Wednesday, 12 August 2015

Why rent controls have worse effects over longer time horizons

There are many topics on which economists disagree. One of the topics on which there is broad agreement is the negative effects of price controls. One common example is the case of rent controls.

A government (local or national) that feels that rents are too high and hurting low income tenants might enact rent controls. There are several ways these might be implemented, but the simplest way is a maximum price in the market for rental housing (alternatives include maximum absolute or relative (percentage) annual increases in rents). Regardless of how the rent controls are implemented, they lead to the same main effect – shortages of (or excess demand for) rental housing.

The ‘usual’ examples we use include the market for New York City apartments, or houses in San Francisco or some other jurisdictions in California. Alex Tabarrok at Marginal Revolution recently pointed to this letter from a resident of Stockholm, to the city of Seattle:
Stockholm City Council now has an official housing queue, where 1 day waiting = 1 point. To get an apartment you need both money for the rent and enough points to be the first in line. Recently an apartment in inner Stockholm became available. In just 5 days, 2000 people had applied for the apartment. The person who got the apartment had been waiting in the official housing queue since 1989!
Rent controls reduced my housing supply and promoted a lack of availability in my existing housing stock. This was a surprise because the Swedish Government didn’t cap rents directly- it limited rises to those negotiated between the landlord and tenant associations; based on analysis of costs and apartment ‘utility values’ that described location and apartment quality.
I’m in Copenhagen this week, and talking to one of the locals there are similar rent control mechanisms at work here in Denmark as well. With similar effects – she mentioned that the waiting lists on rent-controlled housing can be around 30 years or more.

To see why rent control leads to shortages (excess demand) and long waiting lists, consider the diagram below. If the market operated without rent controls, the equilibrium rent (R0) and quantity (Q0) would prevail. There would be no excess demand for rental housing. However, rent control keeps the price below equilibrium (R1) – it can’t rise to R0 because of the rent control rules. The lower rent makes renting more attractive relative to owning your own home. Some people would find it cheaper or more convenient to be a renter at this lower rent, so the quantity of rental housing demanded increases (to QD1). However, the lower rents make rental housing a less attractive investment for landlords. Perhaps they convert that rental housing into commercial rentals instead (e.g. offices) or maybe they choose to live there themselves (the opportunity cost of living in the house is now lower). Either way, the quantity of rental housing decreases (to QS1). The difference between QD1 and QS1 represents the excess demand for rental housing at the controlled rent – there are fewer houses available than the quantity people want to rent.

This excess demand can have a range of negative effects, depending on how it is managed. Perhaps the excess demand is managed by waiting lists of various flavours (as in Stockholm or Copenhagen), which means that potential tenants have to wait years for a rent-controlled space to become available. Instead, perhaps landlords are left to manage the excess demand on their own, in which case the rent-controlled housing is more likely to be rented to higher income tenants. Why? The landlord has a lot of choice over tenants now (because of the excess demand). If they can choose to rent their house to the professional couple with two incomes, or the solo mother with no job and three young children, it doesn’t take an economics PhD to work out who is going to miss out. So in this case the rent control actually hurts the very people (low income tenants) that it was designed to help.

On top of that, landlords might be willing to accept side-payments (bribes) to ensure access to rental housing. Tenants are willing to pay the bribes to ensure they don't miss out on a place to live. This further stacks the rental market against low-income tenants. And on top of that, increased competition between tenants lowers the incentives for landlords to maintain their properties. Since tenants can't be choosy or they will miss out on a place to live, landlords don't need to offer high-amenity living. So the quality of housing available to rent may decline over time, which definitely doesn't make tenants better off.

In the long run, the situation is even worse, as we discuss in ECON100 each semester and as shows in the diagram below. Longer time horizons are associated with more elastic demand and supply. So in the long run, demand is more elastic (D2) than in the short run (D1). In the context of rent control, in the long run potential tenants (who may be homeowners) have more time to adjust to the change in rent. Note that the long run and short run demand curves both pass through the equilibrium point - this reflects that the difference between the two demand curves is only the elasticity of demand. That is, there is no "increase in demand" here between the short run and long run, just an "increase in quantity demanded" (because potential renters are part of the market, as well as those who actually do rent at the market rent). In the long run, supply is also more elastic (S2) than in the short run (S1). Landlords also have more time to adjust to the change in rent in the long run. And note again that both curves pass through the equilibrium point - there is no "decrease in supply" here, just a "decrease in quantity supplied" (because landlords are free to move houses between available to rent and not available, depending on the market rent).

From the diagram, you can see that the excess demand for housing arising from the rent control is larger in the long run (QD2 - QS2) than in the short run (QD1 - QS1). Which explains why rent controls have negative effects, and those negative effects just get worse over time. Leading to decades-long waiting lists for rental property in Stockholm and Copenhagen.

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