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On Price Ceilings And The Sun Revolving Around The Earth…

February 8th, 2012 · 29 Comments
Econ 101 · Markets · Policy

Last week, I introduced you to the IGM Forum economist polls. This week’s question is about rent control:

Local ordinances that limit rent increases for some rental housing units, such as in New York and San Francisco, have had a positive impact over the past three decades on the amount and quality of broadly affordable rental housing in cities that have used them.

Those of you who have taken Econ 101 would probably not be surprised at all but one of the responses. (What were you thinking, Bengt Holmstrom?) For context, let’s do a little review of price ceilings:

(There is a mistake in the numbers in part of the second video, and you may or may not be able to see the annotations that correct it. Consider yourself warned.)

In summary, price ceilings (i.e. mandated maximum prices, of which rent control is an example) create shortages because the artificially low prices lower the incentives for producers to produce and sell stuff and, at the same time, increase the amount that the consumers want to buy. In other words, this:

Without the price ceiling, the market converges to price P* and quantity Q*. With the price ceiling, only Qs units of housing are rented (since the decrease in the quantity supplied due to the lower price is the limiting factor in this market). Granted, the units that do get supplied get supplied at a lower price, but all this means is that some people get a good deal and some people (even some people who were willing to pay the original market price) get, quite literally, in the case of rent control, left out in the cold.

That said, let’s think about the potential logic of price ceilings for a moment.

In general, economists use willingness-to-pay (i.e. the demand curve, which technically combines willingness and ability to pay) as a proxy for how much an individual values an item. Under this assumption, goods in a free market go to those who value them the most, and those who don’t purchase simply don’t value the good at an amount that justifies paying the market price. This can make interpersonal comparisons difficult on a philosophical level- for example, maybe Bill Gates is willing to pay $20 for a pound of cheese simply because he is swimming in money and doesn’t care, and I am not willing (or perhaps able) to pay $20 for a pound of cheese. It would be a little nonsensical to conclude on the basis of willingness-to-pay in this case that Bill Gates is more of a turophile than I am. (Yes, that is actually a word. I had originally used a gallon of milk in the example, but then I googled “lactophile” and was disturbed with what I found.) This comparison would be less problematic if societies weren’t faced with income inequality, but life isn’t “fair” in that way.

Nonetheless, the “goods go to those who are willing and able to pay” principle works pretty well for things like iPads, TVs, and motorcycles, and economists are quick to tout the efficiency of free markets in these cases. On the other hand, we as a society have pretty much decided that it’s not okay to not be able to afford a place to live. It’s also hard to argue that homeless people must just like living outside more and thus don’t value housing as much non-homeless people do. Rent control, for the most part, is a (potentially well-intentioned but misguided) attempt to make housing affordable for people who obviously value it but would have a hard time paying for it otherwise.

I say misguided because the rent control policy makers seem to have overlooked several key insights:

  • It takes two parties to make a transaction happen, and it doesn’t matter how theoretically cheap housing is if landlords aren’t willing to provide it. (In general, it seems easy to forget that people can’t have as much of an item as they want at a low price.) It’s a little strange to me that the rent control laws aren’t coupled with some policy aimed at increasing the supply of housing.
  • When the rent control policies take the form of limits on price increases, they actually act as short-term incentives to overprice housing units in order to get a higher starting price point.
  • In the diagram above, we implicitly assumed that the reduced supply of housing was going to the people with the highest willingness-to-pay. There’s no guarantee that this would happen, and, to the extent that willingness-to-pay reflects the ability to pay rather than the inherent value of the housing, it’s likely not what the policy makers want to have happen. (Who among us doesn’t know someone whose wealthy parents keep the $700 a month 3-bedroom apartment in Manhattan because, well, it’s a $700 a month apartment in Manhattan?) This is probably one of the few scenarios where we’d want the cheap goods to go to those with the lowest “willingness” to pay, but the law doesn’t actually encourage that practice in any way.
  • Rent control appears to be an attempt at some sort of fairness, but it seems in a way more fair for everyone to pay a higher price than for some people to get cheap stuff and others to get nothing, especially when the law doesn’t determine who the winners and losers are.

At the very least, I’m surprised that there isn’t more means testing (i.e. having to show that you are low income) in order to qualify for rent control, but I suppose that would just encourage landlords to discriminate against low-income tenants. A more nuanced policy would likely provide subsidies to low-income individuals and families, but subsidies cost money whereas price controls are “free.” (And yes, I am aware that subsidies are inefficient, but I am also aware that societies are often willing to sacrifice some efficiency for a more fair outcome.) This is reason #824 why policy is hard.

Anyway, back to the question. Techhhhhnically speaking, if none of the housing in an area was deemed “affordable” before the price ceiling, then the price ceiling could, I suppose, increase the quantity of affordable housing. (In fact, Pinelopi Goldberg specifically points this out.) In most realistic cases, however, the rent control laws are going to make builders think twice about putting up residential properties and make potential landlords think twice about getting into the rental business. The quality of affordable housing certainly isn’t going to improve, since landlords have rent-controlled tenants, as one of my advisors once put it, “by the balls,” since what are they going to do if the landlord doesn’t fix stuff or renovate? Move and lose the benefits of the rent control?

I hope this explains why Dick Thaler answered the question with “Next question: Does the Sun revolve around the Earth?” Though his comment does make me wonder why he only put a confidence level of 3 on his answer. Maybe I should send him a book on Galileo.

Tags: Econ 101 · Markets · Policy

29 responses so far ↓

  • 1 Warren J // Feb 9, 2012 at 1:57 pm

    …but it gets local politicians enough votes to keep them in office. Isn’t that more important?

  • 2 Randy Boring // Feb 9, 2012 at 2:10 pm

    Rent control also subsidizes discrimination. In a free market, it costs to discriminate, discouraging it (some will still pay the costs, of course). In a rent-controlled market, there will be more applicants than apartments, allowing landlords the opportunity to pick a favored renter from amongst them all. He WILL use his personal preferences to choose someone more like himself race-wise or religion-wise, or better looking, etc.

    Yet another reason why it is immoral to intervene with force between two willing participants in a mutually beneficial exchange. It’s not just “policy is hard”, it is wrong to even attempt.

  • 3 econgirl // Feb 9, 2012 at 2:36 pm

    @ Warren J: Theoretically, this wouldn’t be the case if people in general actually knew a little economics. Which brings us to why I do what I do…

  • 4 idahotradeguy // Feb 9, 2012 at 5:06 pm

    Thanks for the great explanation!

  • 5 JW Mason // Feb 11, 2012 at 1:19 am

    echhhhhnically speaking, if none of the housing in an area was deemed “affordable” before the price ceiling, then the price ceiling could, I suppose, increase the quantity of affordable housing.

    Or in other words, economics theory actually does not give us any basis to answer the question one way or the other. And of course, whether a decline in the housing supply over all, but an increase in the supply for low-income renters, increases or decreases welfare, is going to depend on what we think of welfare functions. So, maybe it’s not so simple after all?

  • 6 JW Mason // Feb 11, 2012 at 1:31 am

    Also, you do know, don’t you, that rent stabilization in New York only applies to units built before 1974? So it’s kind of nonsensical to say that new construction is discouraged by these laws, since they have not applied to new construction in nearly 40 years?

    Actually, I’m kind of guessing you don’t know that.

  • 7 Randy Boring // Feb 11, 2012 at 8:40 pm

    At the end of the second video you mention quantity ceilings, which have a similar effect, but you couldn’t come up with a good example. How about licensing, in particular, taxi medallions in NYC.

    This is not a consumer good, but does function as a capital good. You cannot supply taxi service, despite having drivers and cars, without also having a medallion, assuming you want to remain unmolested by men with guns. (Unlicensed taxi service does exist, mainly servicing underserved areas that licensed taxis don’t want to service, so they don’t complain to the cops about them, much.)

    Keeping the quantity allowed below the quantity demanded (in fact, they keep them fixed, despite rising demand) functions as your binding quantity level. This raises prices for consumers without giving them any benefits. The beneficiaries are the taxi owners who manage to acquire medallions (at extremely high prices) and can thus charge higher than free market rates for their services.

  • 8 Glen Raphael // Feb 12, 2012 at 12:16 am

    > “Also, you do know, don’t you, that rent stabilization in New York only applies to units built before 1974?”

    That’s not actually true. Some buildings built or renovated after 1974 “that received special tax breaks” are also rent-stabilized for qualifying tenants who moved in by mid-1993.

  • 9 JW Mason // Feb 12, 2012 at 1:20 am

    Glen, true, but participation by builders was voluntary. So there is no sense in which the existence of mandatory rent stabilization 40 years ago would deter new construction today.

    And in fact there is tons of new housing going up in New York. Not as much as the city needs, true, but the policy that deters it are the various zoning and height restirctions that ACTUALLY APPLY TO NEW BUILDINGS (and continue to be strnegthened), not rent stabilization.

  • 10 Glen Raphael // Feb 12, 2012 at 1:52 am

    If the city puts in place a variety of restrictions and taxes that make it economically infeasible to build someplace unless you accept their terms, and those terms happen to usually include committing to provide some rent stabilized apartments, how “voluntary” is that, really?

    There is a sense in which it would, should, and likely does deter.

    So long as rent control and rent stabilization is tolerated and encouraged by the city on an ongoing basis even in older apartments, property owners are correct to fear that it could could always get worse again. You’d have to be a real optimist, a moron, or somebody with a lot of wealth and political connections to be willing to build new housing in New York with that sword hanging over your head. I certainly wouldn’t risk it. Would you?

  • 11 oben // Feb 13, 2012 at 4:39 am

    to buy a House, should we look at the whole building. It all will determine the price. When the House was a good price would be high, I agree with that statement. because I often buy a House

  • 12 Hasdrubal // Feb 13, 2012 at 11:34 am

    I like David Cutler’s comment on the poll: “I suspect zoning and building limits have been more important.” In other words, rent control is not the whole story (in NYC) but it is part of the story.

    Have you seen Richard Dorman’s response to this post?

    “Standing in the shower, my mind drifted back to Orwell: ‘Free markets good! Price controls b-a-a-a-a-d!'”

    I found it via Arnold Kling’s post on Econlog:

  • 13 Punditus Maximus // Feb 13, 2012 at 12:24 pm

    So, there are two ways to encourage developers to build reasonably priced housing that human beings can afford to live in.

    1) Mandate it via the zoning code, opening it to graft and corruption.
    2) Set a gentle rent control cap and let the market figure out which housing to build.

    In markets like Manhattan, where physical constraints prevent buildings from being tall enough to meet demand, you’re going to have a rent. Making sure that rent is transferred to property owners is no more “efficient” than trying to get it split between property owners and renters. In fact, in a dynamic sense, it makes a lot more sense from the point of view of a social welfare function for us to be consistently investing in infrastructure which is compatible with broad prosperity, instead of increasing inequality.

    But sure, “hurr hurr city planners not understand all housing same and technology never change and zoning not exist hurr hurr”

  • 14 Punditus Maximus // Feb 13, 2012 at 12:26 pm

    I just don’t understand why anyone thinks that the assumptions underlying perfectly competitive markets — homogeneity, tiny transactions costs, lots of substitutes — conceivably apply to the housing market. There aren’t a lot of substitutes for “living space near your support system and jobs.” In fact, there aren’t any. And I’ve never heard of a development or rental market that wasn’t dominated by a relatively small number of firms, which means market power.

    The idea of a “supply” curve for rentals is just absurd.

  • 15 Punditus Maximus // Feb 15, 2012 at 11:59 am

    And . . . crickets.

  • 16 econgirl // Feb 15, 2012 at 5:45 pm

    No crickets intended, and I do think that, in parts of some major markets at least, the conditions of perfect competition do come pretty close to holding. For example, if I were to rent an apartment in Boston and didn’t want to go for one of the Avalon buildings or whatever, I would most likely be renting from a small landlord whose units are pretty much like those of the small landlord renting the units next door, etc. The transaction cost part is a bit problematic, I will admit, mainly where potential brokers’ fees and moving costs are concerned. That said, I do think that there is a reasonable supply curve for each category of rental, and it does appear to slope upwards if for no other reason than turning a building into condos becomes less attractive as rental prices increase.

  • 17 Punditus Maximus // Feb 17, 2012 at 12:44 pm

    Every housing market I’ve interacted with has been an oligopsony, with a few leading firms holding pricing power, and/or with associations of landlords doing the same thing. There’s a reason why there’s a cliche of wanting to rent some empty-nester’s spare room, because they don’t know what the space is worth. In addition, these groups tend to have tremendous control over zoning boards, which they use to prevent competition from arising. And if you had kids, who need to go to school and be near your support system, you wouldn’t be so sanguine about transactions costs.

    That one’s the kicker for me — it’s pretty obvious that rent control could reasonably be a clear second-best solution, where the (necessary) existence of zoning laws and boards means that some kind of counterweight to regulatory capture by landlords and developers is needed.

    But no, we’re all supposed to hear “rent control” and genuflect toward Coase, never mind that he understood very deeply the primacy of transactions costs and regulatory capture.

  • 18 Dan L // Feb 17, 2012 at 5:24 pm

    I don’t know about SF, but isn’t this more or less a dead issue in NYC? The only rent-controlled places left are old grandfathered units. Contrary to what Warren J wrote, I doubt that public opinion in Manhattan supports rent control, although the general concept of “affordable housing” does get support.

    I have to disagree with Punditus here. There are way way too many landlords/management companies, both large and small, in order for anyone to have pricing power. (Although the individual landlord in Manhattan is a very rare breed, in the context of the whole city, even managing several buildings is small potatoes.) And how do you account for the low vacancy rates?

    And the empty nester’s spare room is cheap because the renter has to live in the empty nester’s spare room. No mystery there.

    The basic fact that there are too many people with money who want to live here, and therefore it is difficult for people without money to live here. I believe in the concept of affordable housing, but the reality of the situation is very difficult to overcome.

    New construction doesn’t even help, because it is all geared toward the high end of the market, because that is most profitable. Adding these units have nearly zero effect on affordability at the lower end.

    Perhaps one could regulate the floor plans for new construction, so that most new units are unsuitable for the luxury market. That’s sort of an ugly policy, but I’ve never seen any better solutions.

  • 19 Dan L // Feb 17, 2012 at 5:31 pm

    Sorry, I meant to write “rent stabilized.” Rent control is even more dead.

  • 20 Punditus Maximus // Feb 18, 2012 at 12:09 am

    I had a conversation with a city planner about this issue, and he said that every time they zoned for walkable spaces with small lots, they got bid up and bought by folks who appreciated the lifestyle that offers and had the money to enforce their preferences. So they stopped doing it. I stared at him in shock — why would you not just keep zoning and attracting wealthy citizens who care about livable communities, or else eventually exhausting that sector of the market and moving on to folks with lesser means? But that never occurred to him . . .

  • 21 Punditus Maximus // Feb 18, 2012 at 11:58 am

    Anyways, where I’m going with this is that you can see where rent control could be part of a suite of second- or third-best policies that manage the fact that human beings are corrupt and ignorant, but still largely deserve to have a safe home to live in.

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