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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.
