MODULE 1 UNIT 2

Locations decisions in real estate markets

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Table of contents
1. Introduction 3
2. Compensating differentials 3
2.1 Location advantages 3
2.2 Why pay higher prices for more central locations? 4
2.3 An introduction to factor substitution 4
3. Bid rent world: A simple model 5
3.1 Residential bid rent world: Household side 5
4. The monocentric city model 8
5. Polycentric Cities 10
6. Conclusion 10
7. Bibliography 11

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Learning outcomes:

LO3: Articulate why central locations have higher real estate prices.

LO4: Determine whether or not cities are monocentric.

LO5: Determine where commerce, individuals, and manufacturers will locate based on
the bid rent model.

1. Introduction
Location decisions and the benefits of living in cities were explored in Unit 1. How can the
location decisions of firms, consumers, and manufacturers be further explained? Why do
certain locations draw higher prices than others? Is there a link between the price of land
and the height of buildings? This set of notes intends to explore some of the answers to
these questions by introducing the concept of the bid rent curve and the monocentric city
model.

Bid rent theory relates how property prices change as the distance from the central
business district (CBD) changes. The monocentric city model is based on bid rent theory
and suggests that the price of property decreases as one moves further away from the
CBD.

2. Compensating differentials
To understand the factors that drive location decisions, you first need to understand the
factors that cause people to pay more for some locations than they do for others.

2.1 Location advantages

Land rent refers to the price that a user of land would be willing to pay the owner
(O’Sullivan, 2012), and the value of land is thus the sum of the stream of rental income
expected to be received in future.

Higher prices are often paid for location advantages. As discussed in the Unit 1 notes,
cities first arose due to location fundamentals. David Ricardo (1821, cited in McDonald &
McMillen, 2011) proposed that the fertility of land speaks to its location advantage. For
example, it will be more expensive to rent fertile land than to rent infertile land.

How do you determine what people are willing to pay (bid) for land? Firstly, consider the
idea proposed by Ricardo. Farmers would be willing to pay more to rent land that was more
fertile, as it would produce a higher crop yield. Thus, they would be making more profit per
portion of land rented. When the difference in revenues equates to the difference in rents,
thereby resulting in profits being the same regardless of location, users become indifferent
to location.

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2.2 Why pay higher prices for more central locations?

In an urban environment, however, accessibility to land is more important than the land’s
fertility (Von Thünen, 1826, cited in McDonald & McMillen, 2011). The higher the
transportation costs to the consumer, the lower the land rent charged. Von Thünen (1826)
thus swapped the assumptions that Ricardo made, saying that land is equally fertile, but
varies in accessibility (cited in McDonald & McMillen, 2011). Accessibility goes hand in
hand with transport costs – farmers will need to ship their produce to the market, and the
further away they are from the market, the higher the shipping costs will be. Thus, land
closer to the market will be more expensive than land further away.

Von Thünen’s model also makes sense for workers who commute to work in the CBD
(McDonald & McMillen, 2011). Commuters that live further away will have to pay more to
transport themselves to the CBD. Therefore, land that is further away will be cheaper than
land that is closer, because of these compensating differentials (i.e. the compensation for
paying a higher land rent is lower transport costs and vice versa).

William Alonso (1964) drew on these theories to create the earliest version of the bid rent
model that was later expanded upon by Edwin Mills (1967) and Richard Muth (1969).

The following video illustrates how property prices in Chicago are higher the closer land is
to the CBD, serving as an example to show how location influences property values.

Video 1: Property prices in Chicago. (Access this set of notes on the Online Campus to engage
with this video.)

2.3 An introduction to factor substitution

Seeing as property prices are high in the CBD, it is assumed that firms will try to obtain the
most value out of a small amount of space. This can be done by building taller buildings.

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Taller buildings are built when the benefits (i.e. higher rental income) of locating
centrally are greater than the construction cost of building higher buildings. Building
higher buildings consists of two main costs: the cost of physically constructing a building
that is stable when multiple stories are added, and the cost of vertical transportation (i.e.
elevators).

Building higher buildings to maximise land use is a type of factor substitution. Factor
substitution refers to one variable being substituted for another. In this case, capital
investment (construction costs) is being substituted for land.

3. Bid rent world: A simple model

As discussed, Von Thünen’s model can be applied to urban areas. There is a cost to
commute to work, but lower housing prices further away from the city compensate for this
cost. Therefore, the rent that a household would be willing to bid or pay (the bid rent) is
their income less transport costs and non-housing goods consumed.

3.1 Residential bid rent world: Household side

The following assumptions are made when determining where consumers would ideally
locate (i.e. close to the CBD or further away):

• The only factor relating to land that matters to a consumer is its distance to the
CBD.

• Households maximise utility (i.e. maximise the pleasure derived from the
consumption of housing and non-housing goods given a fixed income).

• Households consume one composite good (C) as well as land (L). A composite
good encompasses all goods that a consumer consumes besides the good in
question. In this case, the good is land.

• Households commute to the CBD for work at a transport cost of t over a distance
of x.

• Households earn an income of y.

Therefore, the following formula can be derived, where R is rent cost per unit of land:

y − tx = RL + C

The formula can be rearranged as follows to isolate what the rent cost is:

R = (y − tx − C) ÷ L

This formula denotes the rent cost that will keep the household indifferent between
locations. The equilibrium is when no household at any location has an incentive to relocate
within the city.

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If it is assumed that land is not substituted (i.e. households do not consume more land the
cheaper it gets), the bid rent function can be represented as in Figure 1. The distance from
the CBD is depicted on the x-axis with the bid rent on the y-axis. As you can see, the bid
rent for land decreases as distance from the CBD increases.

Figure 1: Bid rent function with no factor substitution.

In actuality, as rent decreases, land consumption increases. Households can get the same
amount of land at a lower cost and will therefore purchase more land. Population density
also decreases as the distance to the CBD increases, because each household is
consuming more land.

Figure 2 depicts the quantity of land consumed on the y-axis and the distance from the
CBD on the x-axis. As you can see from the graph, land consumption increases as the
distance from the CBD increases. Conversely, because individuals are consuming more
land per capita, the population density decreases. The line L = L* shows the situation where
consumers do not consume more land as it gets cheaper. This is not a particularly realistic
scenario, as it makes sense to consume more land as it gets cheaper (and less of other
goods as they become relatively more expensive the further away from the city centre).

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Figure 2: Land consumption versus distance from the CBD.

With land consumption by households increasing as rent gets cheaper, rent decreases at
a decreasing rate. This can be seen in Figure 3 with the bid rent on the y-axis and distance
from the CBD on the x-axis. The curve is steeper the closer the location is to the CBD,
where households consume less space. This means that L in the equation is smaller, and
thus the slope is steeper, because y − tx − C is being divided by a smaller number.

Figure 3: Bid rent function with factor substitution.

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4. The monocentric city model

Is there any generalised pattern of distribution that seems to occur in cities? As you saw in
Video 1, prices of properties tend to be higher in the CBD, tapering out in the surrounding
areas. The monocentric city model was developed by William Alonso (1964), Edwin Mills
(1967), and Richard Muth (1969). Cities were structured quite differently 100 years ago,
and jobs were mainly located in the CBD. As discussed in Unit 1, firms and manufacturers
locate near the city centre to gain the advantages of agglomeration economies and
economies of scale. Improvements in construction also resulted in high-rise buildings.
Since manufacturers still relied on rail or water transport, they were reliant on a central
transport hub from which to transport goods.

The monocentric city model assumes that one city centre exists, and that all firms locate
there. The city could be laid out in either a circle or a straight line. Households would need
to choose a location to live, and commute to the CBD. The model aims to illustrate how
the prices of properties differ depending on how close they are to the CBD, and to show
the effects of agglomeration economies. As households move further away from the city
centre, housing costs decline, and transport costs increase. The model explores the
relationships between commuting costs, housing prices, and housing consumption.

The aim of the model is to illustrate the following outcomes. The further away from the
CBD:

● The lower the housing prices;

● The higher consumption of housing;

● The lower the population density; and

● The lower the capital-to-land ratio.

The model makes the following assumptions:

● All jobs, as well as a central point of export (where all manufacturers export their
product from), are located in the CBD.

● Land is owned by landlords and households must rent it.

● Workers from different offices meet in the city centre to exchange information.

Different users value proximity to the CBD differently. For each of the following parties, the
focus differs:

● Commercial: The commercial sector is willing to pay the most for central land. For
retailers, it is vital to get high volumes of foot traffic to make sales. For offices
producing knowledge-based tradable services, agglomeration economies are
crucial, because firms have to be very close to one another to benefit from
exchanges of knowledge. Since offices and retailers want to locate closer together
to reap the benefits of agglomeration economies, they have a very high willingness
to bid for space in the city centre

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● Residential: Households are focused on jobs in manufacturing and commerce.

They have a fairly high cost of commuting, but have a means of travelling longer
distances within a reasonable time through the use of subways and cars. Residents
are willing to locate further away from the CBD, as there is no competition from the
commercial sector. This way, land is cheaper, and residents have more space to
build suburban housing.

● Manufacturing: Manufacturers gain the least benefit from locating close to the
CBD. Since they no longer serve only local markets (they also serve national and
global markets), they value the highways on the urban periphery as means to ship
their products. They also generally need larger areas of land, which would be too
costly in the CBD. If manufacturers can locate close to transport lines, they will be
satisfied with locating further away.

Figure 4: Monocentric city model.

Cities are less monocentric in modern times due to the following reasons (among others):

● Trucks and highways have developed, making manufacturers less reliant on a

central transport hub.

● If manufacturers locate closer to the suburbs (and thus their workers, lowering
wages), they would have increased transport costs. Previously, the cost of
transport would increase more than the wages would decrease. However, with
cheaper methods of transport available, the wage saving is, in some cases,
greater.

● Advances in communication technology results in people being able to

communicate effectively across greater distances.

● Subcentres that resemble CBDs have emerged within larger cities. This occurs
because, if there is only one CBD, commuting costs (and resulting wage

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compensations) become very high. These polycentric cities combine the benefits
of large cities (agglomeration economies) with those of smaller cities (shorter
commuting times).

● Edge cities are cities where one or more concentrations of firms, shops, and
entertainment occur outside the central business district in what would have been
a residential or rural area. Edge cities are increasingly being developed, usually at
highway intersections.

5. Polycentric cities
In recent years, and in contrast to the monocentric city model, cities have evolved to include
more than one activity centre. A polycentric city has clusters of centres which are often a
result of urban growth (Broitman, 2012).

The concept of polycentric cities, which was first developed by Harris and Ullman in 1945
states that cities have “multiple nuclei around which growth takes place” (Planning Tank,
2020). The concept of “multiple nuclei” put forth by Harris and Ullman argues that cities
change overtime and although a city may start with a single central business district (CBD),
this can and will evolve overtime as cities become more modified. In a more recent study,
Bertaud and Maelpezzi (2003) collected population density by district for 48 global cities,
and estimated population density gradients. Their results found most cities are relatively
clearly centralised, with only five out of the 48 analysed cities being clearly decentralised.
These five cities include Brasilia, Capetown, Johannesburg, Moscow and Seoul.

The polycentric city model is said to offer various benefits including an increase in
economic competitiveness and climate change (Aydan, 2017).The multiple activity centres
provide economic and employment opportunities by increasing competitiveness between
businesses operating within the activity centres. Due to the structure of polycentric cities,
there is less congestion, which reduces the effects of air pollution and habitat destruction.

Explore further:

To learn more about the nature of monocentric and polycentric cities, access the article
on how polycentric is a monocentric city and download the PDF.

6. Conclusion
Higher prices are paid for better locations due to location fundamentals and agglomeration
economies. These agglomeration economies are so important that it becomes more cost-
effective for firms to build taller buildings than it is for them to locate further away from the
CBD. Therefore, taller buildings are generally located on more expensive land in order to
gain the most benefit per unit of cost, this is the advantage of building taller buildings. The
bid rent curve and the monocentric city model assist in explaining these phenomena.

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Firms are willing to pay greater prices for more central locations. Manufacturers need larger
areas and are therefore amenable to settling further away from the CBD, where they have
access to highways to transport their goods. Residents locate further away from the CBD,
where competition from firms is less and they are able to get more land for a lower price.

Take part in the small group discussion forum to find out how many of your fellow students
live in monocentric cities.

7. Bibliography
Alonso, W. 1964. Location and land use: toward a general theory of land rent. Harvard
University Press.

Ahlfeldt, G.M. 2018. The monocentric city model [GY457 Lecture notes]. Department of
Geography and Environment, The London School of Economics and Political
Science.

Aydan, N. 2017. Monocentric or Polycentric? Defining Morphological Structure of NUTS-

2 Regions of Turkey from 2000 to 2016. Available: http://scindeks-
clanci.ceon.rs/data/pdf/0354-8724/2018/0354-87241801001S.pdf [2020, October
25].

Bertaud, A. & Malpezzi, S. (2003). The spatial distribution of population in 48 world cities:
Implications for economics in transition. Available:
https://www2.lawrence.edu/fast/finklerm/Complete%20Spatial%20Distribution%2
0of%20Population%20in%2050%20World%20Ci.pdf [2020, November 3].

Broitman, D. 2012. Dynamics of polycentric urban structures. The Faculty of Architecture

and Town Planning. Available: https://spinlab.vu.nl/wp-
content/uploads/2016/09/PhDThesis-Final-DaniBroitman-26-07-2012.pdf [2020,
October 25].

McDonald, J.F. & McMillen, D.P. 2011. Urban economics and real estate: theory and
policy. 2nd ed. John Wiley & Sons.

Mills, E.S. 1967. An aggregative model of resource allocation in a metropolitan area. The
American Economic Review. 57(2):197-210.

Muth, R.F. 1969. Cities and housing: the spatial pattern of urban residential land
use. Chicago: University of Chicago Press.

O’Sullivan, A. 2012. Urban economics. 8th ed. New York: McGraw-Hill/Irwin.

Planning Tank. 2020. Multiple Nuclei Model of 1945 by C.D Harris and Edward L. Ullman.
Available: https://planningtank.com/settlement-geography/multiple-nuclei-model
[2020, October 25].

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