Question

Suppose that a house can be rented in an uncontrolled market for a profit of $30,000 this period and $30,000 next period. (There are only two periods).

     

(a). If the market interest rate is 10 percent, what is the most that one would expect a housing investor to pay for this rental property. (8 points).

(b). Suppose the investor buys the rental property at the price determined in (a), and that immediately after making the purchase, a local government decides to locate a half-way house for ex-convicts next to the rental property with the result that it can be rented for an annual profit of $20,000 instead of $30,000. Is the owner likely to suffer an economic loss from this decision, and if so what is the size of that loss? (7 points).

(c). Suppose that the owner in (a) and (b) – call her investor 1 -- sells the property to another investor – call him investor 2. What is the maximum price that investor 1 should expect to receive from this sale? (5 points)

(d) Suppose that Investor 2, having bought the house, goes before the local government and argues that she should be compensated for the negative externality imposed on her by the half-way house. Briefly evaluate the merits of this argument. (5 points).

Answer 1

	Period	1	2
	Rent value	30,000.00	30,000.00
	Market interest rate	10%
a	Maximum investor will pay	52,066.12	Using NPV formula and finding present value
	Assuming that this period rent will also be discounted
b	New rent	20,000.00	20,000.00
	Present value of interest	34,710.74
	Economic loss	17,355.37	Amount paid minus PV of interest rate
c	Maximum price from Investor 2	34,710.74
d	So the negative externality is of the size of the economic loss in partb. Since this has happened due to the half way house and decision
	has been taken by the government. There is merit in this argument and government should compensate investor 2