By Keith Weiner
Net Present Value
Warren Buffet famously proposed the analogy of a machine that produces one dollar per year in perpetuity. He asks how much would you pay for this machine? Clearly it is worth something more than $1.00. And it’s equally clear that it’s not worth $1,000. The value is somewhere in between. But where?
We are not sure why Warren Buffett invoked a money printing machine of all things – another interesting way of looking at the concept is by e.g. considering land. Why does land have a finite value? After all, a piece of land that can be used to grow wheat can conceivably do so in perpetuity (even if it is merely valued as standing room, such as a plot of land on 5th Avenue in NYC, it can render that service forever. The only important attribute is that the land in question be capable of generating rents, or is at least expected to become capable of doing so in the future). Why then isn’t it worth an infinite amount? Land values are appraised the same way the values of other factors of production are appraised, namely (to paraphrase Mises) according to the services they will render at various future time periods, with time preference taken into account (if society-wide time preference is high, the natural interest rate will be high as well and land values will be affected negatively; conversely, land values will tend to increase amid declining time preference and falling interest rates). By applying a discount to a series of consecutive future time periods, one will arrive at a sequence of values converging to zero, hence the price of land is finite (sub-marginal land that cannot conceivably yield any rents will have no value at all, or at best a speculative value). This is just considering the basic ceteris paribus (or equilibrium) framework, as in the ever-changing real economy numerous other factors will also influence the appraisal of land values; still, it is fair to say that the quality of the land concerned (how much output it is expected to produce per input of labor and capital) and time preference (which determines the height of the interest rate used in the discounting procedure) are the most important factors (and it is important to recognize that they are distinct factors, completely independent of each other. Originary interest is not a function of productivity). Other factors can of course overwhelm these basic considerations – these concern mainly various types of government intervention in the economy (such taxes levied directly on land or on land rents, the security of property rights, etc.), or other developments that impact expectations (for instance, if a major volcano outbreak is expected to be imminent, the value of land in the vicinity will probably decline quite a bit). As Keith explains below, time preference is a fundamental pillar of all human action. We are mortal and in our perception of time, there is always a “sooner” and a “later”. Therefore time preference …read more
Source:: Acting Man
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