David J. Pannell

After attending a meeting to discuss the results of some economic analyses of land conservation measures, David Bennett sent me the following email. My reply is shown below.

At 03:57 PM 17/11/01 +0800, David Bennett wrote:
Dear David
At the Mount Marshall Briefing on Friday there were a couple of economic issues that were quite worrying, the first being that someone had suggested that land values be appreciated by one percent per year, whereas everything else was to remain at current prices and a discount rate of 5% was to be used. The second was that it appeared that both land value and what was called "productivity value" (which appeared to be the enterprise gross margin) were both used. Time did not allow me to get to see the model in any detail, but I suspected that there had been some double counting and raised both this point and the point that you make - that the cost price squeeze will continue and therefore (my interpretation) land prices should, if anything, be depreciated.
David Bennett

Dear David

I assume that the context of your question is an investment in land conservation. Yes, this approach sounds like double counting. It is possible in some situations to include changes in land value as a benefit in an analysis of a land conservation investment, but you need to be very careful how you do it in order to avoid double counting. For the purposes of this sort of analysis, land value differences would reflect differences in future productivity as a result of the investment in conservation. If you do include changes in land value at a particular date, then you must exclude from the analysis all productivity changes subsequent to that date, because they have already been included in the land value change. (Rationale: to realise the capital gain, you have to sell the land, and then you don't have access to the land to realise subsequent productivity differences.) Conceivably, you could include productivity differences for 20 years, and then a difference in land value at year 21 to factor in ongoing effects beyond year 20, provided that you then discounted that difference back to year 1. In practice, however, I would ask, how should you determine the change in land value to be included at year 21? The best way would be to do a discounted cash flow analysis of subsequent productivity differences. If so, why not just extend the time frame of the productivity analysis? It amounts to the same thing.

There are some complexities which could be added to this relatively simplistic story. For example, if land value increases, farmers may be able to access greater debt finance to invest in productivity. Benefits from such investments, if you could anticipate them and quantify them, would be legitimate inclusions in the analysis of the investment in land conservation. However, I'd say they are really second order benefits and almost certainly much smaller than the error margins surrounding the first order benefits. They are also completely different in nature to the direct inclusion of changes in land value.

If you assume that prices, yields and costs are constant over time, there is no justification for even expecting land prices to increase, let alone including these increases in the analysis. Unless ...

Perhaps there is an expectation of speculative increases in land value, not reflecting productive value, and a belief that such increases would occur WITH the land conservation investment but not WITHOUT it. If one has some sound rationale for expecting this, then fine, include it as a benefit, but I wouldn't like to be investing much of my own money on that basis. Substantial differences between the value of land for production and the amount people actually pay for it are not sustainable in the long term, due to competitive pressures.

Putting that aside then, I would note that the analyst should be considering whether the assumption of constant prices, yields and costs is the most reasonable. We know that real prices for agricultural commodities have been falling for at least the past century (the real price of wheat has been falling since the 1700s), and I don't think it's time to expect that trend to change. We also know that yields have increased, and will probably continue to. The "constant real everything" assumption is only reasonable if price falls and yield increases are expected to cancel out.

Land prices increases COULD occur if technology is advancing fast enough to more than offset the price falls. Conceivably, productivity growth could be high enough to be the source of the 1% per year appreciation of land value referred to in your question. If the productivity growth is different in absolute terms with and without the land conservation investment, then you perhaps need to worry about it in the analysis. (e.g. if degraded and non-degraded land both have productivity growth of 1% per year, this implies a difference in absolute terms, which needs to be accounted for.) I would be including those productivity improvements in the discounted cash flow analysis of the land conservation investment, rather than as a land value change. Pulling a number like 1% out of the air obscures the implicit assumptions about rates of productivity improvement etc. which are being made. Better to represent these assumptions directly and explicitly. Even if you did want to base the analysis on land values rather than productivity, it certainly wouldn't be correct to include the full 1% increase as a benefit in the analysis of the land conservation investment, unless you believed there would be no increase at all in the value of land which had not benefited from the land conservation investment.

Finally, there is the old issue of real versus nominal rates of change. I couldn't help wondering whether the 1% increase in land value was real or nominal. If it's nominal, then this would actually be a real price fall (assuming inflation exceeds 1%), presumably implying that yield increases are not fully offsetting real price falls. Again, whether this is relevant to your analysis depends on whether the absolute fall is different when you do or don't undertake the land conservation investment. And again, I still wouldn't represent this by a land value change, but by a set of differences in annual profit depending on changes in yields and prices over time.

Overall, it's an area where it is easy to go astray unless you know what you are doing.