The desirability of rent controls

Over at Marginal Revolution, Tyler Cowen posts on what some people have to say about rent control. Several points are put forward as to why rent controls are a good thing, namely:

  1. People do not become happier from a larger, or better quality house and so a lower quality – lower price equilibrium would be preferable.
  2. Given this, lower prices will increase the supply of property over time by getting owners to put more small apartments in a given building.
  3. As it is harder to find an apartment temporarily people are forced to commit to a region for a longer period of time, which may provide a positive externality, or help to solve prisoners dilemma issues through the use of a repeated game.

If you cannot be bothered reading my long, boring post on the issue, then you can just say whatever you think about the above points in the comments 🙂

Commonly economists state that price controls are sub-optimal, as they lead to a shortage (demand exceeds supply), and propagate black market activity.  Now I haven’t made an opinion yet, I’m going to go through and discuss each of these points in the way that they first strike me, then we can all chat about it 🙂

Point 1 troubles me, if we don’t value larger properties more than small properties, then why the hell do we pay a higher price?  This strikes me as A) a normative judgment and, B) one I don’t really believe.  Sure you do become accustomed to your property to a degree, but using myself as an anecdote, I am far happier in a large property than a small one, as I have room to put all my books out :).  I feel that in this case, the price does take account for the way people value the property, so the only reason we may want a low price – low quality equilibrium is if we believed their was a negative externality from someone owning a larger or better quality house.

There are two ways I can see this externality coming about.  1)  Your house is so big that it takes up space someone else could have lived in – this externality is discussed in the second point, and 2)  someone owning a big house increases the marginal cost of you not owning a big house.  In the first externality type, the landlord will invest to maximise their return over the space.  As a result, the person with the large house must value that space (or at least not having someone else there) more than the other potential tenant valued it (or at least this is what the investor believes).  So if we correct this externality we are reducing welfare, as we are taking the space away from the person who values it most.

The second type of externality occurs when people value the size of their house relative to other people, in this case if someone else gets a big house, you feel you have to even though you don’t get any inherent benefit from the larger house .  This is a fair point, however the issue with this type of externality is that it is subjective.  The cost of a smoker to national healthcare is a quantifiable externality, how wealthy people make you feel is not.  When I spend time thinking about social planning, I try to avoid punishing overtly subjective externalities.

Furthermore, I’m not sure that the lower price – low quality equilibrium is a good thing.  There are significant positive externalities to people living in good quality houses (health externalities, workers are more productive when they are not being kept up all not because of a lack of sound-proofing), which we would miss out on in this case.

In the second point we are told that there will be an increase in the supply of property.  Now in the short-run the supply of property on the market is relatively fixed (as long as the rent covers the landlords variable costs), so the lower price will lead to a slightly lower quantity of property.  However, over-time landlords can sell properties and they change their properties.  If the landlord sell their property to an owner-occupier then we have no worries, someone else has come into the market to live there.  As property is an asset, the landlord might decide to convert their property to focus on another investment group where the rents are not fixed, most likely office building.  However, in the second point the author says that property may be converted such that there are more units in a smaller space, after all if rent is fixed then doubling the number of units will double the yield associated with a block of land (assuming we get tenants).

As a result, the assumption here is that landlords will make each rental unit smaller and this effect will dominate the substitution between investment types effect, implying that a lower price will lead to a greater supply of property in the long-run.  We have to then ask why didn’t landlords do this earlier?  As the author assumes that demand does not fall in the size of the property, the landlord could have cut up properties and sold them at the same price.

If we are willing to assume that demand does rise in house size/quality then we need to assume that any increase in supply that may occur (it is by no means ensured) is worth more to society than the loss of consumer surplus.  This is the same as the first externality in point 1, which we said was not optimal.

Point 3 was made by a different author.  This introduces a new social cost to the fore, specifically that quick rental arrangements lead to short-term tenants who have no reason to co-operate if prisoner dilemma type problems (or co-ordination problems) appear in their society.  In this case, the social benefit from having tenants stay longer is positive, but is it enough to make up for the loss of consumer surplus, the loss of profit for the landlord and the inefficiency of potential black market dealings?

Overall, I’m not convinced that rent controls are desirable.  However, the structural issues they put forward are important, and there are conceivable equilibrium where rent controls would be socially optimal.  As other bloggers say these issues are important for fully analysing policy, as economists we have to be willing to use our tools to analyse how the structure of the game might change.

  • Owen

    You are aware that “Tyrone” is Tyler being contrarian with an alter ego, right?

  • Yes I am, that is why I linked to his ‘lunch friend’ thing in the some people bit (I didn’t actually think that someone was living in a small crawl space in his house 🙂 ). I love the alter-ego thing, its great.

    I wanted to keep my discussion very third person like he does, I just felt it was appropriate. I felt that saying it was his alter-ego would spoil it a little.

  • John

    I read that:

    “Every dollar of unearned profit [in stocks and] real estate leaves a hole somewhere”
    So I’m connecting the dots between “Property Climbers” and renters and mortgagees. Maybe i make too much of that??

  • Hi John,

    Sorry I’m not quite sure what you mean, would you be able to elaborate

  • John

    Sorry it is off topic but I’m wondering if, during times of asset inflation where people make large gains, (property investors in boom times) it follows inevitably that there will be a compensatory response such that either rents go up or first home owners pay large mortgages.
    I read an article where it was confidently stated that: “Every dollar of unearned profit [in stocks and] real estate leaves a hole somewhere”
    It seems intuitively correct?

  • When there is a significant amount of house price inflation, the mortgage that first home owners will have to pay will be higher by definition, as the price of the house is rising quickly.

    The rental argument is an important one. People that buy property as an investment choose it based on the capital gains they expect, the associated yield (rents), and the risk associated with the asset. House prices have risen a lot more quickly than rents, and there is a lot of debate about what this means. Ultimately, when house prices rise faster than rents, the yield for the investor is falling. As a result, we must either see a downward correction in house prices, or a significant increase in rents – this depends on how easy it will be to lift rents.

    If income growth stays strong, there is scope for rent increases. If it doesn’t then investors will sell property, driving down the price, thereby restoring the yield associated with property relative to other assets.

  • John

    Thanks Matt. What I was looking for was this:

    What the rising asset values effectively create is a corresponding rise in claims on the economy at the expense of those who do not own such assets. But this is wealth redistribution, not wealth creation.

    http://www.safehaven.com/showarticle.cfm?id=784

    In others words the Rich Mastery and property climber type people are riding on the backs of renters and mortgagees?

  • Hi,

    The price and sale of anything is in a sense a redistribution of wealth rather than a source of creating wealth. All a price tells us is how much something is worth in comparison to other things. If house prices rise more quickly than the price of other goods, services, and assets, then the bundle of other goods you could buy if you sold your house at that price would be higher. Thats fine.

    Wealth is created when goods and services are created, or value is added to them. This is really a separate issue.

    “In others words the Rich Mastery and property climber type people are riding on the backs of renters and mortgagees?”

    In order to look at this we have to think about how ‘freeholders’ may be using their asset to receive surplus. If higher rents followed from higher house prices we could say that the appreciation in house prices hurts renters. Rents are related to prices, however they have not experienced the significant increases that house prices have – in fact they have been moving just around inflation.

    Mortgagees paid the price for a house because they believed the house was worth that much to them, there is nothing wrong with this as the intrinsic value the mortgagee derives from the house is greater than the price they paid.

    Investors have not been forcing prices to rise. There has been a genuine undersupply of property, which councils have reacted slowly to. As zoning regulations are fixed up, and the supply of houses increases we will likely see the price of property fall.

  • I do not believe rent controls are wise, in general. There are some options I wouldn’t mind – some sort of affordable housing that has breaks from the government (tax…) in exchange for a commitment to keep rental rates down. But wholesale rent controls are very unwise I believe.

    A related issue I find amusing. You will hear don’t regulate at all state that it is regulation preventing housing being constructed (zoning regulations) that create rising prices which they imply is unfair. It seems to me the data shows the opposite of what those people claim. People are willing to pay more for the regulated housing markets. That means the market forces value the regulation and in order to increase the economic utility (which is represented by what people will pay) more regulation should be used not less.

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