Thursday, 1 February 2018

Some further notes on rent increases

Rent increases have been in the news a lot recently, especially in Wellington (see my post from earlier in the week). Based on some discussions with students, I thought I would make a few notes.

First, some have suggested that rents have increased by $50 because student allowances and Student Loan living cost payments have increased by that much (e.g. Grant Robertson's Facebook post on this). This is possible, but unlikely. If our incomes increase, we will be willing to pay more for rental housing (rental housing is what economists call a 'normal good'). That shifts our demand curve for housing up and to the right, as in the diagram below (from D0 to D1). The equilibrium rent will increase from R0 to R1. How much more will be willing to pay, and how much will the equilibrium rent increase by? Certainly our willingness-to-pay will not increase by the whole additional $50 of our income, because when our incomes increase we are also willing to pay more for food, clothing, entertainment, and all of the other normal goods that we like to buy. Our willingness-to-pay for rent will increase by some proportion of the $50 increase in income. So, I think it's extraordinarily unlikely that an increase in demand, driven by the increase in incomes, is solely behind the increase in rent.

Second, prices increase when there is excess demand. Is excess demand driving the increase in rents by $50? I covered this in my post on Monday and Eric Crampton also covered it. It's possible that rents are currently below the equilibrium rent, as shown in the diagram below. At the rent R0, there are Qd tenants looking for a house, but only Qs houses available to rent. There is excess demand for housing. Some tenants are missing out on housing. Landlords and tenants both recognise the excess demand, and tenants might start approaching landlords and offering a bit more in order not to miss out, or landlords might increase rents knowing that tenants will be willing to pay a little bit more in order not to miss out. Either way, rents start to rise and eventually the market ends up at the higher equilibrium rent R1. However, we seem to be in a perpetual state of excess demand in the rental market (if you doubt that, look at any of my past posts on housing). I've mused that maybe landlords are offering 'efficiency rents' - rents that are deliberately below the equilibrium rent, because that allows them to have the pick of applicants. So, I think it unlikely that excess demand is a big factor in increasing rents.

Third, and something that I haven't seen anybody considering, is that the accommodation supplement will increase on 1 April. Landlords signing rental agreements now must know that the accommodation supplement will increase during the term of the tenancy agreement, and that this increase in subsidy works sort of like the increase in demand shown above. However, in the case of the accommodation supplement, we can be fairly sure that it does increase willingness-to-pay for housing by $50, because it can't be used for anything else. [*] Why adjust rents now, when the accommodation supplement doesn't change for two more months? Because the rent that is agreed now can't be changed for several months after April - it makes sense to build this increase in now. This is shown in the diagram below. The accommodation supplement is a subsidy, paid to the tenant, so we show this with the D+subsidy curve, which is above the demand curve (for simplicity, the diagram doesn't show an increase in an existing accommodation supplement, which is actually what is happening, but making the diagram a bit more complex doesn't change the story at all). Another way of thinking about this is that, once the accommodation supplement increases by $50, households are willing to pay the same as before (shown by the demand curve), plus the extra $50 of the increased accommodation supplement. The rent before the increase in the accommodation supplement is R0. After the increase in the accommodation supplement, the rent that households pay to the landlords increases to RL, and the effective rent (after subtracting the increase in the accommodation supplement) falls to RT. Notice that most of the benefit of the increased accommodation supplement is captured by landlords. This is because of the very steep (inelastic) supply curve in the rental market - when rents increase, there aren't a lot of additional landlords rushing to make their houses available for renting.

So, my feeling is that the increase in rents we are observing now is the effect of landlords recognising that the accommodation supplement will soon increase, and they are trying to capture that increase early. And not the effect of the increase in student allowances, or excess demand for rental housing. Or maybe it is a little bit of all three? Of course, the easiest way to find out whether this explanation is the right one would be to ask landlords. But given the potential for a media beat-up, would you really expect them to come clean about this?

Finally, some dimwits have been advocating for rent controls (see Anna Mooney of Renters United quoted here). No. Just no.

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[*] You may be thinking here that income is fungible (it can be used for other things besides housing). That means that, when the accommodation supplement increases by $50, households' willingness-to-pay for housing might not increase by $50, because they might re-direct some of their other intended spending away from housing. However, in a world where people are quasi-rational and affected by mental accounting, it turns out that fungibility may actually be reasonably low (I'm currently reading Richard Thaler's excellent book Misbehaving: The Making of Behavioral Economics - more on that when I review it soon). Quasi-rational decision-makers have a household budget for rent, and when the accommodation supplement increases by $50, they may be thinking that means they can spend $50 more on rent (rather than other things) and act accordingly.

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