Monday, June 8, 2015

Will higher standards make apartment residents worse off?


Despite the fact that the principle lesson of economics is that there is no free lunch, for apartment residents this is a free lunch. To be more accurate, it is the landowners who are paying; they will now get less for their land because of the higher cost of converting it to apartments at the new higher minimum standard.

The usual arguments against such regulations are:
  • Costs will be passed on to apartment prices and rents 
  • Pro-choice, freedom and all that
  • Regulations often do more harm than good 
All of these arguments are on display in an overly elaborate and ill-informed way in this piece by the usually sophisticated Alan Davies who argues that higher design standard for apartments will make residents worse off. My beef is with first of them.

This 'cost passed on' argument arises in the economics of housing all too often, particularly in regard to rental regulations. I expect the econ-blogosphere to be bubbling with such 'cost passed on' arguments forthwith after Berlin introduced maximum rental increase regulations. I have briefly had my say about this in the past, as has Matt Bruenig who makes the point that property ownership rights themselves are a form of rent control for property owners. If you believe that rent control is inefficient for standard economic reasons, you open yourself up to the problem that freehold title to property - apparently the building blocks of capitalism - are just as inefficient. 

For the pro-choice people, I’m happy for you to take your chances with a heart surgeon who hasn’t been screened through minimum standards regulation, or buy a house that doesn’t meet minimum building standards. Good luck [1].

But back to minimum design standards for apartments [2].

In standard economic analysis, the incidence of the cost of a tax or regulation does not always fall on the person who is obliged to pay it. What Davies argues is that the incidence of the additional regulatory cost falls predominantly on apartment buyers even though developers and builders pay such costs directly when constructing better buildings. In his view it is

Landowner Developer Apartment buyer
(no economic effect) (pays the cost) (economic incidence)

Why does Davies, and for that matter the much of the economics profession, believe this to be the case? Take the simplest of case of stamp duties on property sales. The economic incidence can clearly be shown to fall completely on the seller rather than the buyer, even though the buyer actually pays the cost. To be clear, if the stamp duty cost of purchasing a home is $5,000, buyers will factor that in and pay the seller $5,000 less for their house. Hence the incidence is on the seller who is $5,000 worse off, not the buyer. Economists routinely get this wrong.

In reality what happens in the case of apartment design standards is that the landowner bears the cost. In the short run that will also include developers who own land.

Landowner Developer Apartment buyer
(economic incidence) (pays the cost) (no economic effect)

Why can I be so confident that this the case and the economic incidence is not shared?

Land is a special case in terms of economic incidence because there is no substitute market for a plot of land. All buyers of any particular vacant plot are price-taking in their developed housing output, but price setting monopsony buyers of their land inputs. Although a development site can be sold in a market with many buyers competing on price, all those buyers will be working backwards from the highest and best use of the land, subtracting costs, and working out how much the site is worth. Add more costs into the development equation and each potential buyer will put these cost in their feasibility spreadsheet and reduce their bid for the land by the same amount. In terms of market power the situation is identical to having a single buyer (alternatively, think of the highest bidder the single buyer).

But how do we know developers can’t pass on costs to buyers through higher prices. Mainly because if they could sell at higher prices they would do so WITHOUT incurring any costs.

As a rule, you can tell where the economic incidence of a regulation is by the groups that oppose it, particularly if their logic makes no sense. The Property Council of Australia opposes stamp duties by arguing that they add to prices. But if developers can simply pass on these costs to the price of housing a) why do they oppose it, since they've admitted it costs them nothing, and b) why aren't they already charging higher prices? The Pharmacy Guild is another great example of lobby groups that proclaim that the economic incidence on regulation will be buyers rather than those who hold monopoly pharmacy licences. 

In sum, there is no free lunch by setting minimum apartment standards. But for residents, the lunch is being shouted by landowners and developers so it will make them better off.

fn.[1] The image above is from a recent fire in Melbourne that spread 15 storeys up the building in minutes due to the use of cladding that did not meet minimum fire standards.

fn.[2] Note that I am ignoring the macroeconomic cost in terms of resources potentially diverted from other uses in the construction sector from building these higher standard buildings. And why not. It’s not like Australia, nor most of the world right now is anywhere near full-employment growth rates. There is slack everywhere you look. Higher standards could even be stimulatory in this environment.


  1. Surely, demand for land is not perfectly inelastic. For example, builders can substitute land for steel and concrete by building the same amount of office space in taller buildings on smaller plots of land.

    1. "builders can substitute land for steel and concrete by building the same amount of office space in taller buildings on smaller plots of land"

      Yes, but they will have to also buy those smaller plots of land from someone who has the same option to build, and compete with others who have in mind the same substitution of steel+concrete for land. Meaning that substitution is ALREADY in the price. Land prices are just a residual (as they must be, since the have no production costs).

      Also, the whole idea of elasticity in land markets is a little problematic because it ignores that land is an asset as well as an input (despite the fact that many people think elasticity in asset markets is a thing), and also ignores the time margin (the choice facing a land owner is mostly WHEN to build and WHEN to sell, not what to build).

  2. I simply cannot agree with this Cameron. Higher input costs leads inevitably to higher end prices for consumers, even if a portion of that added cost can be absorbed. Keep adding on inputs and voila - we have a higher sale price.

    If no one wants to buy at that price, no more will be produced, until extreme demand forces buyers to pay the price. That is a description of how our housing market is currently working..

    Add on a $1.00 tax for every loaf of bread sold and watch the cost of a bushel of wheat come down - I don't think so. You might see some minor cost adjustment at the farmgate, but those poor wheat farmers can't work for much less, we are robbing them blind as it is because we can substitute another food product or flour made from another grain.

    This is very similar to the stamp duty argument that we discussed years ago when Andrew Leigh wrote on the subject. It was wrong then and it's still wrong.

    All input costs matter to the end price, and theory can't change that, Only so much cost can be absorbed by the people in the chain, from landholder, to developer, contractor, salesmen, etc.

    The base price of housing is production cost plus a margin, and input costs are part of that production cost. Reduce the inputs and the price falls, increase them and the prices rise.

    Perhaps we will just have to disagree on this issue.

    1. From what I understand our disagreement is this.

      I don't believe this, but you do.
      "All input costs matter to the end price"

      If this is true than land would always sell for a zero price because it has no inputs and hence costs nothing. So something else must be going on.

      You are taking land prices as determined by some unspecified mechanism, then adding up them to other costs for housing production.

      But let's step back one notch in the production chain to land production. Let's apply to same logic to add together this input costs for land. First, we have... Oh hang on. There are none!

      Your input cost adding up doesn't work.

      What I am saying is that in the case of land development the price of housing is set by the enormous market for existing housing, then costs are subtracted and the residual is the land price. This logic is the only way in which ANY positive price for land can arise, and in this view an increase in other input costs reduces land prices. Reduce other input costs, increase land prices.

  3. Clearly I didn’t explain myself very well. Input costs are not the only items in a cost structure.
    I understand what you are getting at, in your argument the price that allotments are sold for is determined by what the market can and will pay, in which case the price that a developer is prepared to pay for the raw land is sale price less all costs including inputs such as developer contributions and GST, and a fat margin for him. Developers love those markets, but they rarely see them. Life is harsher than that.

    I get your point, but that structure only works in inefficient markets, when land is in high demand. What is your explanation of the price cost breakdown when sales are slow and the developer needs the cashflow to stay out of bankruptcy. You have completely overlooked the issue of cashflow, which in any business is absolutely vital. In the current market it’s easy to forget that Real Estate isn’t always like this.

    Therefore there are multiple cost structures. There is the one that you describe, one that is the polar opposite of what you describe, and a thousand variants in between. Regardless of which one you choose, the addition of more input costs does not force down the cost of raw broad acres to zero. That land still has a production value because if its land suitable for RE development that it’s at least grazing quality land. It won’t be swamp land or other unusable land. It may reduce the “premium” that a developer is prepared to pay, but it will never reduce to zero, so let’s be clear about that.

    I’m prepared to accept that under some market conditions if there was an added input cost that may affect the price a developer is prepared to pay for the raw land, but that doesn’t necessarily mean the farmer or the crown will accept that offer. That’s why of course developers land bank – they simply have to. It’s like a game of chess.

    Make no mistake, everytime the various layers of government add another input cost, it will affect the end price proportionally sooner or later.