New rule – old problem; rent ceiling

Around about this time during IB1, students should be well into the various forms of government intervention that are included in the IB syllabus. For micro economics, these include (indirect) taxes, subsidies, maximum prices and minimum prices. You may rest assured that at least one of these will be the subject of an exam question for you!

During the summer, Berlin became the first German city to implement rent controls, e.g. a maximum rent on inner-city housing in Berlin. The basic rule is that a landlord cannot charge new tenants more than 10% above what the average rental price is for a designated area. (See http://www.telegraph.co.uk/finance/property/news/11645625/berlin-rent-control-law-housing-crisis.html) The new ‘mietpreisbrems’, roughly ‘rental-price-brake’, had the effect of lowering average new contract rents by more than 3% within a month. So, the system is working then?!

Well, maybe. It’s far too early to tell. Most economists would adopt a wait-and-see attitude, as a goodly many of the most debated outcomes are long run effects. One of the more famously hard-line views on rent ceilings was put forward by the famous Swedish economist Assar Lindbeck: “Rent controls are the most effective way, short of bombing, to destroy a city.” (See this link.)

Let’s have a look at the immediate to short run effects and then turn the spotlight on the reasons for rent controls and what we often see as the long run result of rent controls. In diagram 1 below, the price ceiling (Pmax) is set at a level below market clearing price (Pmkt), resulting in an increase in Qd (Qd) and decrease in the quantity supplied (Qs). The initial outcome is the excess of of Qs to Qd.

Right about here one needs to ask what the initial intentions of a rent ceiling are. The answer is basically ‘equity’, e.g. fairness in distribution and access to goods. High rents become prohibitive for low and lower-middle income groups and can result in much needed teachers, nurses, bus drivers and handymen simply not being able to afford inner city rental costs. With the best of intentions, governments intervene to enable these income groups to live in New York, London and Paris.

Diagram 1, above, shows the initial and secondary outcomes of rent ceilings; an excess in demand and a very likely black market. The excess demand arises simply because the maximum price must be set below market equilibrium to have any effect whatsoever – and this situation needs be dealt with via some form of rationing system or queue system. The rationing system was commonly utilised during wartime periods and in the Soviet Union. This doesn’t really work when dealing with apartment rent so in this case government will allot apartments on a ‘first come first served’ basis; pick a number and wait in line! This is what is done in Stockholm, Sweden, and the queue is about 20 years long. Patient people we Swedes.

The long run issues are partially illustrated in diagram 2, below. As most rent controls are applicable to living area rather than commercial properties, there is a huge incentive for suppliers (apartment building owners) to remove empty apartments from the housing market and put them on commercial property markets. So, when an apartment is vacated, the owner might instead rent the apartment out for storage, office space or a local business such as a hairdresser. This decrease in the supply of living area will have the long run effect of worsening the initial excess demand, and increasing the black market price on the market.

Clearly these are unintended consequences and will in fact only exacerbate an existing scarcity of rental apartments? Well, yes, and it is no exaggeration to claim that a majority of economists who have looked at the issue are seriously opposed to maximum rents. The long run is literally littered with miss-allocation of scarce resources:

• Since maximum rents will invariably be applied also to new apartment buildings, there is a huge incentive for land owners to instead allocate their land for hotels, warehouses and office space. Simply put, demand for inner-city apartments will far outstrip any new available rental apartments.
• There will be marked capital destruction as building owners have no incentive for costly repairs, renovation and upkeep. As owners cannot pass on renovation costs to tenants, they will simply do as little as possible. The result is crumbling facades, leaky plumbing and bad insulation. The cost of a complete overhaul after 30 years of neglect is far greater than minor annual repairs and upkeep.
• The ‘old lady effect’ means that when children are grown and flown and the husband/wife is deceased, old people tend to stay on in rent controlled apartments. This is not only due to sentimental reasons by highly rational economic ones! The five room rent controlled apartment Elsa, 83, is occupying will be far cheaper than moving to another apartment where the rent will be higher, as most rent ceiling laws allow owners to raise the rent significantly more for new tenants. Thus, Elsa stays on in 130 square meters when she would be perfectly comfortable with 60.

The initial responses to rent control in Berlin have been largely positive. (See the Financial Times here and the BBC here.) Rents have fallen some 3% during the first months and no major crises have arisen. Yet it bears re-stating that the long run is just a series of short runs and that one might want to wait a few years for a final analysis of the outcome. More to follow.