Model of free market rental economy vs rent controlled economy.
INTRODUCTION
This essay aims to explore the theme of rent controls as witnessed in some European cities after World War II. It attempts to examine the real life situations of rent controls in these and other locations, both then and since, using economic theory to explain such circumstances. It will initially attempt to define rent control in terms of the basic economic theories of supply and demand, and market equilibrium. It will then consider the reasons why governments and local authorities impose these controls, what motivates them, and how they implement such controls. The consequences of rent controls will be considered, as well as how they impact on different sectors of society. The essay will conclude with a set of findings which resulted from this analysis and investigation. It will use secondary research, citing the texts and journals used.
To begin, consider a graphical depiction of a market for flats in the absence of government controls (Figure 1). The source data is taken from Krugman et al. (2007) and it is a simplified model of the market for flats in Prague where supply and demand are allowed to reach an equilibrium level. In this simplified model, it is assumed that all properties are exactly the same and would reach the same level of rent in an uncontrolled market. In such a situation, the market would settle at a level of 200,000 flats available for rent, all at the price of €500.
Figure 1
Source: (Krugman et al.2007, p86)
Now consider that a price ceiling is imposed for the amount of rent which can be charged for a flat. Crucially, this amount must be set below the level which would be achieved in an unrestricted market, otherwise it would have no effect at all on the market. The example from Krugman et al. (2007) uses a maximum allowable rent figure (a rent control or price ceiling) of €400 per month, a figure which is €100 less than the free market equilibrium level. The supply and demand curves stay the same, as they would in such a market. The only thing which changes is the maximum rent which a landlord is able to charge by law. Figure 2 shows that this causes a reduction in the quantity of flats supplied to 180,000 (landlords having less incentive to supply at this lower price level) and increases the quantity demanded to 220,000 (more tenants wanting a flat at this lower rate than at the higher previous rent). So now we have the situation where there is a shortage of 40,000 flats i.e. 40,000 more flats are demanded by consumers than are willing to be supplied by landlords at this new price. Krugman et al. (2007, p87) refer to this as a “persistent excess demand”. With a rent control model established, we can turn to the motivations of governments and local authorities for intervening in free markets in such a way.
Figure 2
Source: (Krugman et al.2007, p87)
THE MOTIVATION FOR INTRODUCING RENT CONTROLS
In the aforementioned example of Prague from Krugman et al. (2007, p84), it is stated that “rent controls in the Czech Republic are a leftover from communism”, with the state still controlling rents in “both publicly owned housing stock and in former state owned property returned to the original owners after the 1989 overthrow of Communism in The Velvet Revolution”. So, in 1991, following deregulation of prices in other sectors, (ultimately absorbing more of workers’ incomes) the equilibrium price in Prague’s rental market was at an unaffordable level for the majority. In this instance, there was strong political pressure on the government to intervene in the market.
The political philosophical ideals of Communism are not the only motivation for rent controls however. After the Second World War, local authorities in European cities such as Berlin and Frankfurt also prescribed price ceilings on rental prices for city flats. In these instances, it was intended that appropriate dwelling space should be accessible independent of income. This was clearly a well-intentioned move by the authorities. A shortage of housing, due in part to bomb damage sustained in the war, combined with the return of large numbers of troops from fighting meant that this attempt at market intervention was intended to ease post-war financial pressures. Hubert (1993, p8) refers to “the massive destruction of multi-family housing in the inner cities during the war” accounting for the dramatic reduction in supply of housing. This situation in a free market would have led to vastly increased rents without the introduction of price ceilings. The post-war economic situation in Europe was tough and this market intervention was intended to help citizens and soldiers alike.
Hubert (1993, p11) notes that “in Germany, rent controls were introduced as a temporary emergency measure during World War I” and goes on to say that “ they were relaxed and partially dismantled in the twenties and thirties but reintroduced during World War II”. It seems that a sense of fairness to impoverished or hard-up citizens is a common motivation.
To further demonstrate that it is not only Communist countries which utilise rent controls, Krugman et al. (2007) tell us that rent controls are still in force in New York City, where they were also introduced during World War II to protect the interests of tenants. Interestingly, rent control still remains in force in parts of New York. Klingenberg and Brown (2007, p57) also note that “rent control is currently used in many US cities and elsewhere as a means to reduce the impact of inflation on housing prices. The objective is to turn rental housing into a cheap and plentiful commodity”
Haffner and Oxley (2009, p10) have the view that
“West German post-war housing policy has been based on a social market economy approach. The principle behind this is that social welfare is best served by bringing about economic progress. In a social market economy, the market dominates and government intervention is designed to support the proper operation of market forces”
Another point of view, from Beer (2004, p1) is that “Nations such as the Netherlands, France, and Germany first introduced rent controls to curb excess inflation during World War One”
Perhaps Klingenberg and Brown (2007, p56) sum the situation up most succinctly by stating “Rent control was implemented with the intent to provide affordable housing to the less fortunate in society”.
THE CONSEQUENCES OF RENT CONTROL POLICIES
Having looked at the reasons why rent controls are introduced, let us now turn our attention to what actually happens when they are introduced. What are the consequences of such market intervention?
In the case of European cities such as Berlin and Frankfurt after World War II, the aim to provide affordable housing for the many was successful in the short term. However, it was not long before negative side-effects appeared. The situation saw a black market for flats develop and, in the longer term, the inner cities’ residential houses got dilapidated.
The model of Prague’s rent controls examined earlier suggests that, despite a government or local authority’s best intentions, there are serious and indeed predictable drawbacks to this kind of market intervention. In basic economic terms, a freely competitive market is efficient, reaching an equilibrium at the point where demand equals supply. At this equilibrium point all that is demanded is supplied and there is no excess supply or demand. A price ceiling or rent control, as we will see, is the cause of inevitable market inefficiencies.
Krugman et al. (2007) provide a comprehensive explanation of why this intervention causes such inefficiencies identifying four distinct ways in which rent control causes inefficiency;
1/ the distribution of flats to those wanting to rent
2/ the time wasted searching for flats
3/ the inefficiently low quality or condition in which flats are maintained by landlords
4/ the illegal behaviour as people try to get around the controls
Inefficient Allocation to Consumers
In Figure 2, we can see that 220,000 people would like to rent a flat at €400 per month. This is 40,000 more than the number available. Of this total number, some will be desperate to find a place to live whereas others will not. Perhaps they already have a flat and just fancy a change of scenery! A free market would enable an efficient allocation of flats which accounted for these different groups. Importantly, those who really wanted one would get one. Furthermore, taking into account the fact that pure luck or personal connections will dramatically affect the distribution of properties, it is clear that rent control results in an inefficient allocation to consumers.
Wasted Resources
Although it may not be apparent at first, the time spent searching for a flat that may never be found is clearly a waste of a person’s time. In economic terms, the opportunity cost of this time is the income they could have earned had they been at work or the leisure time they could have enjoyed instead.
Inefficiently Low Quality
The third way identified by Krugman et al. (2007) by which a price ceiling causes inefficiency is that goods tend to be of low quality. Obviously, landlords facing rent controls have no incentive to provide better conditions. In some situations, they will be unable to raise rents enough to cover the costs of repairs. They can find tenants easily regardless of the state of the property, so why should these profit-maximising businessmen spend money on maintenance “unnecessarily” ? The irony is that there are probably tenants who would be happy to subsidise improvements at a level which would enable landlords still to profit. This, however, would constitute a rent increase and would be illegal. Inevitably, rent-controlled flats are poorly maintained becoming dangerous to inhabit in extreme cases. A truly free market would never allow conditions such as the dilapidation of properties to develop.
It is worth mentioning at this point that such is the demotivation to maintain housing under rent controls, the supply curve often shifts to the left as landlords simply leave the market altogether. Other voices in agreement here are Balchin & Rhoden (1995) who make the point that rent control legislation is the most commonly cited cause of the decline in the private rental market in Britain, adding that “rent control effectively removed the attractiveness of rental housing as an investment as rents were frozen for long periods and subsequent adjustments failed to match inflation”. According to Beer (2004, p1), Balchin & Rhoden (1995) paint a particularly bleak picture of the operation of rent controls, stating that “even when the rental market was freed from controls – for example by the Housing (Repairs and Maintenance) Act of 1957 which removed rent regulation from five million households – the private rental housing stock continued to decline” They also observe that “once adopted, rent control becomes politically difficult to abandon, even when its adverse consequences are widely apparent”.
Black Markets
The fourth and perhaps most unappealing (but, again, almost completely inevitable) effect of price ceilings is the development of black markets. Although unattractive, they are simply attempts by the market to correct itself, under the radar of the authorities. Black market activity is certainly inefficient and, by definition, illegal. Clearly the flouting of laws will not have a positive effect on the society in which it takes place.
There are two forms the black markets can take. Firstly, the illegal subletting of properties by tenants and secondly, the bribing of landlords to jump the queue for a flat in return for the payment of a fee (and/or a secret agreement for the tenant to pay more than the legal maximum rent). Due to the economic conditions of a rent-controlled market, there will always be those who will choose to enter into such agreements. Perhaps these people are not really in that much need of a flat, moving on a whim. Ultimately, there may be desperate people who need to find a flat who will never be able to find one. So, despite the good intentions of governments, a rent-controlled property market can prove even more unfair than an unrestricted one.
Additionally, as Haffner and Oxley (2009) observe, rent controls are costly to control. The twin roles of the state in a rent controlled market are decision making (rent setting, allocation i.e. eligibility) and implementing (making the policy a reality by a chosen method) There could also be the further stage of evaluation. All in all, it is a potentially bureaucratic and expensive endeavour.
CONCLUSION
Having examined the phenomenon of rent controls, what conclusions can be made about them? Are they good or bad? Are they worth pursuing? Can they ever work? It is certainly apparent that they have a myriad of downsides so why would governments impose them? Well, despite the difficulties surrounding the setting-up and maintenance of price ceilings, they are always well-intentioned. Governments want to ease the financial burden on their citizens. This is all very well, but we have seen the problems that can be caused, leaving some people in a worse situation than if the market was allowed to operate freely. There is a depressing inevitability of the downsides but, as Krugman et al. (2007, p90) observe in their focus on Prague, “while tens of thousands of Czechs have worse housing than they would in the absence of rent controls, thousands get much cheaper housing than they would if the controls were lifted”. Perhaps Krugman’s most telling observation as to why rent controls have been implemented is that real world policies are sometimes uninformed and not always the result of common sense. They state that “ it is not easy to tell markets what to do” and I would agree that this is both difficult and ill advised.
REFERENCES
Balchin, P. & Rhoden, M. (1995) Housing Policy, An Introduction, 4th Edition. London. Routeledge
Beer, A. (2004) Private Rental Housing in Europe: The View From Australia. Australia. National Housing Action, Vol. 13, No. 1
Haffner, M. & Oxley, M. (2009) Private sector involvement in social rented housing : England and Germany compared. Australia. Asia-Pacific Network for Housing Research
Hubert, F. (1993) Germany’s Housing Policy at the Crossroads. Germany. Discussion paper, Freie Universitat Berlin
Klingenberg, B. & Brown, R. (2007) Rent Control Revisited: Effects on Property Management. USA. Property Management Vol 26 No. 1, 2008
Krugman, Wells, Graddy. (2007) Economics, European Edition. Worth Publishers