertainty of the physical qualities of the resources and the uncertainty of future human desire. The former category is manifest in the fact that the human does not know whether position B will, in fact, deliver him the good of firm ground that he desires; rather it is merely an estimate, a prediction. Also when he gets there he might find that there are other conditions that had not entered his consideration that make position B a more or less desirable place in which to stand than position A. In the second category, the human does not know his future evaluations and choices. He might, for example, no longer desire the end of firm ground upon arriving in position B. Or he might become aware of the even better position C; but that position C was closer to position A than it was to position B and hence the move to the latter was unnecessary. There is, therefore, the element of risk that a utility stream gained through action will not, once it is accomplished, be more highly desired than that foregone. Sixthly, there is the element of profit (or gain) and loss. The human will experience a psychic profit to the extent that the utility stream received through action actually does contribute to his welfare more than the utility stream given up, the extent of the profit being his mental appreciation of the difference between these two. He will experience a psychic loss if the utility stream received through action does not contribute to his welfare more than the utility stream given up. Finally, there is the realisation of value, the “reward” of the profit and loss being derived entirely from the decision to prefer one stream of utility over another.

There is an additional complicating factor that is added to the element of cost. In reality, of course, a human faces a multitude of positions on which to stand. But his labour too is also scarce and he can apply it to only one position at a time. If there were also other positions on which he could stand and, for arguments sake, the labour cost of appropriating each of them was equal, then the human would choose the one with the firmest ground. But psychically, his profit and loss would be evaluated against the opportunity cost and not the actual cost foregone even though the former is not demonstrated through action. So if, for example, he is standing in position A and position C he estimates to be better than position A but worse than position B, in choosing to stand in the latter his profit and loss will be the utility gained from B minus C and not from B minus A.

The gross utility from a good that is achieved through a human’s action can, therefore, be categorised into two elements:

  1. Compensation for Cost
  2. Profit and Loss

This may be illustrated as follows in Figure A.

Figure A

Position A          0A—————————1A

Position B          0B—————————1B——–2B

0A–1A represents the utility derived from position A that is lost through the action (and the cost of labour involved in the move from position A to position B). 0B–2B represents the gross utility that is derived from moving to position B. Out of this gross utility 0B-1B represents compensation for the cost of losing 0A–1A while 1B–2B represents the profit and loss. The net gain in utility, that part that has caused an improvement to the human’s welfare, is therefore represented by 1B-2B and it is this part that represents the achievement, that which is better than that which experienced before. This gain in value, this preference for position B over position A is imputed back to the goods themselves so that we can say that, for this human, position B is more valuable than position A.

In no way, of course, should the length of the lines be taken as a “measurement” of the two utilities involved. The fact that we have illustrated 1B-2B as being smaller than 0B-1B should not be taken to mean that these two elements can be compared in magnitude. For the gain is only psychic and irreducible to a common unit with only the individual human knowing precisely how much more satisfied he is by the move from position A to position B. 1B-2B could be represented smaller or it could be so big that it could not be fitted on the page.

This is, of course, a very simple example which the reader may regard as so trivial as to be hardly worthy of any elaboration at all. But imagine if this is the human’s first ever act on his Earth. The result has been to compensate him for his loss of the original gift of standing room which was provided to him by nature and to give him a gain, something additional that was not there before. He has now, then, moved out of his starting position and onto the course of the rest of his life where he will make further actions after this initial one. Every single action that he undertakes from now will involve these very same elements; they will all undertaken because the human expects them to a) compensate him for the costs of utility foregone and b) to provide an excess of utility above this compensation. The net change in a human’s position, the part that has made him better off, has rewarded him and improved him, is only that part that remains after compensation for costs. This fact, we will see, is very important when we consider the income from land ownership and the ownership of durable natural resources such as land, ore deposits and mining facilities.

Another simple example, but one that involves a more obvious act of production, is where the human is faced with a choice of two apple trees. At the moment he picks apples from tree A, which yields him five apples per day. However, he believes that tree B will yield him more than five apples per day. He therefore decides to stop picking apples from tree A and starts picking them from tree B. Let’s assume that the labour cost from each is equal and that this operation is successful. He is therefore now able to pick seven apples a day from tree B. Figure B illustrates the composition of his gain in utility.

Figure B

A1—-A2—-A3—-A4—-A5

B1—-B2—-B3—-B4—-B5—-B6—-B7

A1-A5 represents the utility gained from the five apples from tree A; B1-B7 the gross utility gained from seven apples gained from tree B. A1-A5 is the utility that is given up by (i.e. the cost of) moving from tree A to tree B. Of the utility gained from tree B, therefore, B1-B5 represents the compensation for cost and B5-B7 represents the gain in utility, the profit and loss. Once more, we should not understand the equal spacing of the lines to mean that each additional apple contributes an equal increase in utility in the human’s mind. We do not know by how much each additional apple contributes to his welfare. All we know is that tree B contributes more to his welfare than tree A. The move from tree A to tree B has, therefore, been a realisation of value, of something better, an improvement, and this is imputed back to the goods themselves so that we can say that tree B is more valuable, more preferred as a result of its contribution to welfare, than tree A.

From where has this gain, this realisation of value, come? What is its source and from where does it spring? Is it from tree B? It is true that the utility itself, B1-B7 as illustrated above, is serviced by tree B. But we must remember that both trees A and B are just a collection of chemicals in the absence of any human. It requires a human being to appreciate the stream of utility provided by tree B as being preferable to the alternative stream of utility that was provided by tree A. Crucially, however, this stream of utility would not be realised or discovered if it was not for the human’s decision to apply his labour in the direction of yielding it. It was the human who decided that it would be worthwhile to give up tree A and move to tree B and therefore, the increase in value, the gain, the improvement, is solely an achievement of this decision-making ability. There are two ways in which we can illustrate this. First, what if, in addition to a choice between tree A yielding five apples and tree B yielding seven apples, there was also the option of tree C that yields three apples? Let’s say, though, that the human erroneously estimates that tree C will yield seven apples and so he gives up tree A in favour of tree C but tree C in fact yields only three apples. We can illustrate this as follows in Figure C:

Figure C

A1—-A2—-A3—-A4—-A5

C1—-C2—-C3—-C4—-C5

(C4)—(C5)

C1-C5 represents the compensation for loss of A1-A5, but (C4)-(C5) represents the loss that was experienced by the move. This loss is not generated by tree C itself; it is merely doing what it is under the order of the laws of physics so to do. The loss is, rather, entirely a derivative of the human’s erroneous decision to move from tree A to tree C. The “punishment” for the loss – the reduction in utility and, consequently, of welfare – is accorded to the bad decision-making ability. In exactly the same way the profit from the move from tree A to tree B was the result of a good decision and the increase in value was entirely a product of good decision-making ability. Bad decisions are therefore punished and good decisions are rewarded and all of these decisions are made in the aura of uncertainty that the result will be as intended. The second illustration is to imagine a world in which there is no gain in utility from any action at all. Let’s say that all trees in the world yield only five apples and that whatever the human does, wherever he goes he will never find a tree that yields anything other than five apples. In this case, therefore, the utilities exchanged in the act of, say, moving from tree A to tree B will be as follows in Figure D:

Figure D

A1—-A2—-A3—-A4—-A5

B1—-B2—-B3—-B4—-B5

In this example, therefore, the utility achieved exactly equals the utility that is lost. What is lost is recouped and what is recouped is what was lost. There is nothing better nor worse that can result from any action. Therefore, there is no need for any decision at all nor any decision-making ability, no reason to decide how to act for all acts will produce the same, uniform result. Any decision will yield an outcome that is exactly the same as its cost and hence there is no reward for good decision-making ability and no punishment for bad decision-making ability. In a complex economy this situation is akin to that of the evenly rotating economy, a world in which there is utility but revenue always equals cost. If the stream of utility given up is equal to that received then there can be no preference and if there is no preference then there can be no questions of there being any realisation of value. We will use this fiction to illustrate the profits from ownership of land and of natural resources. The realisation of value, therefore, can only result from a decision, a decision to withdraw labour from one stream of utility and to direct it towards another. The increase in utility received determines the height of the profit and, consequently, how good the decision was.

Could it be said that a person gains value merely from luck? Could it be that, actually, a person could possess no skill whatsoever and still profit from his actions? Yes, it could, but one must remember two things. First, that to consign one’s fate to luck is itself a decision and to the extent that it is more successful than not doing so then it is a good decision. Indeed such a world where we only had to rely on chance to provide us with every gain in value would be a serious improvement on the existing world. Secondly, as we shall see in more detail when considering profits that are gained from the ownership of natural resources in an exchange economy in part two, net gains from luck can only result if one’s luck is more accurate than someone else’s decision.

Time

What we have said above is true of all human action in relation to simple resources that yield an immediate gain in value. Let us now turn our attention to another aspect that is related to the use of natural resources such as land (including resources under the ground such as ore deposits or coal fields) and the more complex decisions and actions that have to be taken in order to yield value from them. This is the aspect of time, that is, that utility is yielded not immediately but, rather, after the elapse of a period of waiting (such as a long process of production) so that, if one was to start acting in relation to a good now, the utility to be derived would not be received until, for example, another year9. We noted above that physically homogenous resources are not necessarily praxeologically homogenous goods – for example, the differing locations of physically homogenous water can mean that they are, to the acting human, different goods with different degrees of serviceability. Exactly the same is true of time and portions of the same physically homogenous resource that are serviceable at different times may be considered as different goods. Water that is immediately serviceable, or serviceable with only a single action, may be one good, whereas water that is serviceable after only one year may be considered entirely differently, and water after two years forming a third category of good. The necessity of having to wait for serviceability burdens the utility of goods to be received with a degree of remoteness. It therefore follows that goods with serviceability nearer in time will be of higher value than the goods with serviceability further into the future, even if they are the same, physically homogenous resource. Where, therefore, one has to consider in one’s action goods that will yield a utility only in the future one has to discount the utility that is to be derived from the future yield, the effect of the discount being to apply a present value to a future good. The height of the discount will be dependent upon the individual’s preference for present utility over future utility. If he is very present oriented and prefers satisfaction sooner rather than later then the discount he will apply to any future utility will be heavy, perhaps bringing the present value of this future utility to below the value of immediately serviceable goods. If, however, he is not so present oriented the discount he applies may be light, perhaps assigning to a future good a present value that exceeds that of an immediately serviceable good10.

For the sake of simplicity, let us illustrate this with apple trees. We still have the following trees yielding the following numbers of apples as we did above but now let’s also add a fourth tree, tree D:

Figure E

Tree A               Five Apples                    Now

Tree B               Seven Apples                 Now

Tree C               Three Apples                 Now

Tree D              Ten Apples                    After One Year

In figure E, whereas with trees A, B and C the utility is immediate and the yield from the trees was, praxeologically, contemporaneous with the action, this is not so with tree D, where the utility the human will receive will only come after one year. If our human is currently picking apples from tree A, what are his options if he wishes to receive an increase in value, a stream of utility that is better than what he is receiving already? They are as follows:

  1. Lose five apples from tree A now and gain seven apples from tree B now;
  2. Lose five apples from tree A now and gain three apples from tree C now;
  3. Lose five apples from tree A now and gain ten apples from tree D in one year’s time.

It is obvious that, all else being equal, the human will not choose option 2 unless he was acting in error as that would represent a clear loss. The choice, therefore, is between options 1 and 3. We note that if he moves to tree D rather than to tree B he will gain ten apples rather seven, a difference of three apples. But to gain these additional three apples he must wait an entire year. What can we deduce from the choice he makes, or rather, what will determine this choice?

In order to make the valuation he has to discount the future utility to be derived from tree D in order to compare it with tree B. If he is very present-oriented then he may, as we noted above, apply a hefty discount. Let’s say he applies a discount of four apples to tree D. Therefore, in this scenario, the present value of tree B would be seven apples and the present value of tree D would be six apples. He will therefore choose option one, foregoing the greater utility that could be received in one year’s time in favour of a smaller utility that can be enjoyed now. In other words, the additional three apples that he would gain from tree D by waiting a year were not preferable to the additional two apples he would gain from tree B now – he would prefer seven apples now to ten apples in one year’s time. If, however, he is not so present-oriented and he applies a lighter discount to tree D (let’s say two apples), what would be the result? Now, the present value of tree B remains at seven apples but the present value of tree D stands at eight apples. He will therefore choose option three, foregoing an immediate, smaller utility in order to gain a larger utility in the future.

The height of the discount that is applied in order to reach the present value of a good that yields utility in the future is known as interest. If, as we just stated, he applies a discount of two apples to tree D then the height of the interest is two apples. We now have, therefore, not two but three elements that make up the gross utility of a decision to act in relation to a good:

  1. Compensation for costs;
  2. Interest
  3. Profit and Loss.

In the case of this choice of tree D, although his actual cost is the loss of five apples from tree A now he incurs the opportunity cost of foregoing the seven apples that he could have picked from tree B now. The composition of the gross utility from his action can therefore be illustrated as follows in Figure F:

Figure F

B1—-B2—-B3—-B4—-B5—-B6—-B7

D1—-D2—-D3—-D4—-D5—-D6—-D7

(D8)—(D9)—-D10

So D1-D7 (seven apples) represents compensation for the loss of utility from foregoing the gain from tree B; D7-D9 (two apples) represents the discount while D9-D10 (one apple) is his resulting profit and loss. Even though, therefore, physically our human has three more apples than he would have if he had chosen tree B, the fact that he has to wait a year for these apples means that his net gain is reduced by the height of the discount he applies. In this case, therefore, this gross gain of three is reduced by the discount of two apples to a net gain of just one apple11.

A person will therefore, all else being equal, act in relation to a good if he a) believes that it will sufficiently compensate him for his costs, b) believes that it will provide an increase in utility compared to the current stream of utility, and c) prefers a larger gain in utility in the future (or later) to a smaller gain now (or sooner).

In the real world the concept of time is very important when considering natural resources such as land and mineral deposits. For example, a field of wheat must be fertilised in the winter, ploughed and sown in the spring, tended in the summer then finally harvested in the autumn. It is not until this latter act, almost a year after the first, that the human can consume his first bushel of wheat. But more importantly the total benefit to be derived from many natural resources will yield itself not in the first year but across many years to come. Only one harvest’s worth of wheat can only be gained from a field this year; one has to wait until the second year before gaining the second harvest, until the third year for the third, and so on. A copper mine might extract only a small percentage of its total deposit in one year, a similar percentage the next year, etc. Time therefore plays a major role in valuing these streams of utility and in analysing the composition of that utility that is gained as a result. Let us explore this in more detail by considering, again, a lone human who now tries to settle himself on and make use of a durable natural resource.

Land Settlement and Capitalisation

Let us once more put our human in the position of picking apples from tree A. As we stated above he derives an immediate utility of five apples from this tree. However, he now wishes to abandon apples altogether and wants to settle a plot of land in order to grow wheat year after year. Let us assume, for simplicity’s sake, that there is only one plot of land to settle. His costs will again be the loss of utility from tree A, but also the cost of settlement, labour, planning, ploughing, seeds, and so on. His gain will be the additional utility above and beyond the amount of wheat necessary to compensate him for these costs. In addition, however, the field will not only yield a harvest this year, but also next year as well, and in the third year, and so on. His gain in utility, the part that does not compensate him for costs, will stretch across many years and therefore must be discounted accordingly.

Let us say, for argument’s sake, that the land will yield 200 bushels of wheat per year. Of this, 100 bushels will compensate our human for costs leaving the remaining 100 representing a gross gain in utility. Let us also say that he applies a discount of the height of 10% to this gross gain. The gross yield, therefore, of the harvest in the first year can be analysed as follows:

Figure G

Year      Gross Yield        Costs                Gross Gain        Discount                  Net Gain

1          200 bushels       (100 bushels)     100 bushels       (10 bushels)      90 bushels

As a result of having to apply the 10% discount, therefore, the net gain in utility is from 90 bushels of wheat per year and not from 100. We could, therefore, say that the net value of this action, the increase in utility, what has been gained, is 90 bushels. This value, in turn, is imputed back to the land itself so that we would say that the land, having applied the discount at the start of year 1, is, at that time, “worth” 90 bushels. However, as we noted above, the land will not only yield 200 bushels in year 1, but also in years 2, 3, 4, 5 and potentially forever. How is this gain in future utility valued at present, i.e. what is the value of these yields to our human at the start of year 1?  As more time has to elapse for the bushels that appear in year 2 and even longer for those that appear in years 3, 4, 5 and so on, he will apply a heavier discount to the value of the net gain from these successive years so that the present value of this gain diminishes. If we assume, for simplicity’s sake, that the costs remain fixed at 100 bushels per year and that he will continue to discount the gain in future utility at a rate of 10% of per year we can now analyse the gross yields from each year as follows in Figure H:

Figure H

Year      Gross Yield        Costs                Gross Gain        Discount                  Net Gain

1          200 bushels       (100 bushels)     100 bushels       (10 bushels)      90 bushels

2          200 bushels       (100 bushels)     100 bushels       (20 bushels)      80 bushels

3          200 bushels       (100 bushels)     100 bushels       (30 bushels)      70 bushels

4          200 bushels       (100 bushels)     100 bushels       (40 bushels)      60 bushels

5          200 bushels       (100 bushels)     100 bushels       (50 bushels)      50 bushels

6          200 bushels       (100 bushels)     100 bushels       (60 bushels)      40 bushels

7          200 bushels       (100 bushels)     100 bushels       (70 bushels)      30 bushels

8          200 bushels       (100 bushels)     100 bushels       (80 bushels)      20 bushels

9          200 bushels       (100 bushels)     100 bushels       (90 bushels)      10 bushels

10         200 bushels       (100 bushels)     100 bushels       (100 bushels)     0 bushels

What we see is that the more remote in time the gain in utility the heavier the discount that is applied to it. The effect of this is to completely wipe out any gain of utility that appears after ten years or more. In other words, even though the land will go on yielding harvests way after this time they are so far off that they are of no present value. The total present value of the gain in utility from the land is, therefore, the sum of the final column, which is 450 bushels. This will be imputed back to the land itself so that the land will have a capitalised value of 450 bushels of wheat. In other words, the land is “worth” 450 bushels and we could expect the land to fetch that amount if it was sold.

It is very important to realise that this net gain in utility is a one shot affair. The capitalised value of 450 bushels is the value of the land now, having already accounted for the fact that the utility will not be received until a period of time has elapsed and hence, in our human’s mind, is realised now and he does not yield a perpetual net gain in utility year after year. Even though, at the start of year 1, the present value of the first year’s harvest is 90 bushel’s yet after the end of that year the landowner yields a gross gain of 100 bushels and the difference of 10 bushels will obviously form part of his income from which he will derive utility, this income is interest, earned solely because of the elapse of time between these two points and it does not represent any net gain in utility. While, therefore, a landowner can yield a perpetual interest income from the land year after year, he cannot yield a perpetual net income. Once it is known how much the land will yield each year any net gain in utility will be fully discounted to a present value – in this case, 450 bushels – achieving a place in the landowner’s value rankings now and determining his impetus towards future action now. In the real world, however, there are two complicating factors. First, the yields from future harvests are themselves uncertain and must be estimated before they are discounted to a present value. Secondly, our human must weigh the present value of the utility of the land against the utility to be derived from other possible actions. It is these factors that provide the opportunity for further net gain. What, then, are some of these options that he could face and what is their consequence on his gain?

One possibility is that another patch of land may – or may not – be more productive than the one he is settled on currently. Let’s call this new patch of land plot B and the current patch of land plot A. He therefore has to make a choice – to stick with plot A or to move to plot B. There are three possible outcomes regardless of the choice that is made:

  1. Plot B is more productive than plot A;
  2. Plot B is equally as productive as plot A;
  3. Plot A is more productive than plot B.

Which option is true is, of course, unknown before the action is completed. For argument’s sake we will assume that the costs of farming plot A are equal to the costs of farming plot B (although in reality, of course, variable costs will factor into the consideration and will serve to increase or decrease the net gain in utility from land). We will also continue to assume that the yields from each plot are constant year after year and that the same discount rate – 10% per year – will be applied to the net gain in utility. All that is unknown, therefore, at the point a decision has to be made to stick with plot A or move to Plot B is the productivity of Plot B. We will explore each of these outcomes 1-3 under each of the two possible actions that he can take.

First, let us say that our human abandons plot A and moves to plot B. What will be the effect of scenario 1? Let us say that Plot A continues with a gross yield of 200 bushels per year. Plot B, however, yields 300 bushels a year. How now will we analyse the net utility from Plot B? One solution could be as follows in Figure I:

Figure I

Year      Gross Yield        Costs                Gross Gain        Discount                  Net Gain

1          300 bushels       (100 bushels)     200 bushels       (20 bushels)      180 bushels

2          300 bushels       (100 bushels)     200 bushels       (40 bushels)      160 bushels

3          300 bushels       (100 bushels)     200 bushels       (60 bushels)      140 bushels

4          300 bushels       (100 bushels)     200 bushels       (80 bushels)      120 bushels

5          300 bushels       (100 bushels)     200 bushels       (100 bushels)     100 bushels

6          300 bushels       (100 bushels)     200 bushels       (120 bushels)     80 bushels

7          300 bushels       (100 bushels)     200 bushels       (140 bushels)     60 bushels

8          300 bushels       (100 bushels)     200 bushels       (160 bushels)     40 bushels

9          300 bushels       (100 bushels)     200 bushels       (180 bushels)     20 bushels

10         300 bushels       (100 bushels)     200 bushels       (100 bushels)     0 bushels

Figure I points out the fact that plot B is, after direct costs, physically twice as productive as plot A. However, this would not be a true statement of the net gain that is yielded by our human from plot B. This is because he can already, with the same costs, gain a utility from Plot A. By moving to plot B from Plot A he foregoes the utility to be derived from this latter plot and so this becomes an opportunity cost. In other words, the gain in utility from Plot A that could have been made has to be subtracted from the utility gained from plot B. This is illustrated in Figure J:

Figure J

Year      Gross Yield        Costs                Gross Gain        Discount                   Opp. Cost          Net

1          300 bushels       (100 bushels)     200 bushels       (20 bushels)      (90 bushels)      90

2          300 bushels       (100 bushels)     200 bushels       (40 bushels)      (80 bushels)      80

3          300 bushels       (100 bushels)     200 bushels       (60 bushels)      (70 bushels)      70

4          300 bushels       (100 bushels)     200 bushels       (80 bushels)      (60 bushels)      60

5          300 bushels       (100 bushels)     200 bushels       (100 bushels)     (50 bushels)      50

6          300 bushels       (100 bushels)     200 bushels       (120 bushels)     (40 bushels)      40

7          300 bushels       (100 bushels)     200 bushels       (140 bushels)     (30 bushels)      30

8          300 bushels       (100 bushels)     200 bushels       (160 bushels)     (20 bushels)      20

9          300 bushels       (100 bushels)     200 bushels       (180 bushels)     (10 bushels)      10

10         300 bushels       (100 bushels)     200 bushels       (200 bushels)     (0 bushels)        0

As we can see, therefore, our human’s net gain of moving from Plot A to Plot B is equal to his net gain from moving to Plot A in the first place. While, therefore, Plot B produces a gross gain that is double that of plot A, the effect of discounting and of opportunity cost has been to reduce this gross gain to a net gain that is equal to that of the original move to Plot A. There is, however, some net gain and the move from Plot A to Plot B is profitable.

The effect of scenario two should be obvious – if both Plots A and B have a gross yield of 200 bushels a year and we apply the same costs and discounting then there will be no net gain whatsoever. The opportunity cost that is incurred by abandoning plot A will be exactly recouped from plot B. We can illustrate this as follows in Figure K:

Figure K

Year      Gross Yield        Costs                Gross Gain        Discount                        Opp. Cost          Net

1          200 bushels       (100 bushels)     100 bushels       (10 bushels)      (90 bushels)      0

2          200 bushels       (100 bushels)     100 bushels       (20 bushels)      (80 bushels)      0

3          200 bushels       (100 bushels)     100 bushels       (30 bushels)      (70 bushels)      0

4          200 bushels       (100 bushels)     100 bushels       (40 bushels)      (60 bushels)      0

5          200 bushels       (100 bushels)     100 bushels       (50 bushels)      (50 bushels)      0

6          200 bushels       (100 bushels)     100 bushels       (60 bushels)      (40 bushels)      0

7          200 bushels       (100 bushels)     100 bushels       (70 bushels)      (30 bushels)      0

8          200 bushels       (100 bushels)     100 bushels       (80 bushels)      (20 bushels)      0

9          200 bushels       (100 bushels)     100 bushels       (90 bushels)      (10 bushels)      0

10         200 bushels       (100 bushels)     100 bushels       (100 bushels)     (0 bushels)        0

While, therefore, the move has not incurred a loss it was, otherwise, pointless and purposeless12. What about scenario three? Let us assume here that the gross yield from Plot B is only 150 bushels a year, lower than that of Plot A. What happens then?

Figure L

Year      Gross Yield        Costs                Gross Gain        Discount                        Opp. Cost          Net

1          150 bushels       (100 bushels)     50 bushels         (5 bushels)        (90 bushels)      (45)

2          150 bushels       (100 bushels)     50 bushels         (10 bushels)      (80 bushels)      (40)

3          150 bushels       (100 bushels)     50 bushels         (15 bushels)      (70 bushels)      (35)

4          150 bushels       (100 bushels)     50 bushels         (20 bushels)      (60 bushels)      (30)

5          150 bushels       (100 bushels)     50 bushels         (25 bushels)      (50 bushels)      (25)

6          150 bushels       (100 bushels)     50 bushels         (30 bushels)      (40 bushels)      (20)

7          150 bushels       (100 bushels)     50 bushels         (35 bushels)      (30 bushels)      (15)

8          150 bushels       (100 bushels)     50 bushels         (40 bushels)      (20 bushels)      (10)

9          150 bushels       (100 bushels)     50 bushels         (45 bushels)      (10 bushels)      (5)

10         150 bushels       (100 bushels)     50 bushels         (50 bushels)      (0 bushels)        0

As we can see in Figure L the effect of the lower productivity of plot B, after accounting for what he lost from the move from Plot A, has been to impose a loss on our human. Even though he is still producing something it would have been far better for him to have stuck with Plot A where the yield was much higher.

Now let’s examine what happens if he doesn’t move from Plot A to Plot B. What are the results of our three scenarios then? Now, where Plot B is more profitable but he chooses to remain on Plot A, he will continue to derive the same utility from Plot A that he does at the moment however the effect of the foregoing of the more profitable plot B is to impose an opportunity cost upon his gain from Plot A. Applying the same costs and discounting as before his net utility gained will, therefore, be as follows in Figure M:

Figure M

Year      Gross Yield        Costs                Gross Gain        Discount                        Opp. Cost          Net

1          200 bushels       (100 bushels)     100 bushels       (10 bushels)      (180 bushels)     (90)

2          200 bushels       (100 bushels)     100 bushels       (20 bushels)      (160 bushels)     (80)

3          200 bushels       (100 bushels)     100 bushels       (30 bushels)      (140 bushels)     (70)

4          200 bushels       (100 bushels)     100 bushels       (40 bushels)      (120 bushels)     (60)

5          200 bushels       (100 bushels)     100 bushels       (50 bushels)      (100 bushels)     (50)

6          200 bushels       (100 bushels)     100 bushels       (60 bushels)      (80 bushels)      (40)

7          200 bushels       (100 bushels)     100 bushels       (70 bushels)      (60 bushels)      (30)

8          200 bushels       (100 bushels)     100 bushels       (80 bushels)      (40 bushels)      (20)

9          200 bushels       (100 bushels)     100 bushels       (90 bushels)      (20 bushels)      (10)

10         200 bushels       (100 bushels)     100 bushels       (100 bushels)     (0 bushels)        (0)

While, therefore, our human continues to derive utility from Plot A the existence of the opportunity cost of foregoing the utility of Plot B has had the effect of imposing upon him a net loss. In other words, he made the wrong decision in choosing to stay on the less profitable Plot A and this erroneous decision has been penalised by the loss.

In the second scenario, obviously there is, again, no net gain or loss from remaining on Plot B and the composition of utility derived will be as in Figure K, above. What about scenario 3, however? This is where Plot B is less profitable than plot A and our human chooses to remain on Plot A. What is the composition of utility now?

Figure N

Year      Gross Yield        Costs                Gross Gain        Discount                        Opp. Cost          Net

1          200 bushels       (100 bushels)     100 bushels       (10 bushels)      (45 bushels)      45

2          200 bushels       (100 bushels)     100 bushels       (20 bushels)      (40 bushels)      40

3          200 bushels       (100 bushels)     100 bushels       (30 bushels)      (35 bushels)      35

4          200 bushels       (100 bushels)     100 bushels       (40 bushels)      (30 bushels)      30

5          200 bushels       (100 bushels)     100 bushels       (50 bushels)      (25 bushels)      25

6          200 bushels       (100 bushels)     100 bushels       (60 bushels)      (20 bushels)      20

7          200 bushels       (100 bushels)     100 bushels       (70 bushels)      (15 bushels)      15

8          200 bushels       (100 bushels)     100 bushels       (80 bushels)      (10 bushels)      10

9          200 bushels       (100 bushels)     100 bushels       (90 bushels)      (5 bushels)        5

10         200 bushels       (100 bushels)     100 bushels       (100 bushels)     (0 bushels)        0

 

What has happened is that Plot B, although less productive than Plot A, still yields a greater productivity than that which our human was experiencing before his first move to Plot A. Therefore, his net gain in utility from the original move to Plot A (Figure H, above) has been reduced accordingly, although there is still a net gain and the decision to remain on Plot A is profitable.

What we must reiterate from all of this is that our landowner’s gross income all falls into three categories:

  1. Compensation for Costs;
  2. Interest;
  3. Profit and Loss

Category 1 includes compensation for all direct costs associated with producing the land’s yield and also opportunity costs. The more productive, therefore, an alternative action on an alternative piece of land the higher these latter costs will be and category 1 will claim a larger portion of the gross yield than categories 2 and 3. Category 2, interest, is equal to the height of the discount that is applied to each yield and is earned only after the appropriate period of time has elapsed. Category 3, the net yield, can only be earned through an entrepreneurial judgment, a decision that takes place under the condition of uncertainty. Once it is known or realised precisely how much the yield will be this income will be fully discounted to a present value and, thereafter, a landowner can earn only interest on this income. In reality, of course, the decision is much more complex because of a multitude of uncertainties that exist:

a)     Direct costs of farming a plot will change from year after year and must be estimated in advance of their occurrence;

b)     Opportunity costs will change from year after year and, likewise, must be estimated;

c)      The gross yield of a plot of land is not certain in advance; rather, factors such as the weather, seed quality and soil deterioration will intervene;

d)     The discount to be applied to future gains is dependent upon the individual’s time preference rate which is subject to change.

A fuller analysis of these factors will become clearer through the situation not of a lone, individual human being, but through one where there is the trade of land and resources between many human beings. To this task we shall turn in part two.

Go to part two.

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1Alternatively by a deity if that is one’s inclination. The cause of the creation of matter and life in the universe is not under examination in this essay and one is perfectly entitled to substitute “God” for “nature”.

2The neutrality of description of that which is yielded to a human by utility is extremely important to grasp, as we shall see a just below.

3It is actually more often the case that the matter in existence falls into this second category. In spite of a population of approximately 6 billion people on the planet, humanity has only succeeded in tapping into a very small fraction of the matter available in the Earth. Although much of the Earth’s land surface has been utilised to a wide extent, the seas, the sky and below the Earth’s crust remain unexploited territories simply because it is too costly to make use of them.

4Carl Menger, Principles of Economics, pp. 94-8.

5It is also possible for physically heterogeneous resources to be praxeologically homogenous goods – for example, if there are two steaks on sale, one of which weighs 300g and the other of which weighs 300.1g, this physical difference will be irrelevant if the human believes that each of the two resources has equal serviceability and they will, therefore, be two portions of the same good].

6A clear conception of the law of marginal utility may assist any difficulty in the comprehension of what is being said here. Briefly, as the available units of a good increase, the quantity of a human’s ends which become fulfilled by these units increases also. If, therefore, a human loses one unit of a good then he will forego the least urgent end and continue directing the remaining units to the more valuable ends. His appreciation of any one unit of a good, therefore, is the loss of utility that he would experience by leaving the least urgently needed end unfulfilled. However, as the quantity of air exceeds the number of ends towards which a human can direct it the loss of one unit of air entails no loss of utility whatsoever and hence a single unit of air is unappreciated by a human being. For a particularly lucid explanation see Eugen von Böhm-Bawerk, The Positive Theory of Capital, Book III, Chapter IV.

7The valuation between goods again springs not from the utility to be derived from whole classes of goods such as “present air” and “future air” but only from the marginal units of these classes. If all units of air exist as present air, a human will act to direct units towards future air when the stream of utility to be gained from the first unit (i.e. the unit to be gained) of future air is, to him, preferable to the stream of utility to be derived from the last unit (i.e. the unit to be lost) of present air. He will stop acting in such a way when the utility from the last unit of present air is more preferable to him than the utility from the next unit of future air.

8As the human is standing in position A and not position B it should be obvious that the quantity of firm ground available for his immediate use is zero.

9Again, what matters here is not the physical elapse of time but its praxeological significance. All actions, of course, take place through time and their resulting utility can only be received at a point after which a decision has been made to carry them out. For example, I first have to decide that I want to eat a sandwich before I derive the utility from doing so. But unless the elapse of time involved in this process is consciously appreciated by me then it will have no significance in economics.

10One can analogise goods that yield utility at different times to those that yield utility in different locations as both time and distance are factors of remoteness that cause one to apply a discount to the net utility to be derived. All else being equal, goods that are closer are more serviceable than those that are further away. In order to compare the utility from a distant good with a near good, therefore, one has to apply a discount to the distant good. Here, however, the discount is easily calculable as it consists simply of the costs of transporting the distant good. If, therefore, the utility from a distant good minus transportation costs is higher than the utility to be derived from a near good then the distant good is more valuable than the near good and the human will act in relation to it. If, however, the effect of transportation costs brings the utility of a distant good below that of the near good then the distant good is not more valuable than the near good and the former will remain untouched.

11The height of the discount applied will also, of course, account for the fact that apples D1-D7, compensating him for the loss of B1-B7, will also not be received until after a year.

12In reality, also, there would be the transaction cost of moving plots to be accounted for which would result in an overall loss from the move but for simplicity’s sake we have omitted these here.