I was sent this new paper from Cameron Murray, otherwise known as @rumplestatskin, outstanding http://ckmurray.blogspot.com/2014/01/time-for-new-theory-of-firm.html it completely undermines the notion of a ‘supply curve’ in neoclassical economics.
It combines the old classical insight that firms seek to maximise the rate of profit measured in terms of capital advanced with modern options theory. As a result the neoclassical concept of the supply curve is no longer supportable. As a by product:
The usually approach is to suggest that rising home and land prices have some connection to town planning regulations that determine location and density limits for new housing. If prices are rising, then according to our mainstream theory there must be a regulatory or physical constraint on the ability to shift the supply curve.
But the theory of return-seeking firm suggests that for many land owners the optimal choice is to withhold their land from development. Because there is an ability to delay investment, deferring capital improvement maintains the option value to develop at a later date to a much higher density [ he could equally have said at a higher profit when in the future there is a greater housing backlog]. It may currently seem optimal to develop a 3 storey apartment building, but if I delay investing, I might be able to develop a 10 storey building in five years time and increase my return on the land.
In fact land development is a core example in real options theory.
If a government wanted to intervene in this market to increase housing stock compared to the status quo under existing regulations, our theory of return-seeking firms suggests that any policy that reduces the rate of return of the land owner when they delay will be effective at bringing housing investment forward in time. One idea is to announce a future restriction on development density, or implement a land value tax, which will reduce the potential rate of return from delaying investment.
The issue here is not the ‘flow’ of housing permission relative to the ‘flow’ of builds (land banking) but the stock of all development land including that without permission to the total stock of housing (land hoarding). The theory helps explain why there has been the collapse in investment in higher cost brownfield sites.