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Department of Economics
Duke University
Spring 2013

Economics 345/554 Urban Economics

Lecture #3:

Economic Models of Cities: introduction to land rent

Borts-Stein Model of Regional Economic Growth
Economic Models of Cities: theoretical analysis of urban structure
Reading: McDonald & McMillen, Chapters 22 and 6
Professor Charles Becker
1.
Borts-Stein model of regional economic growth: Start with two sectors. One produces a
capital-intensive export good X and the other produces a labor-intensive, non-tradable domestic good Y. A
hugebut simplifyingassumption is that of Cobb-Douglas, CRS technology:

X AK X L X

Y AK Y LY

By assumption, > . Given the CRS assumption, and assuming perfect competition, we can assume without
any loss of generality that each sector behaves as though decisions are made by a single, perfectly competitive
firm. First order conditions for profit maximization imply
K
W X PX (1 ) AK X L X PX (1 ) XL X PX (1 ) A X
LX
A similar equation holds for Y. We also have a bunch of market clearing conditions:
W W X WY

L L X LY

K K X KY
Profit maximization with respect to choice of capital requires that the value of the marginal product of capital
be equal to its rental cost, rPK
1

L
4
rPK PX AK X L X
PX XK X PX A X
KX
A similar equation holds for Y. Then there are the adding up conditions and income accounts identities.
Defining Z as gross regional product, and assuming all capital is owned in the region, and further assuming
that marginal propensity to import, consume, and save are all constant,
1`

Z PX X PY Y S PX C X PM M PY Y
PX C X cZ

PY Y eZ

For individual budgets to balance, it must also be true that:

S sZ

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PM M (1 c s e)Z

Assume further at that the labor force growth rate (always denoted by primes in my notes) is exogenous while
capital stock increments are equal to investment I (equal to savings S in a closed economy) less depreciation:

L
L'
L
I
K'
K

Note further that GRP must equal the sum of the wage bill and capital payments
Z WL rPK K W ( LX LY ) rPK ( K X KY )

In equilibrium, if demand for exports is perfectly elastic at a fixed price, and if capital is available at a constant
price, then it can be shown that one gets balanced growth at the labor force growth rate:

L' K ' X ' Y ' Z ' S ' C' M '

The critical results emerge when we ask how values respond to an external demand shock and in particular a
rise in the price of export goods, PX. From (4) we know that
P
X
rPK PX
K X X X
10
KX
rPK
Similarly, we find from inverting profit maximization FOCs and solving for L* that
X
P
11
W PX (1 )
L X (1 ) X X
LX
W
Substitute both of these factor demands in terms of PX, w, r, and X into the production function; solving out
for X (and collecting terms) gives us a supply function. But, we dont want supply: we want to solve for W:

P
P
X AX X (1 ) X X
rPK
W

Notice that the X terms cancel, and that we can collect the PX. Solve this for W as
W

(1 )

APX
rPK

12

1 1 PX

13

Taking natural logarithms ands differentiating, we get the core result: the elasticity of regional wages with
respect to export good price is simply

W ,P
X

d ln W
1

d ln PX 1

14

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Thus, a rise in export price drives up local wages by the inverse of labors share: if labors share is 75%, then a
1% rise in export good price will cause wages to rise by 1.33%.
This sort of model is very similar to some of the small open economy trade models (except, of course, no
exchange rate). Exogeneity of the labor force is one major problem defensible for a country, but not a city or
metro area. The focus on expansion of the export sector the base of the economy is natural given the
models construction.
Note, too, that this sort of model is easy to estimate, and lends itself to nice projections. Softer models that
are based on quality of schooling, infrastructure, and new small business start ups do not give neat sectoral
precision, and may not give as nice econometric fits when estimated against past data. However, I still think
they contain more information
2.
Market value, present value, and rent:
The text will define the price of land as its rent,
R, while the market value of land is equal to the present value of the stream of rental income it generates.
For an asset with an expected life of n years, generating expected rent R (t) in year t, and given interest rate i at
the time of calculation, the PV is
n

R(t )

t
t 0 (1 i )

PV

15

If R is constant, and the stream of earnings is infinite, and i is less than 1, then the series
n
1
1
lim
.
t
n
i
t 0 (1 i )

16

In that case,
R
17
i
Note that if there were inflation at constant rate , then one would expect land rents to grow at that rate. Then
for low inflation rates
PV

R (1 ) t
PV
(1 i) t
t 0
n

1
R

t 0 1 i
n

n
1
R
1
R

R
t
i
t 0 1 i
t 0 (1 i )
n

18

That is, the present value is linked to todays rent divided by the real interest rate. Whether one uses R or PV is
not critical for most analysis, since they are so closely linked. As most other variables are presented in flow
terms wage rates, cost of capital -- it makes sense to think of the price of land as a flow, or rental rate as
well.

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3.

Land rent and fertility:

consider an agricultural economy where there are:

Fixed input (labor, seed, fertilizer, capital) and output (corn) prices, and that these prices are equal in all
locations.
Zero economic profit: free entry into farming, so farmers all make the opportunity cost of their time,
but zero economic profit.
3 land types (high, medium, and low quality)
Landowners rent to the highest bidder
Zero transport costs.

Profit before land rent varies greatly and will be completely absorbed as land rent. Note that low fertility land
will not be farmed in this example: costs are high relative to output price.
Output price/bushel
MC
AC
Bushels/acre
Revenue/acre = Bu x P
Cost/acre = Bu x AC
Land rent/acre = R C

HIGH FERTILITY FARM

MEDIUM FERTILITY

LOW FERTILITY

10
10
4
220

10
10
8
160

10
10
12
100

2200
880
1320

1600
1280
320

1000
1200
(bounded at
zero) 0

Land rents follow the leftover principle: because of competition for land, the landowner gets the leftovers.
This will not hold if there are restrictions on entry and competition, in which case rents will also accrue in part
to the beneficiaries of curtailed competition (for example, legal restrictions on tobacco farming that once
existed will benefit the landowner if the right is attached to the land; to an individual if it accrues to an
individual farmer).
4.
Land rent and public works: suppose that the Bihar (India) state government decides to
build a series of irrigation ditches and provide free water to farmers (or electricity to slum dwellers). Who will
benefit?
The answer is straightforward. Free irrigation lowers production costs (both MC and AC). For a given price
say, in a rice farming area, where the benefiting area is small relative to the national or world market then the
result is (a) expanded production by all farms higher productivity, and more intense farming [increased use
of other inputs] as well, (b) active farming of previously uneconomic plots, and, hence (c) more output, and
more rents/acre. But as long as there is competition for land, then the added rents accrue entirely to
landlords.
Reality is a bit more complex:
(a) If the market is not national or international in scope say, the farmers in the region produce
vegetables, or (as has been the case in India) interstate trade is restricted then output prices fall, and
some or all benefits accrue to consumers.

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(b) Increased demand for labor may bid up wage rates, helping tenant farmers (whose major asset is their
labor).
(c) Farmers may also work harder, benefiting through increased employment if there were previous
constraints.
(d) Landlords might have to pay off politicians to get the irrigation works built.
(e) Landlords might be intimidated by angry peasants and Marxist guerillas, and decide not to extract full
rents.
In general, though, we expect the benefits of the project to be capitalized into the market value of the land.
Notice, though, that land rents to not simply appear, but rather reflect demand and supply conditions. Rents
are high when demand is high. As OSullivan writes, the statement that The price of land in Mumbai [Boston]
is so high that few people can afford to live there has it backward. The price of land is high because so many
people can afford to live there, and want to do so. Large demand for housing in a city generates a high price of
land. Of course, while it is true that higher demand will mean higher densities and more people living in
Mumbai than before, it also means that some people cannot live there.
5.
Land taxation:
Toward the end of the 19th Century, the social reformer Henry George
advocated taxation on all land equal to its undeveloped value that is, a 100% tax on rental income. He argued
that land rents are determined by nature and society, and not by the efforts of landowners. At the same time,
by not taxing improvements, there would be an incentive to invest in crops, buildings, houses, and factories.
Obviously, since one cannot take land away, the tax would have no adverse supply effects it would be, in
effect, a lump-sum tax.
George did not carry the day, but was highly influential. Critics argued:
(a) The tax would drive net rents and hence land value to zero in effect, governments would confiscate
all land. At true 100% taxation, tax revenues would be zero, since the land would have no private
worth. In effect, the proper tax would be indeterminate.
(b) If landowners abandoned their land, then it would become property of the state, which would be
unlikely to allocate it efficiently.
(c) It is also likely to be difficult to really separate the value of land from that of improvements.
To some extent, these criticisms can be countered by instituting a partial land tax, whereby land is taxed at
less than 100% of its value, and therefore retains value on the private market. And, indeed, this has been an
influential argument behind the use of property taxes as a major source of revenue
Also popular are two-rate taxes, or split taxes, under which improvements are taxed at lower rates than land.
Evidence from Oates and Schwab (1992), who examined Pittsburghs decision to implement a graded property
tax system in the 1980s, raising land taxes (taxed at twice the rate of improvements) and lowering taxes on
improvements. A commercial building boom followed; they conclude that the incentive structure provided by
the dual rate was in part responsible.

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Monocentric model of urban structure

6.
Model 1: an urban area with a single industry.
Our goal is to understand why certain
types of goods are produced in cities, where they will be produced within an urban area, to understand
residential patterns, and to understand city growth. Urban areas are characterized by large amounts of capital K
and labor N relative to land use L in the production of goods and services.
Production location within an urban area is largely determined by the extent to which K and N can be
substituted for L. Things produced in the center will allow for this to a large extent. Industries with weaker
substitution will produce at more distant locations. To summarize: understanding how the urban economy
operates largely involves understanding how land can be combined in varying proportions with other inputs.
Assumptions:
A1.
Wherever the commodity is produced within a region, it must be shipped to a point of export (so
production close to the export point is advantageous).
A2.
The supply of usable urban space is a fraction of the area given by the proportion of the circumference
available for urban activities. The circumference of a circle of radius is 2; some fraction 2 is available.
Then the citys area is
2
2

2

A3.

19

One commodity, sold locally and exported, but all distribution occurs through the export node.

A4.
Production is constant returns to scale (CRS) with land and capital; no labor. Substitution between
land and capital is possible, but with diminishing returns to the additional use of capital with a fixed amount of
land.
A5.
Competitive (price taking) output markets and capital market (same price throughout the urban area).
Producers take land rent as given, but the equilibrium land rent at each point is endogenous.
A6.
Shipment costs of the good to the export node equal a constant times distance. Therefore, transport
costs depend on distance but not direction; therefore, all land at distance from the export point has the same
rent.

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7.

Efficient behavior:Ignoring N for now, a producer at distance will try to maximize profits:
MAX PQ ( K , L) rK RL tQ( K , L) [ P t ]Q( K , L) rK RL
{ K , L}

FOCs

[ P t ]MPK r 0

20

21

[ P t ]MPL R 0

P is the commodity price at the export node; P - t is the effective price received by the firm. It can also
be shown that a price-taking firm that satisfies these conditions and has CRS technology will make
exactly zero profits (Eulers Theorem).
Now R will vary with distance: R R (). For most goods (inputs), the marginal product conditions, summed
over all firms, will determine factor demand. In the case of capital, with regionally fixed price r^, the efficiency
conditions simply determine total capital use. But there is only a fixed amount of land at each point: price R
(endogenous to the system) rather than quantity adjusts.
MPK
R*
R^

MPL
K*

L^

How will R vary with u? Suppose no input substitution were possible. Then factor inputs per unit of output
would be independent of input prices and u. The equations in (21) would not have to be solved
_

simultaneously and R* [ P t ] MPL , the rent that equated expected profit to zero, would decrease
linearly with u to make the second equation in (21) hold.
But there is normally input substitution, and so R must rise faster than linearly (as u approaches zero):

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R(u)

u
Suppose not that R(u) is at a level such that land rents and profits equal zero for some large u^, and that as
u declines, R rise linearly (a passive bid-rent function). But as R increases as u falls, the input
proportions optimal at nearby u^^ will no longer be the same as at u^. Capital will be substituted for more
expensive land: K/L will rise. If there was no substitution and R increased linearly, profits would be just
zero. But because profitable substitution can be made, if the increase in rent as one got closer to the center
were just linear, profits would be positive. Therefore, R must rise more rapidly as u falls, as the urban area
will be in equilibrium only when profits fall to zero everywhere.
Example:
Q AL K 1

FOCs, substituting (21), yield

Q
MPL QL R

L
Q
MPK QK (1 ) r
K

R p(1 tu )

22
Q
L

r p(1 tu )(1 )

23
Q
K

24

Rearrange (23) and (24) to get

L* p(1 tu ) Q

R
K * p(1 tu )(1 ) Q

Substitute these in (22) to get:

25
r

Ap (1 tu )Q (1 )1
.
R r 1

26

Note that the Q terms cancel. Then

Ap (1 )1
R (1 tu )

R c (1 tu )1 / ,
27

1
r

where c is defined as the term in brackets. Taking natural logs, one can estimate this easily. Then (27)

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dR
tc
(1 tu )
du

<0

d 2R
t 2 c(1 )

(1 tu )
du 2
2

and

28

1 2

0.

29

Hence, as u gets larger (that is, as one goes from the CBD to the urban fringe), R falls [from (10)], but does
so at a decreasing rate from (29), dR/du gets larger (becomes less negative).

RESULT 1:

land rent rises more than linearly as one gets close to the center (CBD)

RESULT 2: the capital/land ratio also rises rapidly [why?] as u 0. Thus, one sees tall buildings at the
center of a city, and not one the outskirts.
This second result comes from taking ratios in (23) and (24), and, without loss of generality, normalizing the
price of capital r at 1. Then, letting the prime symbol denote percentage change
K 1

R
L
*

(
(

) ( )
)(

)( )

( K / L)' R'

30

)( )

That is, the capital/land ratio must rise at the same rate as land prices. If K could not be substituted for L
then rent functions would be linear, and land used for each purpose would be used with the same intensity
everywhere. But in reality, land rent, population density, and K/L ratios all fall rapidly as u rises near the
CBD, and then flatten out toward suburbs.
That land rents should fall nonlinearly in a model with linear transport costs is superficially surprising. After
all, the transport cost savings is the same for 2 to 3 miles out as it is for moving in from 8 to 9 miles. The
essential reason for the land price nonlinearity is input substitution.
To complete the model, we must have
Full land utilization: for each u, L(u) u .
A production function Q=Q(L,K).
Market equilibrium in demand for and supply of the good produced in the city:
_

D f ( P) S Q(u )du QL(u ), K du

u

31

Although each producer in an urban area takes P as given, it will depend on total production in the
urban area. Equation (31) endogenizes P* conditional on u; the equation also yields Q* (inverting f yields

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P*). We can use the factor input condition to find (K*/L*) at any location to find K* since full land
utilization yields L*.
What happens in the event of a productivity gain in an urban areas production functions?
(a) Local consumption rises
(b) Exports increase: the area in which exports are competitive rises, so market area rises
(c) City size (use of K, population N, and area) all increase.

Finally, what determines and urban areas boundary? Assume that land has a non-urban use

price of R^. Then the edge of an urban area is determined by the boundary condition R(u ) R . This
completes the basic land rent/land use model. We will explore comparative statics and some extensions, and
then present the remainder of the model formally.

R(u)

R^
u^
8.

Patterns of density gradients across the globe (Bertaud & Malpezzi, 2003):

If youre interested in this, go to http://alain-bertaud.com/.

Even if we restrict attention to (reasonably) large cities, it is striking how much cities differ in form. Broad
findings:
Negative exponential density gradient fits the data well in most (but not all) cities
Density gradients flatten with income (as a country becomes richer).
Repressive or state planned economies (Russia, South Africa, historically) tend to have flatter or even
inverted gradients

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Patterns of note:
Density gradients are steepest in lower income and older cities, but relationship isnt
strong.
Not much of a pattern with respect to density and city population either: one needs
multivariate regression to sort effects out.
Specific cities:
Abidjan, Cte dIvoire: small gradient is driven by the waterways; lots of cleared and
government space not far from the center; poor high-density suburbs a bit further
out.
Berlin, Germany and Chicago: Very steep, non-log-linear gradient; then flattens out.
Brasilia and Curitiba, Brazil and Cape Town and Johannesburg, South Africa: wealthy
live not far from the CBD; poor live in densely populated suburban areas.
Houston: standard gradient, but some high density areas beyond the CBD, and then
some high density areas on the periphery. To some extent, one finds the same
patterns in Mexico City.
Jakarta, Indonesia: very high density for a long time and then only gradual decline,
followed by a great fall-off in the most distant suburbs
Riga, Latvia and St. Petersburg, Russia: dense center, decline, followed by a large
increase because of dense high rises in suburban mikroraiony. As Soviet-style cities built
out, 3- and 4-storey khrushchovki were followed by 8- to 15-story buildings from the
1970s and 1980s.
Seoul is an anomaly, with very high density across the board. This is because of a huge
zoned green space that restricts the citys size.