Council Banking on Market Failure?

This posting challenges Auckland Council presumptions and plans that arise from its growth assumptions, and which relate to its determination to incentivise and otherwise promote on a massive scale, residential development beyond the RUB and redevelopment within the RUB (RUB= Rural Urban Boundary).

I argue that Council's plans for residential development ( contained in the Auckland Plan, the developing Long Term Plan and the Unitary Plan) not only rely on market failure, but will increase the extent and impact of market failure already present in Auckland's property market.

I first of all present a simplified description of the economics, then, in that light, go on to consider what Auckland Council appears to be planning.

Auckland Property Market Economics

If Auckland's residential development market was operating as a truly free market, then it would typically be argued by economists that no local government (or central government) intervention would be required.

Market failure is the standard justification for local government or government action in neoclassical welfare economics. The basic presumption is that market processes work best to allocate scarce resources in the most efficient way. This assumes perfect competition, where price information will direct self-interested market participants to correct “mistakes” in resource use (Pareto optimal allocation).

And that when competition is imperfect, the consequent “market failures” can and should be corrected by local government (or central government). Such intervention is based on an implicit assumption that political actors (in local government or government) have both appropriate incentives and accurate information, so that Pareto optimal allocations of resources are then achieved. (Paraphrased here from KEECH et al, (2012), Market Failure and Government Failure)

This is a bit over-simplified.

Economists generally use the term market failure to describe a situation in which the invisible hand (Adam Smith's "invisible hand of the market") fails to allocate resources in a socially desirable manner, so as to maximize aggregate economic well-being. Market failure arises when economic agents face incentives that are distorted because of institutional failings or some other reason, leading to economic outcomes that are bad from society’s point of view. (I quote here from Jan Brueckner (2000), Urban Sprawl: Diagnosis and Remedies)

The classic example of a market failure is air and water pollution, where a factory has little incentive to take account of the environmental damage it causes and, thus, ends up polluting too much. In New Zealand we have institutions like the Resource Management Act, Regional Government, Central Government and the Parliamentary Commission for the Environment all involved because of this particular market failure.

An important consideration arises from institutional involvement in any market.  

We can distinguish "passive government failure," where government inaction results in inferior economic outcomes, from "active government failure," where government action results in outcomes worse than if government had done nothing.

It is oddly idealistic simply to expect that local government (or government) actions will be obvious improvements on market failures. In fact, such idealism is every bit as naive as “free market fundamentalism” that simply assumes markets will always perform optimally with zero intervention. It is better to recognise that because few processes - market or political - turn out the way we expect or desire, then we need to critically evaluate all local government policies that seek to intervene in a market.

Urban Development and Growth Market

The first question to ask is why is local government involved in the regulation of land use at all?

The right of individuals to control their property has long been recognised, but that autonomy is counterbalanced by the fact that property use sometimes must be regulated for the common good. The common method of land use control in New Zealand is zoning, which allows local government to divide its territory into districts or zones where particular uses or activities are permitted or prohibited. Zoning, which became common in the early 20th century, is the foundation of the modern local system of land use control. The prevalence of use zoning has tended to leave land use decisions almost entirely to local discretion.

What is interesting about what is happening in Auckland now, is that the local government institution that is responsible for zoning land, is the same institution that has the parochial interest in taxing (rating) the occupants (users) of the land. Before local government amalgamation in Auckland it was regional government (the equivalent of state government in other western democracies like Australia, Canada and USA) that had responsibility for deciding the zonings of land when it shifted from rural use to urban use, or from low density to higher density. And it was local government that enforced and regulated land uses consistent with regionally set zonings, and which collected rates to pay for publicly provided services.

Now it's a one stop shop in Auckland. But is that one stop shop capable of making economically efficient decisions about land use?

Internationally, and here in New Zealand, ratepayer groups typically favoured regional control of land use planning because they were suspicious of capricious action by local government and its parochial view of planning and development. On the other hand, ratepayer groups might prefer local control in the case of emotionally charged issues, such as the disposal of toxic waste, because it is easier to mobilize local residents than to persuade a remote regional agency to reopen debate on a difficult decision already taken. Business, too, can see advantages on both sides of the debate about local vs. regional control of land use. Business owners may prefer to conduct their affairs unhampered by a regional land use agency, but they recognize regional involvement in land use planning can work to their advantage by overriding local objections to development, and by creating predictability for landowners (who don't want investment values undermined by un-neighbourly activities.)

This debate has already been had in Auckland, and we now have an amalgamated local government entity, which has all the responsibility for land use planning (subject to legislation of course), for addressing any market failures which come its way in the property market, and, hopefully, not introducing additional market failings into that market.

Urban Growth and Market Failure

Considering urban sprawl (a critical description of development outside the RUB vs compact development inside the RUB), three market failures can cause excessive spatial growth of cities:

• The first arises from a failure to take into account the social value of open space when land is converted to urban use. 
• The second arises from a failure on the part of individual commuters to recognize the social costs of congestion created by their use of the road network, which leads to excessive commuting times for everybody. 
• The third market failure arises from the failure of real estate developers to take into account all of the public infrastructure costs generated by their projects. 

Additional to the second market failure is the social cost associated with having to travel large distances (compared with compact mixed use development) for life's basic needs including education, shopping, employment and entertainment.

Thus, development appears artificially cheap from the developer’s point of view, encouraging excessive urban growth. (Brueckner, 2000)

What is Auckland Council doing about these market failures that are internationally recognised as being associated with greenfield development? Or is it happy to go along with those sectors of the property development industry whose budgets and profit forecasts are predicated on the free lunch that comes with this package of market failures.

Open Space Market Failure

Taking these market failures one at a time: Ready access to open space is important for society’s well-being. Open space provides city dwellers with escape from the urban scene and a chance to enjoy nature. Such open-space benefits, however, are not taken into account when land is converted to urban use. Conversion depends solely on the land’s productivity in urban use (which depends on the value of the houses built) relative to the land’s productivity in agriculture (as reflected in the value of farm output). Since intangible open-space benefits do not constitute part of the income earned by the land when it is in agricultural use, the disappearance of these benefits does not show up as a dollar loss when the land is sold to a real estate developer. The invisible hand thus ignores open-space benefits, causing too much land to be converted to urban use and leading to excessive spatial growth of cities.

This is not an easy problem to solve. A simple form of government intervention could remedy it: charging a development tax on each hectare of land converted from agricultural to urban use (this tax is added to any fees already levied). The magnitude of the tax is set equal to the value of the open-space benefits that are lost when the land is converted. This might appear overly theoretical - eg how would you work out the value of this tax? Some jurisdictions charge an increased development levy for greenfield development vs urban redevelopment. This works to incentivise brown-field development.

The previous MUL and the current RUB boundary planning devices wilol always be prone to development leak across the line. A more robust and useful planning device is a green belt - such as is deployed around Vancouver and London. This is much more of a barrier to greenfield development leakage. Not only that but it provides more valuable greenspace in close proximity to the city. And this is what could be purchased using the sort of greenfield development levy described above.

Excessive Road Commuting Market Failure

The second market failure affecting the spatial sizes of cities arises through commuting. Commuters incur substantial costs, which include the outof-pocket expenses of vehicle operation as well as the “time cost” of commuting. The latter cost measures the dollar value to the commuter of the time consumed while in transit, which is mostly wasted. Together, these out-of-pocket and time costs represent the “private cost” of commuting, the cost that the commuter himself bears. And when the commuter drives on congested roadways to get to work, another cost is generated above and beyond the private cost. This cost is due to the extra congestion caused by the commuter’s presence on the road - which everyone else has to "pay".

We are facing this problem in Auckland now. Various think-tanks are considering alternatives. Some traffic could be diverted to off-peak hours (like heavy freight), when roads are less congested. Some car commuters would switch to public transport if it met their needs. In Auckland the average commute distance is too long from society’s point of view and should be shortened (not easy, but mixed land use policies can begin to address this). The problem with these solutions is though, is that they encourage people to commute long distances, the solutions effectively say "what you're doing's OK", and unless there are congestion charges or some sort of toll, road users never have to face the true costs of excessive road use leading directly to market failure, and lead indirectly to more urban sprawl.

Infrastructure Subsidy Market Failure

The infrastructure costs generated by new development are another source of market failure that affects urban growth. When a new housing development is built, roads and sewers must be constructed, and facilities such as schools, parks, and community facilities. The market failure arises because, under current financing arrangements, the infrastructure-related developer levy burden on new homeowners is typically less than the actual infrastructure costs they generate. The reason is that the cost of new sewers and schools is shared among all of the city’s residents rather than charged directly to those who require the new infrastructure. In effect, infrastructure is priced approximately at average cost rather than marginal cost. Because the developer levy burden on new homeowners is lower than if they fully paid for their infrastructure costs, these homeowners are able to pay a higher purchase price for their houses than if the true costs were levied.With their houses selling for more, developers are then able to offer more for agricultural land than would be possible if the true costs were levied on new homeowners. Higher bids for agricultural land in turn mean more conversion of land to urban use, leading to too much development and excessive spatial sizes for cities. Thus, by undercharging new homeowners for the infrastructure costs they generate, the current Auckland Council plan to subsidise growth related infrastructure will inevitably lead to more urban sprawl.

Auckland Council policy settings are likely to stimulate urban sprawl because they include incentives which encourage developers to undertake greenfield development.

Urban Regeneration and Market Failure

Which brings me to the urban regeneration and redevelopment policies that are contained in the Unitary Plan. Simplification and removal of regulatory red-tape loomed large on the list of political objectives that needed to be ticked off with the inclusion of four simplified residential zones in unitary plan. The vision behind the unitary plan was for a quality compact city form following quality intensification of parts of Auckland's existing residential urban landscape.

All sorts of economic efficiencies can be claimed from compact city approach including more efficient use of existing infrastructure, closer proximity for residents to amenities and employment.

But this is not just a pretty idea it's another part of the property market. And the way it's being handled by Auckland Council it also appears to be reliant upon market failure for success.

How so? It is well known that Council's combined policy of Special Housing Areas and upzoned urban neighbourhoods is designed to make redevelopment of existing residential properties attractive to developers. It is also well known that the objections that are coming from existing residents in those neighbourhoods stem from concerns over impacts of taller buildings on their houses, worries about the capacity of existing infrastructure (roads and schools for example), and fears that the value of their homes might drop because of the perceived impact of intensification. All of these fears are well grounded. Yet the Council does little in the way of active community and area planning and investment to compensate for such concerns, and stands back having created opportunity for the development market who will benefit from the set of market failures that will inevitably ensue:

• The first arises from a failure to take into account the loss in value of the existing sense of community and neighbourhood amenity when urban land is converted from detached residential to intensive use. 
• The second arises from a failure on the part of the first-off-the-block developments to pay for (compensate for) the loss of amenity their intensive project is responsible for, while benefiting from the premium of being first. 
• The third market failure arises from the failure of real estate developers to take into account all of the public infrastructure costs generated by their projects.

These market failures must inevitably lead to conflict between existing residents and would-be developers. At present Council appears reluctant to recognise this problem, or to do anything about it. Other OECD countries have plenty of examples. These always include explicit public development agency intervention in neighbourhood redevelopment, to get the planning right for the new pattern of land uses, and to build needed infrastructure. Such public actions are either funded by the new development and by a contribution from uplift in property values, or from levies that are charged on greenfield development.

One thing is for sure. Unless council addresses the market failures that are built into its current policies for urban regeneration, then developers will run a mile and concentrate on greenfield opportunities. We have a situation whereby Council compact city policies are driving sprawl.

Perhaps the council believes it has found an easy answer to rapid population growth in Auckland. That is just to give in to it, and allow the development industry to profit from it in the name of GDP growth and increased economic activity. And I don't think we want that.