Thoughts on economics and liberty

Extracts from The Economic Case for Private Residential Development by Fred E.Foldvary

Folvary had an excellent chapter in is an excellent article in Private Cities ed. Glasze, Weber and Frantz (2006) from which a few key points are worth noting:

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The economic feasibility of private residential governance, empirically confirmed by the worldwide growth of private communities, turns the prevailing ‘market failure’ doctrine on its head. This doctrine posits that collective goods are subject to free-riders, making the private provision sub-optimal. But the reality of private communities demonstrates the opposite. The governmental provision of public goods such as security and recreation is often deficient, and private enterprise has responded to the demand for such by developing private residential communities.

The accusation that ‘gated’ communities create exclusive zones for the wealthy and fragment the urban community conflates cause and effect. To the extent that private communities fill needs and wants not provided by govern-ment, the fragmentation is ultimately caused by government. Gated communities are the effect, the symptom, both of the failure of government to provide adequate security, and of the desire of residents to enjoy a greater amount or better quality of club goods than provided by governments.

None of [the] … market-failure premises have any justification in logic or evidence in the context of civic goods.

The public goods typically provided by government [streets and highways, street utilities (lighting) and architecture, parks, security, fire protection, schooling, recreation and public transit such as bus services] are located in physical space. Most users are located in the vicinity of the good. Even national defence protects territory, rather than existing abstractly in ether.

To the extent that such collective goods are valued by the residents, they increase the demand to be located near them, relative to not having such goods. This added demand increases the rental that tenants (including owner-tenants) are willing to pay to be located there and the purchase price of land in that territory.

The need to pay rent, either periodically or in the purchase price or as an admission charge, in order to be located in the territory served by the public goods, prevents the resident tenants from being free-riders. Aside from occasional guests, most users are rental-payers. The rental provides the means by which private enterprise can finance the goods. If a firm or club can collect the rental, then they can finance the public good. The market does not fail.

The rentals provide the means of determining whether to provide the territorial goods, and the optimal amount. If the rental generated by the goods is greater than the cost, the good is profitably provided. The optimal amount is where the marginal or additional rental generated equals the cost of additional amounts of the goods. For example, an entrepreneur deciding on how many swimming pools to provide to a large community development would, from previous experience and data, provide pools if they add  more to site values or rentals than they cost. Since the marginal utility of swimming pools declines with increasing quantity, the profit-maximising developer provides more so long as an extra pool generates more expected rental than it costs.

Territory is inherently excludable, although in some cases the cost of complete exclusion may be higher than the benefits. Territorial clubs include private communities such as condominiums, homeowners’ associations, shopping centres, industrial estates or parks, resorts and recreational facilities, office buildings, universities and hotels.

Territory makes club goods excludable in two ways. First, the club can prevent outsiders from entering, such as with a fence and a gate. Second, club services can be de facto excludable if most of the users are paying members, so that free-riders do not materially affect the ability of the club to provide collective goods to the members. A hotel, for example, is financed by the rentals paid by the guests and other tenants, and the fact that non-payers may enter and sit in the lobby or use the elevator does not detract from the financial viability of the hotel.

When government provides the territorial public goods, users are typically double-billed for the cost. Most taxation today falls on wages and capital. A worker-tenant therefore pays taxes on his wages to finance the collective good, and also pays extra rental to a landlord to be located by the territorial goods. If he wants to be located near a metro-rail stop, he pays extra rental relative to locations further away, and he pays sales and wage taxes to the government. To the extent the worker is mobile, a tax on his wage may be passed on to the owner of the firm and to the customers, but typically there are large moving costs and few untaxed options, leaving workers rather immobile for taxes on their wages, and thus forced to bear the burden as a lower net wage.

If some are being double-billed, others must be collecting subsidies on one of those bills. With today’s typical government financing, the free-rider is not the user, who has to pay twice for the territorial goods, but the landowners, who get their land values pumped up as the goods become capitalised into higher rentals and purchase prices for real estate. The landlord of a town house near the subway stop receives higher rentals from his tenants due to the public goods paid for by others. This is an implicit redistribution of wealth, a forced transfer of income from worker-tenants to landowners in general, whether they rent out their premises or occupy them as tenant-owners.

When private communities such as homeowners’ associations, condominiums or hotels provide territorial goods, they do not enquire about the income earned by the members or tenants, or impose surcharges on the sale of goods in their territory. Hotels instead charge a room rental, and condominiums and associations have a monthly member assessment, which in effect is a site rental payment. They do not have the political power to impose arbitrary costs, so instead they must operate contractually, according to the benefit principle. The rental pays for the territorial benefits.

In private communities, tenant—users therefore pay but once for territorial public goods. They pay only the rental. The providers are thus not free-riders, because in return for the rental payment they receive, they finance the goods, rather than having them provided by some governmental third party. Aside from occasional guests having no material impact, with the private provision of territorial public goods there are neither free-riders nor forced taxpayer drivers.

Why do city, provincial, state and national governments not operate like private communities, financing their territorial goods from site rentals? Such has long been proposed by economists, including the French physiocrats, Adam Smith, Henry George and a number of contemporary public-finance theorists. Why does the public tolerate double billing by government, but does not put up with it in private settings?

Sanjeev Sabhlok

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