real estate e samle - · pdf filepublished by df institute, inc., d/b/a dearborn real estate...

Ignacio Gonzalez, Contributing Editor

FIFTH EDITIONCALIFORNIA REAL ESTATE ECONOMICS FIFTH EDITION

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CALIFORNIAREAL ESTATE ECONOMICS

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FIFTH EDITION

Ignacio Gonzalez, Contributing Editor

CALIFORNIAReal Estate Economics

CA_RE_Econ_5E.indb 1 8/13/2015 11:20:04 AM

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This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional advice. If legal advice or other expert assistance is required, the services of a competent professional should be sought.

President: Dr. Andrew TemteChief Learning Officer: Dr. Tim SmabyExecutive Director, Real Estate Education: Melissa Kleeman-MoyDevelopment Editor: Julia Marti

CALIFORNIA REAL ESTATE ECONOMICS FIFTH EDITION©2015 Kaplan, Inc.Published by DF Institute, Inc., d/b/a Dearborn Real Estate Education332 Front St. S., Suite 501La Crosse, WI 54601

All rights reserved. The text of this publication, or any part thereof, may not be reproduced in any manner whatsoever without written permission from the publisher.

Printed in the United States of AmericaISBN: 978-1-4754-2904-6PPN: 1523-4107


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iii

CONTENTS

Introduction ix

Acknowledgments xvi

UNIT 1 Introduction to Economic Systems and Principles 1

Key Terms 1Learning Objectives 1What Is an Economic System? 2A Brief History of Economic Systems 6Capitalism and Socialism: Theory and Practice 13The U.S. Economy Today 17Summary 18Review Questions 18Unit Quiz 19

UNIT 2 Supply and Demand 21

Key Terms 21Learning Objectives 21Supply and Demand 21Value 23Supply Factors 26Measuring Supply 29Demand Factors 30Measuring Demand 33Equilibrium 35Local Economic Strength 36Summary 37Review Questions 38Unit Quiz 39

UNIT 3 Economic Change Analysis 41

Key Terms 41Learning Objectives 41The Inevitability of Change 42Economic Forecasting 50Major Economic Indicators 54Summary 75Review Questions 76Unit Quiz 77


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iv California Real Estate Economics Fifth Edition

UNIT 4 Money and Monetary Policy 79

Key Terms 79Learning Objectives 79The Evolution of Money 80U.S. Monetary Policy and the Federal Reserve System 86The Money Supply 94Inflation 98Impact of Monetary Policy on Real Estate 100What Determines the Overall Level of Interest Rates? 101Summary 102Review Questions 103Unit Quiz 104

UNIT 5 The Real Estate Market 107

Key Terms 107Learning Objectives 107The Nature of Real Property 108Characteristics of the Real Estate Market 110Evolving Issues 113Summary 126Review Questions 127Unit Quiz 128

UNIT 6 The U.S. Housing Market 131

Key Terms 131Learning Objectives 131Residential Construction 132Who Owns America’s Housing Stock? 140Characteristics of the Market 144Summary 151Review Questions 152Unit Quiz 153

UNIT 7 California's Economic Profile 155

Key Terms 155Learning Objectives 155At Home in California 155California’s Microeconomies 173Summary 175Review Questions 176Unit Quiz 177

UNIT 8 The California Real Estate Market 179

Key Terms 179Learning Objectives 179Building a Market 180Other Housing Issues Faced by California 189Summary of California Housing Market 192Commercial and Industrial Trends 193California’s Rural Real Estate Market 201Lumbering and Mining 204Open Space Protection 207


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Contents v

The Outlook for California 209Summary 211Review Questions 212Unit Quiz 213

UNIT 9 Land-Use Planning and Development 215

Key Terms 215Learning Objectives 215Introduction to Land-Use Planning 216Steps in the Development Process: An Overview 219Government Regulation of Land Use 223Regulation of Land Development 237Regulation of Land Sales 242Economic Cooperation 243Summary 245Review Questions 246Unit Quiz 247

UNIT 10 Fair Housing and Environmental Regulations 249

Key Terms 249Learning Objectives 250Fair Housing Laws 250Environmental Issues 258Summary 278Review Questions 279Unit Quiz 280

UNIT 11 Financing and Taxation 283

Key Terms 283Learning Objectives 284Introduction to Real Estate Finance 284Loan Programs 294Creative Financing Techniques 301Financing Legislation 306Taxation 311Summary 319Review Questions 320Unit Quiz 321

UNIT 12 The Economics of Real Estate Investment 323

Key Terms 323Learning Objectives 323What Is Real Estate Investment? 324Investing In Real Estate 324Tax Benefits 331Investing With Others 333Summary 336Review Questions 337Unit Quiz 338


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vi California Real Estate Economics Fifth Edition

UNIT 13 The Economics of Appraisal 341

Key Terms 341Learning Objectives 342The Evolution of Property Valuation 342The Appraisal Industry 344Essential Elements of Value 348The Three Approaches to Value 352The Appraisal Process 360Summary 363Review Questions 364Unit Quiz 365

UNIT 14 Analyzing Residential Income Property 367

Key Terms 367Learning Objectives 367Analyzing Residential Income Property: A Process Approach 368Step One: Clarifying the Issue 368Step Two: Collecting the Data 369Step Three: Interpreting the Data 372Step Four: Making the Decision 375Measures of Investment Performance 376Summary 380Review Questions 381Unit Quiz 382

UNIT 15 Analyzing Commercial Investment Property 385

Key Terms 385Learning Objectives 385Fundamental Principles 386Types of Property 387Commercial Property Investment: An Analytical Approach 390Sample Economic Analysis: New Construction 392Sample Economic Analysis: Existing Property 393The State of the State 395Now Let’s Try It 402Summary 404Review Questions 404Unit Quiz 406

UNIT 16 Real Estate Trends in California 409

Key Terms 409Learning Objectives 409Affordable Housing in California 410Redevelopment 421Smart Growth 424Environmental Issues in Real Estate Economics 436The Next Economic Boost for California 442The State of the Real Estate Market 444Summary 450Review Questions 451Unit Quiz 452


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Contents vii

UNIT 17 Understanding and Using Economic Data 455

Key Terms 455Learning Objectives 455U.S. Population Projections to 2060 456Understanding the Consumer Price Index 467Limitations of the CPI 477Updates and Revisions of the CPI 479Summary 483Review Questions 484Unit Quiz 485

Appendix I 487

Appendix II 489

Appendix III 493

Glossary 499

Answers to Unit Quiz Questions 541

Index 543


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ix

INTRODUCTION

From the Gold Rush days of 1849 to the explosive growth of the inter-net at the beginning of the 21st century, California’s economic history has been one of constant change, growth, and prosperity. Originally a sparsely populated western frontier with fewer than 100,000 residents in 1850, Cali-fornia is now an extensively developed region whose population exceeds 38 million and whose economy ranks eighth in the world. California’s gross domestic product exceeded the trillion-dollar mark in 1997—the first state to achieve this record. California is also the first state to top $1 trillion in personal income.

California is also a world technological and economic leader and an example of what the future has in store for the rest of the country. It has been the birthplace of many of the world’s most significant technologi-cal innovations, from the aerospace industry to the personal computer to telecommunications and the internet and beyond. California serves as the model for economic innovation and prosperity.

California leads the nation in the production of fruits and vegetables. The state’s most valuable crops—grapes, cotton, flowers, nuts, oranges, and dairy products—also contribute to the largest single share of farm income. The state also produces the major share of U.S. domestic wine. California’s farms are highly productive as a result of good soil, a long growing season, and the use of modern agricultural methods. Much of the state’s industrial production depends on the processing of farm produce and upon such local resources as petroleum, natural gas, lumber, cement, and sand and gravel.

Since World War II, however, manufacturing, notably of electronic equipment, computers, machinery, transportation equipment, and metal products, has increased enormously. Silicon Valley, located between Palo Alto and San Jose, so-called because it is the nation’s leading producer of semiconductors, is also the focus of software development. California con-tinues to be a major center for motion picture, television film, and related entertainment industries, especially in Hollywood.


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x California Real Estate Economics, Fifth Edition

California, like the rest of the nation in 2008–2009, was in the midst of a severe economic downturn. As a result, California experienced falling home prices and shrinking equity values in its real estate, and growing job losses almost devastated both the U.S. and California economies in 2008. Additionally, consumer and business spending, which is at the very core of the economy, also took a shift downward. The efforts of the U.S. govern-ment, including Congress, the Treasury Department, the Federal Reserve, and the White House to stimulate the economy appeared to have done little to excite and stimulate the economy, and, thus, economic output fell significantly in 2008. California experienced the highest unemployment rate (12.2% in August 2009) since 1940. Both the California and U.S. economies did not significantly improve until credit became much more available.

As we moved out of the “Great Recession,” the U.S. unemployment rate has remained at 5.8%. U.S. total non-farm jobs rose by 321,000 in November 2014, the biggest increase since January 2012. California’s unemployment rate remained unchanged in October 2014, at 7.3%. California’s non-farm payroll employment grew by 41,500 jobs in October, higher than the 22,500 monthly average for the first nine months of 2014. Relative to the real estate market, the median sales price of an existing single-family home fell in October 2014 by 2.3% to $450,620. Compared to the prior year, the median price was up by 5.4%.

California’s strong entrepreneurial spirit, world class seaports, transporta-tion, and university systems, coupled with an existing high technology base developed in part from the defense industry, have contributed to Califor-nia’s venerable position as a world leader.

For many people, the prospect of reading a book about economic principles is not attractive, even when the focus is on their own industry, or even their own state. California Real Estate Economics attempts to address this widespread “econo-phobia” by presenting classic and substantive informa-tion in a timely, engaging, and understanding way. If we are to succeed in our professions, we must learn to understand our past and prepare for our future. We need to understand how real estate fits into the overall economy of the state and why it is so important to our economic vitality.


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Introduction xi

A Look Back at Trends in California

By January 2007, the population had increased to 37.7 million, and by July 2008, California’s population had surpassed 38 million, which represented a growth rate of 1.6%, adding 436,000 new residents between July 2007 and July 2008. Since April 2000, the State of California has grown by almost 4.3 million people for an overall growth rate of 12.6%. The state’s nine largest counties (Los Angeles, San Diego, Orange, Riverside, San Ber-nardino, Santa Clara, Alameda, Sacramento, and Contra Costa) each have over one million residents. They are home to 70% of Californians. Placer, Imperial, and Riverside Counties had the largest percentage increases in population, each growing more than 2%.

In 2002, the California Association of REALTORS® noted in its monthly affordability index measures that the percentage of households able to afford a medium priced home in San Francisco was about 16% followed by Contra Costa County at 17%. Overall, the San Francisco Bay Area averaged about 25%, while Los Angeles County came in at 36%. The high cost of housing can be attributed to the economic growth that California enjoyed during the late 1990s and into 2000. During this period, California experienced an increase of 2 million jobs, boosting the economic vitality of the state. With unemployment at the lowest level since the 1960s, wages rose, and poverty fell along with unemployment to a record level of 4.5%. However, housing prices continued to outpace people’s income. In 2005, the cost of housing throughout California rose, with the median price of a home being $538,770 in October 2005, while the annual income needed to purchase a median-priced home in California stood at $128,480, based on an average mortgage rate of 6.03%. At the conclusion of 2005, the most affordable region of California was the High Desert region with an affordability index of 25%, and the least affordable region was the Northern Wine Country at 7%. Because of this, only one in four households was able to afford a typical home in California. However, by July 2009, primarily due to the national and state recession, the statewide median price stood at $285,480. The recession resulted in the median price falling from $560,270 in 2007 to $346,750 in 2008, which is a 38.1% decrease.

However, by 2014, California’s housing market had vastly improved, and by October 2014, the median price was now at $450,620, a significant improvement from 2008. By the beginning of the final quarter of 2014,


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xii California Real Estate Economics, Fifth Edition

California’s unemployment rate was at 7.3%, and non-farm payroll grew by 41,500 jobs in October 2014. Additionally, more than 126,000 building permits were issued in October 2014 for the construction of new single-family homes, and 93,000 were also issued for multi-family units.

Despite recent job growth, home appreciation, and more Californians going back to work, many people are still forced to commute long distances in order to afford their first home. Because of this, urban sprawl has continued to be an issue in all parts of the state. Due to the urban sprawl California has endured, there has been a movement by urban planners, environ-mentalists, and government to practice smart growth techniques, which, in essence, borrow from European and old world planning by implement-ing mix-use developments and maximizing the state’s resources, including land. The vision is that we in California will be able to live and work in the same community without spending hours commuting and, thus, reduc-ing congestion. With no doubt, this trend or desire will continue to be the paradigm for years to come. In 2015, California also embarked on the first phases of the construction of the State’s high-speed rail system that will link the San Francisco Bay Area with Southern California. The initial por-tions of the route will commence in the Central Valley between Madera and Fresno.

Features

This book was designed to take advantage of a variety of instructional design principles and content features, all of which are intended to make it more accessible to students. Page layouts are clean and easy to read and include generous right margins for note-taking. There are numerous illustrations, and all graphic elements have been designed for the greatest possible clar-ity. Throughout the book, we have tried to ensure that the language is as clear and direct as it can be.

This book has 17 units. The units are arranged in a logical order, from broadest principles down to specific investment applications.

In addition to this book’s innovative content and structure, other features have been included to enhance the learning experience:


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Introduction xiii

Learning Objectives

Learning objectives tell readers what they should get out of each chapter’s discussion.

A Closer Look . . .

This feature provides relevant real-world, historical, or background infor-mation that helps enhance readers’ understanding of sometimes difficult issues.

The Next Step

Sometimes a unit’s focus will shift to a different direction. This feature alerts readers to such changes within a unit and provides a preview of the next unit’s coverage.

In California

Several units of this book are dedicated to California’s unique economy. In more general units, however, information about California is sometimes included. This icon lets readers easily locate California-specific information.

Summary

Each unit includes a comprehensive, highlighted summary of its most important information, provided to both reinforce learning and help make studying and review easier.

Unit Quiz

Each unit ends with a quiz covering its material. The questions have been completely revised to reflect the information covered in a challenging and yet constructive way. An answer key is included in the back of the book, including page references for each correct answer.


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xiv California Real Estate Economics, Fifth Edition

Appendices

We’ve included some interesting and valuable material at the end of the book, too:

■ Appendix I: California Facts

■ Appendix II: California Counties

■ Appendix III: Websites

Statistical Information Included From the U.S. Census

This text has included the most current information available, including information released by the U.S. Census Bureau. However, it should be noted that the U.S. Census is completely updated only once every 10 years, with all aspects of the census considered and made available. The Census Bureau makes every effort to periodically update its information; however, not all information may be available. Some information may not be com-pletely available at this time due to timing and release of information. Both the author and the publisher encourage the student/reader to constantly check the U.S. Census Bureau’s as well as the California Department of Finance’s websites for any changes and updates, as information relative to both economics and real estate is ever-changing.

Our goal throughout this book is to provide you with the most current, complete, and relevant information about basic economic principles and the real estate economy. We’ve tried to make what can be dry information come alive by showing how economic theory is played out in the real world.


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Introduction xv

TO THE STUDENT: WHY STUDY REAL ESTATE ECONOMICS?

The fundamental question for you right now is, “Why should I study real estate economics?” For real estate professionals, the answer is clear: real estate is a constantly changing market that is formed, defined, and manipu-lated by economic forces on a local, regional, state, national, and even worldwide level. In a highly competitive environment, the players who understand what the rules are that govern the game, how the rules work, and how they can be manipulated will be the ones who not only survive but prosper. Real estate economics is not a dry, theoretical field of academic study for Nobel laureates only: it’s the world in which you work and live.

ABOUT THE AUTHOR

Contributing editor Ignacio Gonzalez is a California-licensed real estate broker, a professional land-use planner, and an adjunct instructor/lecturer and Real Estate Coordinator for Mendocino Community College in Ukiah, California. He has been a real estate educator for over 25 years and cur-rently teaches classes in real estate principles, real estate practices, real estate economics, finance, appraisal, and property management as well as land-use planning and home inspection. In 1999, he was the recipient of the Mendocino College President’s Award for Outstanding Faculty. He has also taught real estate courses for Anthony Schools in the San Francisco Bay Area and College of the Redwoods. Gonzalez is also a GRI instruc-tor teaching classes in environmental hazards, land use, and construction throughout California. Mr. Gonzalez is currently a consulting land-use planner to government agencies, providing land-use planning services throughout California. Previously he served as the Planning Director for both Mendocino and Santa Clara counties. In 2012, he was appointed by the Governor as Chairman of the State Mining and Geology Board, where he served until January 2015.


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Like a real estate transaction, this textbook is the product of teamwork and cooperation among skilled and knowledgeable individuals. The author, the publisher, instructors, and other professionals have worked together to help make California Real Estate Economics the best introductory real estate economics textbook in California. The participation of these profession-als and their willingness to share their expertise and experience is greatly appreciated.

For his insightful and detailed review in preparation for this Fifth Edition, we would like to thank Edward M. Cohan, MBA, JD, East Los Angeles College (ELAC).

We would also like to recognize those who helped with previous editions of California Real Estate Economics:

Thurza B. Andrew, GRI

Thomas B. Gruenig

Howard E. Harris

Fred L. Martinez

Kartik Subramaniam

Martha R. Williams, JD

ACKNOWLEDGMENTS


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1UNIT ONE

INTRODUCTION TO ECONOMIC SYSTEMS

AND PRINCIPLES KEY TERMS

capitalism consumption communism distribution economics economyemployment

expansionism feudalism goods industrialization labor productivity laissez faire mercantilism

mixed economies resources services socialism value wealth

LEARNING OBJECTIVES ■ Distinguish among different types of historical and modern

economic systems

■ Understand how capitalism evolved into its present form

■ Explain how the U.S. economy operates


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2 California Real Estate Economics Fifth Edition

WHAT IS AN ECONOMIC SYSTEM?

The Study of Real Estate Economics

Real estate economics analyzes national, regional, statewide, city, and neighborhood trends. This allows us to improve our understanding of the various effects these trends have on the real estate market, both locally and regionally. By studying real estate economics, we gain a better understand-ing of how a market establishes the price of goods and services and how the distribution of these goods and services in the economy affects the real estate market.

An economy is any system designed for the production, distribution, and consumption of necessary and desired goods and services. Economics is the social science that studies, describes, and analyzes that process.

As we’ll see later in this unit, there is a wide range of economic systems operating in the world. Regardless of their differences, however, all eco-nomic systems share these three basic functions:

■ Production

■ Distribution

■ Consumption

These three words form the basis of all economic systems and are the cen-tral focus of the science of economics.

Operation

Economic activities draw on the special capabilities of the human species. The means and arrangements that support the operation of economic sys-tems include:

■ Tool—Humans are inventive toolmakers and tool users. The creation and use of tools makes the production and distribution of goods and services more efficient.

■ Techniques and knowledge—Human beings are learners; we learn from experience and develop techniques in response to what we learn; that’s how we build bodies of knowledge. The progressive evolution


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Unit 1 Introduction to Economic Systems and Principles 3

of human knowledge creates both greater efficiencies of production and greater demand for new and better goods and services.

■ Social arrangements—Humans are social animals. We accomplish tasks by organizing ourselves, by cooperating, by taking on special-ized roles, and by acting in accordance with rules that the group has agreed upon.

A C L O S E R L O O K The people of a South Sea Island depend on fish in their diet. The fish are caught in a lagoon using canoes and nets (tools). They have developed a method of throwing the nets (technique) to ensure the greatest catch. The islanders have accumulated a detailed understanding over many gen-erations (knowledge) about which fish are desirable. Traditional social arrange-ments govern who does the fishing (roles) and how the catch is shared by the community (rules).

The satisfaction of needs and wants almost always requires more than tools, techniques, knowledge, and social arrangements, however. Human effort is required because most of the things needed and wanted are not immedi-ately at hand and freely available. Planning, cooperation, skill, and effort are required to make any economic system function.

Wealth

In economic terms, the word wealth does not refer merely to riches. Rather, wealth is anything that contributes to human comfort and enjoyment. Strictly speaking, wealth can only be obtained through some form of labor and is characterized by being desirable by others. That is, wealth is some-thing that is perceived by others as having value, which is evidenced by being sold or exchanged for other goods or services. Wealth, then, requires a community of at least two people and an object that is owned by one and desired by the other.

Adding Value

Wealth is not limited to what currently exists. Human productive activi-ties can create wealth by adding value to existing goods or services. Often a productive process has many steps, and value is added at each step, as illustrated in Figure 1.1.


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FIGURE 1.1: Adding Economic Value

$0

$200

$400

$600

$800

$1,000

Tree Log Lumber House

Tree Log Lumber House

In Figure 1.1, we see how a tree is cut down, the log is cut into lumber, and the lumber is used to build a house. Note how the value of the same material (wood) rises at each stage of the process. After it is cut down, its value increases only slightly. At this point, the wood’s value is only potential value; it is a raw material waiting to become something else.

Once the log is milled into lumber, however, the value of the wood more than doubles. Once the lumber is assembled into a house, its value skyrock-ets. We are speaking here, of course, in purely economic terms; the tree may have other value besides economic—it has aesthetic value in its appear-ance, environmental value in its biological functions, and other intangible values that are real but of less interest to an economist.

Goods and Services

Wealth is used to obtain goods and services. This trading of wealth—whether composed of beads or coins or stock certificates—for goods or services defines economic activity.

The term goods usually refers to material things that are perceived to have monetary or exchange value. Here again, as in the case of wealth, percep-tion is everything. Clothing, automobiles, and wheat have economic value only if they are perceived as desirable.

Services, on the other hand, are immaterial. The term service refers to activ-ities that are perceived as having monetary or exchange value. Examples of services include legal advice, health care, education, and entertainment. If you are paid a wage, salary, or commission for doing your job, you are receiving money in exchange for your services.


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Needs and Desires

The goods and services that are created and distributed through the econ-omy can be classified as those that are necessary for survival and those that are desirable for quality of life.

Biological Needs Certain resources are absolutely necessary for human biological survival. These are

■ food,

■ air,

■ water, and

■ shelter.

A person who lacks these essential needs for any significant length of time will not survive. They are necessary to life.

Socially Defined Needs There are other needs, however, that are not vital to an individual’s physical survival. Nonetheless, they are still neces-sary. These are the needs that are dictated by the society in which one lives. Clothing, for example, may not be strictly required for physical survival in some climates, particularly in parts of California. However, social conven-tions in many societies (including our own) demand that individuals wear clothing when walking around in public places. Failure to comply with such a rule will not be tolerated by the society, so clothing is a socially defined need; while not necessary to biological survival, it is necessary to social survival.

Socially Defined Desires In any society, but especially in consumer cultures such as our own, individuals may want things that are not neces-sary to their social or physical survival. This may or may not be a natural human condition. In Western industrial societies, people are taught to desire many of the goods and services they purchase. Through advertising and marketing, consumers are shown how desirable a product is and are encouraged to possess or use it.

Modern industrial economies derive much of their energy from creating and then supplying consumer wants. Throughout the industrialized world, “quality of life” is equated with material prosperity and leisure.

Such a view is not, of course, universal. Throughout history, groups and individuals have rejected materialism and consumer-style culture and have attempted to build simple communities based on ensuring the minimum


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essentials of life for their members. Such societies, however, have rarely been popular on a mass scale.

Rules

Rules are established principles of behavior. They are guides or regulations agreed upon by groups of individuals among themselves or imposed by an authority. Rules define the rights and responsibilities of people in society. At their best, rules express a social agreement about what is right, what is fair, what is wrong, and what is permitted. Rules also establish mechanisms for their own enforcement.

All economies are governed by rules established and enforced by the soci-ety in which they operate. The social rules that govern the functioning of economic systems may be customary and informal, or they may be written into formal law. They may be enforced by individuals, by social pressure, or by the state.

A BRIEF HISTORY OF ECONOMIC SYSTEMS

An economy is a system designed for the production, distribution, and con-sumption of necessary and desired goods and services. Throughout history, a variety of economic systems have been invented, tried, and rejected in favor of new systems. Some have been successful while others have been disastrous failures.

Human history is not a simple timeline. The overview provided here is not intended to be a complete history of the world or even to offer a substantive view of economic history. It is provided, however, to give you some idea of how economic theories and systems have evolved over time, specifically with regard to the U.S. economy.

Hunter-Gatherer Economics

The fossil record shows us that the earliest humans, called hunter-gather-ers, lived by hunting and foraging for food. Foraging bands had to cover a wide territory—as much as a 20-mile radius—in order to sustain the small nomadic communities.

Agriculture

A revolutionary development took place between about 10,000 B.C. in the Middle East; some of the nomadic people settled down. Here, people


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began to develop agricultural technologies to control the production of their food rather than simply gather it. Agriculture requires planting, and planting meant that people stayed in one place, tending crops and, eventu-ally, domesticating animals.

While the hunter-gatherers had congregated in small bands, the agricul-tural communities tended to be much larger, supported by the surpluses that resulted from controlled food production.

By 4,000 B.C. populous societies with centralized governments had emerged. With a settled life and economic surpluses, complex political structures grew. With the end of subsistence farming, literacy, specialized occupations, art, and architecture flourished.

Trade and Conquest

As agricultural technologies improved and surpluses fed rapidly growing populations, communities found it necessary to expand their geographi-cal boundaries. Exploration gave rise to increased trade with neighboring agrarian cultures.

Economies based on agriculture and trade were easy prey for the armies of a succession of empire-builders, who gained control of large expanses of ter-ritory through military force. The empires and expansionist nation-states such as ancient Egypt, Greece, Phoenicia, and Rome served as resource allocators for their neighbors by providing established markets for local natural resources like dyes, cedar logs, and shellfish, as well as agricultural products. As the empires grew, the variety of products available rapidly expanded.

Feudalism

Following the collapse of the Western Roman Empire, a complex economic system called feudalism developed and flourished. Based on a complex hierarchy of loyalties, services, and land grants originating with the king and supported by a large mass of landless peasantry, feudalism dominated Europe through the end of the 13th century. So deeply did feudalism influ-ence the society and culture of medieval England that modern real property law in both Britain and the United States still reflects much of its terminol-ogy and principles (see Figure 1.2).


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FIGURE 1.2: Modern Real Estate’s Links to Feudalism

MODERN FEUDAL

Transfer of land evidenced by the passing of a handful of earth or a bundle of sticks from a tree on the property

Bundle ofLegal Rights

Master-servant relationship, in which servant owed absolute loyalty

Agency

Feud or fief: an inheritable estate in land held on the condtion that the holder perform some service for the grantor

Fee Ownership

Rise of the Merchants

As urban culture slowly re-emerged during the late Middle Ages, it was accompanied by a growth in the urban merchant class—a new member of a feudal society formerly composed strictly of the aristocracy, the clergy, and peasants. The new merchant class had little need for the land-based relationships of feudalism and was more interested in maintaining a stable climate in which trade could operate freely. As the strength of the urban merchant class grew, the traditional agrarian feudal hierarchy weakened in the face of this new mercantilism.

Exploration and Colonialism

The search for new markets for a growing surplus of goods led to global exploration. The colonial policy was based on creating self-sustaining mar-kets by importing raw materials and valuable resources from the colonies to be converted to finished goods for resale back to the colonies and to other trading partners. As the American Revolution demonstrated, how-ever, there were limits to the colonies’ willingness to be exploited without sharing in the economic benefits of international trade.

Adam Smith Not only was 1776 the year of the American Revolution but it also marked the publication of one of the most influential books in economic history, Adam Smith’s The Wealth of Nations. Written as a reaction against the dominant economic theory of his time, mercantilism, Smith’s book essentially marks the foundation of modern capitalism.


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Mercantilism, according to Smith, was flawed in its assumption that a country’s wealth was measured by the amount of gold and silver in the government’s treasury. Rather, wrote Smith, wealth should be measured by a nation’s annual production. Smith’s ideal economic system was governed by two forces: the participants’ self-interest and the demands of competi-tion. The action of these two forces Smith called “the unseen hand of the market.” Smith was convinced that the highest good of both the nation and the individual was best served by permitting the unseen hand to oper-ate freely, with a minimum of intervention by government. This approach, called laissez faire or “hands off” economics, assumes that a free market-place will be self-policing and maximally profitable.

The Industrial Revolution

Between about 1750 and 1850, the adaptation of fossil fuels for industrial use led to a flurry of new mechanical inventions that turned Europe from a collection of farms and small cities into a humming mechanized metropo-lis. Factory-building surged, and smoke from what the poet William Blake called the “Satanic mills” darkened the skies and rained soot on the cit-ies. This industrialization ushered in a merchant class of factory owners who prospered while the factory workers’ quality of life declined. Wages were low as mechanization reduced the number of necessary workers, and conditions in the new factories and factory towns were far from pleasant or healthy.

Political Revolutions

A combination of social and economic factors—the excesses of industri-alization, the disparity between owners and workers, and the erosion of monarchies—led to wide-ranging social changes sparked by the Industrial Revolution.

The rise of democracy and the labor movement led to a more equitable allocation of resources among workers, as well as an improvement in work-ing conditions and wages. These reforms were far from universal, however, and in many countries the tensions created by industrialization led to more violent reactions.

Karl Marx The author of the Communist Manifesto (1848) and Das Kapi-tal (1867) is another significant figure in economic history. While Adam Smith had prophesied the free-market capitalism that flourished during the


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Industrial Revolution, Marx observed the darker side of the reality. Indus-trialization, according to Marx, exaggerated the normal fluctuations in the economy, creating bigger, more frequent, and for workers, more disastrous depressions. Because wages did not accurately reflect the owners’ profits, Marx felt that the surplus value that the workers added to goods was being exploited by the capitalists for their personal profit. Marx’s view was not pretty. According to his theory of dialectical materialism, capitalism would inevitably create greater and greater burdens for workers until they rose up in revolution, seized the means of production, and ended their exploitation by establishing collective ownership in a socialist society.

Roots of the Modern U.S. Economy

Prior to the colonization of North America by Europeans, the native popu-lation of the continent did little to disturb the abundant natural resources that this country possessed. The quantity of resources available for exploi-tation made for rapid settlement and expansion by Europeans.

The colonial movement was led by England, France, and Spain dur-ing the 17th and 18th centuries. Raw materials from this continent were exchanged for finished goods from the occupying nations, in keeping with the prevailing mercantile theory. Cleared fields, villages, and roads soon replaced much of the wilderness. The exploitation of the English colonies by the home government led directly to the American Revolution.

The New Nation Economic activity had its first restraints under the provi-sions of the U.S. Constitution, established in 1791. Following the Revolution, the former colonies had remained independent of one another, only loosely tied by the Articles of Confederation. After the enactment of the Constitu-tion, the former colonies were unified with a common currency and without taxes or tariffs between states; a true common market was created.

Certain economic powers were granted to the central government: the regulation of foreign trade and commerce, the printing of money, and the granting of patents and copyrights. A central postal authority ensured con-tinuous and reliable communication.

Divergent Philosophies The Founding Fathers were, however, not entirely unified in their vision of the new nation. There was considerable disagreement among the ranks of the framers of the Constitution about


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what form the new society should take. The argument was personified by two divergent points of view:

■ Thomas Jefferson believed in small farms, an independent press, and a weak decentralized government.

■ Alexander Hamilton looked toward an industrialized society bolstered by high tariffs and a strong centralized government.

The debate between the Jeffersonians and the Hamiltonians was intense and long-lived. Today, however, it is clear that Hamilton’s view, in large part, prevailed.

Expansionism In the 19th century, land surveys were undertaken to stake out new territories in anticipation of admission of new states when adequate population had settled in the area. An infrastructure of canals, roads, and railroads facilitated the westward transport of goods and people, and the abundance of land lured settlers to seek their fortune beyond the Appalachians. This type of policy, advocating territorial gains, is known as expansionism.

The continuing conflict between visions of the nation was played out in the movement west. Many of the pioneers shared the Jeffersonian distaste for large cities and pervasive government regulation of commercial activi-ties. The move west was partly spurred by the settlers’ desire for isolation and for a more pure freedom from social and economic constraints on their behavior.

Industrialization In the 19th century, the United States began to indus-trialize. Cotton from the south was made into finished goods by mills in New England. Iron ore mining began in the 1850s in the Great Lakes area followed at the end of that decade by the discovery of oil in Pennsylvania.

As there was little control of the production, allocation, and distribution of wealth within the country, enterprising individuals were able to seize control of key economic resources. At the top of the pyramid were Andrew Carnegie, who had a stranglehold on the steel industry, John D. Rockefeller in oil, and Leland Stanford in the railroad business. The rise of monopolies spurred greater government regulation of the U.S. economy through enact-ment of antitrust laws and the breaking up of monopolistic enterprises. The government was concerned that the growing power of the monopolies cre-ated a concentration of wealth and influence in a few people and severely hindered competition and a free market.


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Labor Movements As was the case throughout the industrialized nations, the rise of factories and industry also spurred the growth of orga-nized labor. The U.S. labor movement grew in visibility and power with establishment of the American Federation of Labor (AFLA) in the 1880s by Samuel Gompers and the Congress of Industrial Organizations (CIO) in the 1930s.

The Great Depression and the New Deal The stock market crash in October 1929 and its aftermath was probably the darkest economic period in U.S. history. Unemployment rose to catastrophic levels, and the nation’s social structure was severely tested. Through a series of reforms initiated by the New Deal program of President Franklin D. Roosevelt, a variety of new government agencies and programs were established as a means of sta-bilizing and revitalizing the economy. These included the Federal Deposit Insurance Corporation (FDIC) to regulate savings, the Social Security programs, and the Federal Housing Administration (FHA). The Civilian Conservation Corps and the Public Works Administration were examples of activities undertaken by the government to provide employment in vari-ous works projects that are still enjoyed by our citizens today.

The Second World War not only defeated fascism in Europe, it elevated the U.S. economy to a position of preeminent strength in the world. The nation experienced unprecedented prosperity in the years after the war and was lifted out of the lingering effects of the Depression.

Modern Economics

The second half of the 20th century in the United States has been defined by two rival, but related, economic theories: Keynesian and monetarist.

In 1936, the British economist John Maynard Keynes published the General Theory of Employment, Interest and Money. Essentially, Keynes rejected the conventional wisdom that full employment was the natural state of a stable economy. Left alone, Keynes wrote, the economy could operate in a stable state that tolerated a significant level of permanent unemployment. Keynes argued in favor of government intervention to stimulate the economy in order to create full employment. This was a radical rejection of traditional capitalist theory. It dominated American economic policy through the 1960s.

The monetarists, on the other hand, continued to advocate an unfettered free market. Led by economists such as Milton Friedman and Arthur Laffer, monetarists contend that the only legitimate role of government is to cre-


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ate and preserve an environment in which a free market can operate with complete freedom. Monetarists, as their name suggests, look to a steadily increasing supply of money as the key to economic stability. They reject any government actions that interfere with the supply of money (such as raising or lowering interest rates to achieve certain social, political, or eco-nomic goals). The monetarists and supply-side economists of the 1980s view the free market as the best tool for defining and creating social good.

T H E N E X T S T E P In this brief historical discussion, we’ve already alluded to the principal tension underlying economic theory and history: the role of government in defining or controlling the operation of a free market. In the next section, we’ll examine the distinction between the two prevailing economic sys-tems in the world today, capitalism and socialism, as they exemplify this tension.

CAPITALISM AND SOCIALISM: THEORY AND PRACTICE

In the modern world, there are a variety of economic systems ranging from simple barter economies, in which goods and services are traded directly, to complex international market economies. They all lie, however, on a broad spectrum between two fundamental economic theories (Figure 1.3):

1. Pure capitalism: the complete freedom of individuals to engage in the three essential economic activities without interference from regulatory authorities

2. Pure socialism: the ownership, management, and control of all means of production and distribution by the community

FIGURE 1.3: The Economic Spectrum

PureCapitalism

Mixed

Economies

PureSocialism


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Capitalism

Hand in hand with the industrial revolution, the concept of capitalism took shape. Capitalism is a market-driven economic theory fueled by the independent forces of supply and demand (discussed in detail in Unit 2). The major components of this system in its purest form are:

■ private ownership of the means of production and distribution through which individuals have the right to own, control, and dispose of their property;

■ individual enterprise, which is the private ownership of the majority of a nation’s businesses as well as the private ownership and free con-trol of the resources used to manufacture products;

■ the profit motive, or the desire for personal gain that inspires indi-viduals to take risks to produce the goods and services desired by the population (this is very characteristic of the California economy where many individuals left their employers in the late 1990s to start their own businesses; any of these individuals ultimately provided consulting services to their former employers);

■ free competition, which allows buyers and sellers to compete equally and freely among one another to fulfill the needs of the consumer and the producers; and

■ unregulated markets, or laissez faire, which holds that government should not interfere in the economic affairs of a nation.

As we have learned, capitalism’s basic philosophy of free and open, unregulated markets was formalized by Adam Smith (a Scottish econom-ics professor) in 1776, in his work, The Wealth of Nations. Adam Smith believed the “hands off” approach, or laissez faire, would stimulate the pro-duction of goods and services without government interference. Capitalism is based on free economic interaction between individuals. The capitalist assumes the risk of competition and is entitled to reap the rewards of market success. On the other hand, capitalism can be viewed as “hard-hearted” in its tolerance of economic failure and inequality.

Socialism

To understand socialism more clearly, we must understand the roots of socialism. The father of socialism, Karl Marx, wrote Das Kapital in 1867, in which he stated that capitalism would fail primarily because capitalists


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were motivated by profit and would continually pay the labor force low wages in order to attain greater wealth. This, in turn, would thrust workers into abject poverty. Marx further theorized that the impoverished workers would revolt and overthrow the capitalists and seize the wealth on behalf of the workers. Marx believed in a classless society, with the government owning all of the resources and major industries on behalf of the people. Today’s modern socialism and even communism have been derived from the writings of Karl Marx.

It should be noted that the development of the socialistic economic system was the direct result of the excess of unregulated capitalism experienced by impoverished and exploited workers during the industrial revolution. In its purest form, socialism is a command economy (the market responds to com-mands from above). Under socialism, the government makes the economic decisions on how and what is to be produced as well as setting the prices for goods and services. This was very true of the former Soviet Union where the state controlled prices. Under socialism, the consumer does not influ-ence the economics of a nation.

The major defining components of socialism are as follows:

■ Public or collective ownership of the means of production and distribution

■ Regulated enterprise

■ Economic policies reflecting social/political policies

■ Economic equality as a goal

■ Resources that are administered and distributed in the common interest

Communism

In a strict sense, communism is a stage of economic development said to occur when all classes in society have been absorbed into the proletar-iat. In this society, the state (government) would have withered away and each person would contribute according to ability and receive according to needs. This utopia envisioned by Karl Marx was seen to be the stage of economic development that follows capitalism and socialism.

Mixed Economies

Pure capitalism breeds inequality; pure socialism’s equality stifles innova-tion. What’s the answer? The answer, as it has developed in the modern


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world, is the mixed economy—neither socialism nor capitalism but a mix of elements of both. In today’s world, there are no pure market economies and no pure command economies.

Look at Figure 1.4. The vertical axis defines a spectrum of government intervention in an economy, from total control to laissez faire. The hori-zontal axis describes whether the market is based on socialism’s policy of protected equality or on capitalist principles of individual responsibility and risk-taking.

FIGURE 1.4: Modern Real Economic Systems

Laissez Faire

Pure Capitalism

Individualism

Guided Market

Government Control

Pure Socialism

Equality

Communism

The old Union of Soviet Socialist Republics (USSR) might have been placed in the upper left quadrant, while the U.S. economy placed in the lower right. Note that both of them, being mixed economies, are pulled toward the center rather than toward the extremes of the spectrums. Also, note that communism and capitalism are both on the same end of the gov-ernment intervention axis. This is because, under the theoretical economic system of communism, there is no government authority; all property is held and administered communally by a wholly self-directed society. In pure capitalism, all property is held by individuals but also in the absence of any government intrusion. This similarity between these two “opposed” economic systems is interesting.

T H E N E X T S T E P That completes our overview of economic theory. In the final pages of this unit, we will present a general outline of the U.S. economy as it operates today.


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THE U.S. ECONOMY TODAY

By examining the components of production, consumption, employment, and income, we can outline a profile of our national economy.

Note that income can be examined either as national income (employee compensation, proprietors’ income, rental income, corporate profits, and net interest) or as personal income (after taxes and including transfer payments such as Social Security and public assistance, as well as wages, dividends, interest, and rents). The first is somewhat analogous to national product, and the second translates more directly into purchasing power.

Employment

As mentioned previously, the U.S. economy has been moving away from manufacturing as it becomes more service oriented. Service oriented is best described as an economy that is primarily driven by jobs that provide ser-vices to people, such as fast food, cleaning, and other support services.

Productivity is a measure of economic efficiency that shows how effectively economic inputs are converted into output. (Economists view productivity as the ability to produce more with the same or less input.) Relative to the production of goods and services, advances in productivity (such as techno-logical advances) have resulted in a significant increase in national income. The U.S. economy has been able to produce more goods and services over time, not by requiring an increase in labor time, but by making production more efficient. According to the U.S. Bureau of Labor Statistics, output per hour of all persons (labor productivity) is the most commonly used productivity measure. Labor is an easily-identified input to virtually every production process. Since our economy is constantly changing, so is our approach to becoming much more productive. For example, many U.S. companies now outsource or offshore much of their production to overseas countries due to lower labor costs. Outsourcing and offshoring have the potential for greater effect on labor productivity at the industry level.

T H E N E X T S T E P Now that you have a general idea about the history of economic theory and about what a market economy is, you’re ready for more specific economic ideas. In the next unit, we’ll look at how the forces of supply and demand interact in a market economy.


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SUMMARY

■ An economy is any system designed for the production, distribution, and consumption of necessary and desired goods and services. Economics is the social science that studies, describes, and analyzes that process.

■ The word wealth describes anything that contributes to human comfort and enjoyment that is perceived by others as having value, evidenced by being sold or exchanged for other goods or services. This trading of wealth for goods or services defines economic activity.

■ The goods and services that are created and distributed through the economy can be classified as those that are necessary for survival and those that are desirable for quality of life.

■ Throughout history, a variety of economic systems have been invented, tried, and rejected. Some have been successful, while oth-ers have been disastrous failures. Some historical systems include hunter-gatherer, agricultural, feudal, mercantile, colonial, industrial, and monetarist.

■ Modern economic systems lie on a spectrum between capitalism (a market-driven economic theory based on private ownership of the means of production and distribution) and socialism (a theory that calls for a command-economy with public or collective ownership of the means of production and distribution). Most world economies are mixed economies: a combination of these two theories with one or the other tending to dominate.

REVIEW QUESTIONS

1. What is the definition of economics?

2. Define the role of government in both a capitalistic and a social-istic economy.

3. What role does government play in your local real estate market?

4. Have social programs in your area primarily affected real estate in your area?

5. What types of government subsidy programs for the purchase or rent of real estate are in your community?

6. What types of businesses or industries have moved out of your area due to outsourcing or offshoring to other countries, and how has that affected your local economy?

7. What types of businesses has your community been able to attract in recent years, and in what kind of industries are they?


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UNIT QUIZ

1. An economy is a. the social science that studies, describes, and analyzes any system

of production, distribution, and consumption. b. any system designed for the production, distribution, and con-

sumption of necessary and desired goods and services. c. anything that contributes to human comfort and enjoyment. d. any system based on a complex hierarchy of loyalties, services,

and property transfers.

2. The trading of wealth for goods or services defines which of the following? a. Feudalism b. Production cycles c. Redistribution of wealth d. Economic activity

3. All of the following represent modern real estate’s links to feudal economies EXCEPT a. agency. b. fee ownership. c. escrow closings. d. the bundle of legal rights.

4. Who of the following is considered the founder of modern capitalism? a. Karl Marx b. Adam Smith c. Thomas Jefferson d. John Maynard Keynes

5. Productivity is the measure of a. economic efficiency. b. outsourcing. c. offshoring. d. service oriented employment.


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6. Which of the following is a market-driven economic theory? a. Socialism b. Communism c. Capitalism d. Command economy

7. Who of the following argued in favor of free and open, unregulated market economies? a. Karl Marx in Das Kapital b. John Maynard Keynes in the General Theory of Employment, Inter-

est and Money c. Thomas Jefferson in the Preamble to the Declaration of

Independenced. Adam Smith in The Wealth of Nations

8. Economic equality is the goal of which type of economic system? a. Capitalism b. Socialism c. Feudalism d. Mercantilism

9. The dominant economic system in the world today is best character-ized as a. capitalist. b. communist. c. laissez faire. d. mixed.

10. The fastest-growing sector of the U.S. economy is which of the following? a. Goods producing b. Manufacturing c. Service providing d. Real estate


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California Real Estate Economics sets the standard for real estate education in California. This exciting new edition provides you with the latest developments and trends in California real estate.

This new edition features:• Key Terms that begin each chapter to inform students of the

vocabulary and concepts they need to know to succeed.

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• Learning Objectives at the start of each chapter to help students focus on the main issues described in the text.

• Illustrations and clear explanations of difficult key concepts for better comprehension of the text.

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