Land markets Development and Transition II Tbilisi, 2008 Introduction • Proper functioning of the land market is very important for the overall development of the economy. • If land is held unequally and many individuals fail to obtain access to it, they are likely to leave agriculture and concentrate in cities (massive rural-urban migration), which might have serious political and environmental consequences. • Also from the economic point of view it is very important to have a well functioning land market. Focusing on economic efficiency, we ,are going to analyze: – how the land rental markets deal with substantial inequalities; – Efficiency of land rentals; – Efficiency of inequality of ownership (link between size and efficiency); – The role of land reforms. Ownership and tenancy • As one might expect, owner-cultivated farms are preponderant in countries with a relatively low level of inequality. • Tenancy, exists all over the world, even though measuring correctly its extent may be problematic, especially if legislation favors tenants working the land for some pre-specified numbers of years in acquiring ownership or use rights (incentive to “disguise” tenancy). • However there are variations (table 12.2 - Ray) in the form of the tenancy arrangements. The two most common arrangement types are: – fixed-rent tenancy (Latin America); – sharecropping (Asia). [While in Latin America sharecropping=16.1%, in Asia sharecropping=84.5%]. Land rental contracts • Fixed-rent contracts – Fixed amount to be paid to landlord; – Landlord relieved of all the risk; – Requires tenant to be willing and able to bear the risks of agricultural production; – More common in presence of highly mechanized and capitalistic farms using wage labor; • Sharecropping – Landlord receives a share of the production and might pay a share of the costs; – Landlord and tenant share the risks of agricultural production; – More common in presence of smaller and risk-averse tenants. Land rental contracts,cont. • It is possible to build a general class of rental contracts containing fixed-rent and sharecropping as well as pure wage contracts: • R=αY+F – With α =0 we have pure fixed-rent contract; – With F=0 we have pure sharecropping; – With α =0 and F<0 we have pure wage contract where the wage w=-F Contracts and incentives • Traditionally, sharecropping has been seen as an inferior system to that of the fixed-rent tenancy. • The argument dates back to Adam Smith and Alfred Marshall and is mainly based on the idea of the appropriate provision of incentives. • The main idea is that, if the effort of the tenant cannot be monitored and controlled by the landlord, in the case of sharecropping the tenant has an incentive to undersupply his effort, as a fraction of the output produced is transferred to the landlord. • This is not true in the case of a fixed-rent tenancy. • This can best be seen graphically (Fig.1 and 2) Contracts and incentives, cont. B Production Function A Output, Costs C E Production Costs Figure 1 D L’ L* Labor Contracts and incentives, cont. B Production Function A Output, Costs Fixed rent C E Production Costs Figure 2 D L* Labor Contracts and incentives, cont. • Summarizing: – Sharecropping leads to a distortion to the tenant’s input supply due to a reduction in the marginal rate of return to the input (becomes lower than actual value of marginal product). This leads to undersupply of the tenant’s input; – Other types of agreements modifying the marginal rate of return to the input will lead to a sub-optimal provision of tenant’s input; – Rational landowners trying to maximize the earnings from land lease will always prefer a suitable fixed-rent contract to any share contract (giving same return to the tenant). Risk, tenancy and sharecropping • Another important element that we should include in our analysis of land rental contracts is uncertainty. • Agricultural production is subject to random shocks and this adds an element of uncertainty. • We can consider a case in which only two levels of output are possible: G (good) and B (bad). • The probability that a good output will be produced is given by p. • We assume that a wealthy landlord is less risk- averse (thanks also to diversification of incomes) than his tenant. Risk, tenancy and sharecropping, cont. • With a fixed-rent contract, the tenant will have to pay R regardless of the output generate by the plot of land, receiving G-R if things go well and B-R if things do not go well. • If we want the (risk-neutral) landlord to be indifferent between sharecropping and the fixed rent contract we must have R=psG+(1-p)sB (which is the expected return of the sharecropping contract). • s will have to be R/(pG+(1-p)B) Risk, tenancy and sharecropping, cont. • If the expected return to the landlord does not change, this will be true also for the expected return of the tenant. • However, we know that the tenant is risk-averse. Would he prefer the sharecropping contract or the fixed-rent contract? • It can be shown that the return in the good state under sharecropping is lower than with the fixed- rent contract. However, it is also true that the return in the bad state is higher in sharecropping. Choice of contract type with risk- aversion • Outcomes of good state for tenant: (1-s)G-(G-R)=R-s(G)=R- [ GR/pG+(1-p)B]<0 • Outcomes of bad state for tenant: (1-s)B-(B-R)=R-s(B)=R- [ BR/pG+(1-p)B]>0 If the expected returns are identical and the tenant is risk-averse, he will prefer sharecropping, as it reduces the variability of his outcome. Risk, tenancy and sharecropping, cont. • This will allow a risk-neutral landlord to extract some additional rent (to increase the expected value of his returns) as a compensation for the risk he is bearing, while the tenant will still be experiencing a gain in terms of utility. • The most attractive feature of sharecropping is that it is not only a way to share the output of the productive activity but also the risk associated with it. Risk, tenancy and sharecropping, cont. • However, we might even move further and transfer completely the risk on the landlord if the landlord decided to pay a fixed wage to the tenant and keep the output. Why isn’t this happening then? – Landlords are not necessarily risk-neutral; – Incentive problems (with imperfect monitoring) trade-off between need to insure and proper incentives – lower share to the tenant, lower incentives). Trading off some insurance implies that full efficiency is not reached as it is incompatible with the landlord’s objectives. Risk, tenancy and sharecropping, cont. • Would it be desirable and possible to avoid sharecropping by combining a fixed-rent contract with a fixed-wage contract? • Not necessarily, as: – Fixed wage contracts have worse incentive problems than sharecropping; – Mixing different contracts may be difficult in practice (working in own plot of land AND as hired laborer); – May not be possible to find a “safe asset” such as a fixed-wage contract characterized by the absence of uncertainty. Forms of tenancy, other considerations • Cost sharing of inputs: can limit the inefficiency in the provision of observable inputs by reducing the marginal cost of the tenant; • Double-incentive problem: both for tenant and landlord fixed-rent not always desirable as landlord has no incentive; • Limited liability and sharecropping: we should expect sharecropping to be more common with poor tenants (unable to pay fixed rent in bad times) and to shrink when tenants’ wealth increase; • Sharecropping as screening device: e.g. preferred by “low productivity” tenants (however, consider also risk- aversion and long-term effects). Useful with multiple types of incomplete information. Land contracts, eviction and use rights • When we move from a static to a dynamic context, we have to consider the possibility that a tenancy contract may not be renewed. • In this case, the landlord acquires an additional instrument through which provide effort incentives (sharecropping + threat of eviction in case of poor performance). • However: – Uncertainty for tenants increases tenants will have to be compensated; – The value of the contract must exceed the tenant’s next-best alternative or the threat will be ineffective. – Risk of long-run losses as the tenant will be less inclined to engage in activities leading to increases in the long-run earning potential of the land. Land contracts, eviction and use rights, cont. • Ray indicates two cases in which contracts with eviction may be widely employed: – Limited liability: usually this type of contracts provide a return that exceeds tenant’s opportunity cost in case of poor tenants this threat may significantly increase the incentive effect on effort; – Non verifiable information regarding tenant’s effort: while this information may not be used in courts (not included/enforced through a standardized contract), it can still be used to improve incentives through the threat of non renewal. Land contracts, eviction and use rights, cont. • Welfare effects of eviction: – Banning eviction can increase the economic welfare of incumbent tenants by increasing their bargaining power; – However, banning eviction potentially reduces the welfare of potential tenants by making it harder to get “fresh” tenancy contracts; – Banning eviction can heighten productivity by transferring the bargaining power from the landlord to the tenant, especially in a context of trade-off between the provision of incentives and the provision of insurance (may not occur spontaneously as it may go against the interests of the landlord that is interested in maximizing his own return and not productivity). In general, removing eviction, we can have increased productivity if the positive incentive due to the increase in the tenant’s share is higher than the negative incentive associated with the loss of the eviction instrument. Which effect dominates is an empirical question [see Operation Barga, pp. 444-445 and Banerjee, Gertler, Ghatak, 2002; found evidence of increasing productivity] Land ownership, land size and productivity • The present (mostly unequal) distribution of land ownership represents the result of history. • Where we have an unequal distribution of land, we might ask whether this has an impact on productive efficiency and what type of action would be best to improve productive efficiency. Land size and productivity: some concepts • Productivity – Total factor productivity of small vs. large farms (production function “above” or “below”?); – Production efficiency of small vs. large plots (marginal products of inputs equaling marginal costs – usually tested comparing output per acre, correcting for land quality – assumption: whenever the conditions of efficiency are violated under application of inputs); Land size and productivity: some concepts, cont. • Factors potentially explaining different performances: – Technology: given other inputs – expanded in proportion - we might expect land to exhibit constant or increasing returns to scale as size increases small size is not an advantage; – Imperfect insurance markets and small-farm productivity: in presence of imperfect information, limited liability (and imperfect credit markets) and uncertainty (and risk-aversion coupled with imperfect insurance markets) making impossible to design and offer productivity-maximizing contracts ownership of small plots farmed by family labor is associated by intrinsic productivity advantages; Land size and productivity: some concepts, cont. – Imperfect labor markets (unemployment) and small-farm productivity: Per-acre production function Output per acre Opportunity cost for Opportunity cost for the family < w the employer = w (because it includes a certain probability p of unemployment) In presence of unemployment : 1 ) we can assume that w>marginal product of labor (unemployment); 2) output per acre on small farms will tend to be higher. Family farms including in their evaluations the probability of unemployment seem to be moving closer to the efficient allocation of resources L* L** Labor input per acre Land size and productivity: some concepts, cont. – Pooling land: if it is possible to pool farms’ activities subject to returns to scale, then small farms can always “win” over large farms. This however depends crucially on the nature of the returns to scale. • An example of successful pooling are cooperatives whose main activity is to market the products. • In other cases (when increasing returns are at the production level), the incentive problem returns, as joint production creates externalities (undersupply of effort - free riding). [Example: TFP decreasing following collectivization and increasing with de-collectivization]. All these counteracting forces lead to the conclusion that the question can only be answered empirically Land size and productivity: empirical evidence • Productivity gains arising from incentives (with imperfect markets) seem to outweigh the technological returns to scale from larger plots, in developing countries [differences with respect to USA and Canada]. • From more to less productive: 1. Owner-occupied and using predominantly family labor (except very smallest ones); 2. Large, mechanized, owner-cultivated farms employing wage labor (some efficiency losses from hiring labor, at least partially compensated by mechanization); 3. Sharecropped land. Land size and productivity: empirical evidence, cont. • Note: empirical productivity studies must be treated with care, as: – There might be differences in the quality of the plots of land (smaller, higher quality – inheritance, less productive sold, etc.); – Mixed evidence in some studies (very smallest less productive – then productivity increases to a maximum and finally decreases with size). • At any rate, productivity per acre on sharecropped land appears to be lower than productivity of the same farms under owner cultivation and size appears to be negatively correlated with productivity. Land size and productivity: empirical evidence, cont. • Suggestion that there is at least some tentative support for the hypothesis that regions of greater inequality have proportionally more to gain – at least under the efficiency viewpoint – from land reform. • Another interesting result is that advantages of small farms over larger ones are smaller in higher-risk environments. This may be due to the existence of imperfections in credit and insurance markets. The larger these imperfections, the more vulnerable smaller farms will be, the smaller the productivity differential is likely to be. • if land ownership implies also better access to credit (land as collateral, for example) productivity per acre may be further increased relative to pre-reform. Land sales • In a “second-best” world in which fixed-rent contracts are not optimal and, more generally, tenancy contracts do not reap fully the incentive gains, the possibility of small landowners to buy land from rich landowners could lead to productivity gains. • This, however, requires a properly working land market. • Empirical evidence suggests that land markets in most cases do not work well, with sales from relatively rich to relatively poor not being very common. Most sales instead appear to be distress sales from poor to rich. Land sales, cont. • Possible reason of thin land mkt - dual value of land: 1. Discounted sum of income streams generated working/renting the land; 2. But ALSO possibility to use land as collateral (especially valuable in presence of imperfect credit markets). The value for the buyer that does not have the money needed to buy the land will not include the possibility to use land as collateral, so the value for the buyer may turn out to be lower than that of the seller (despite possible productivity gains). Land reform • If: 1. Productivity is higher on smaller plots; 2. Productivity gains cannot be realized fully by tenancy; 3. Land sales markets cannot adequately substitute for imperfect land tenancy markets. • we still have the option of organizing land transfers from rich to poor with or without adequate compensation (paid by the government of by donors – anyway, not entirely by the beneficiaries). • However, resistance of powerful lobbies is very likely to make the implementation of this type of reforms very difficult. This is why in the past major land reforms have been the product of political upheavals in society (Cuba, Japan, Korea and Taiwan). Land reform, cont. • There are, however, intermediate steps between government inaction and large-scale redistribution. For example, providing tenants with unlimited use rights to land or putting land ceilings. • Anyway, even if they may go in the right direction (Teklu, 2004 - Banerjee, Gertler, Ghatak, 2002), also these methods fail to solve completely the productivity problem. – Unlimited use rights do not allow using land as a collateral; – Land ceilings can be circumvented. • Most successful land reforms remain those where property was transferred and incentives where set right (see Korean example). Conclusions • For several reasons the operation of land markets alone appear to be potentially inadequate to create the required balance between land and labor endowments. – Rental markets for land must balance the conflicting demands of providing insurance to the tenants with appropriate incentives to maximize production. This principal-agent problem leads to a sacrifice of overall efficiency. – Similar considerations preclude an efficient functioning of the land sales market. • It is important then to understand the market(s) for labor, the various forms that such markets assume and the implications for the development process.