Tuesday, March 30, 2021

Making sense of property as a monopoly

Let us start by assuming that the property system is competitive and see how far that gets us in making sense of property pricing. After all, there are many different owners of different locations. That seems like what the textbooks describe.

The competitive market of economic theory has a few quirks. At the firm level, the demand curve is flat. Varying your own supply has no price effect. Yet, at the market level, varying supply does have a price effect. The problem of adding up a bunch of zero effects from firm quantity variation to a positive effect at the market level is an issue. It is resolved by assuming free entry at the market price; if a firm decreases its output while all others retain the same output, a new firm will enter the market and sell exactly that amount necessary to get back to the market equilibrium.

Neat, huh?

So let’s get back to it. We have a bunch of property-owning firms that can redevelop their space into housing. Each property owner sees a flat demand curve at the market price (because of our neat assumption) and has a cost curve that looks like...

Well, what does it look like exactly?

In strictly economic terms, the only input to the property right over a location is the existence of a property system. There are no input costs. To develop housing there are of course costs involved, such as fees, construction, and selling costs. But you can net these costs out of both demand and supply to look at the market for “empty” locations, or property rights to locations. After all, new housing supply is merely the subdivision of space—the subdivision of property rights into smaller pieces. The demand curve is still downward-sloping for that property rights market, but the supply curve must sit at zero.

Here we hit our first problem. If we assume perfect competition, we can only have land (location) prices of zero.

This “zero cost of location” view is what Ed Glaeser argues is the right way to think about housing.
…housing is expensive because of artificial limits on construction created by the regulation of new housing. It argues that there is plenty of land in high-cost areas, and in principle, new construction might be able to push the cost of houses down to physical construction costs.
In other words, land prices should be zero everywhere. Any deviation from this is due to regulatory intrusions in the market. Indeed, this implies that the very existence of a land market with trades at non-zero prices indicates it is not competitive. This is a bizarre conclusion in my view.

Maybe we will have more luck making sense of the property system by assuming it is a monopoly despite the many different owners. This has some intuitive appeal. First, you can’t choose to have your locations supplied by a competing property titles system. You can’t run more than one property system in parallel. Can you imagine the conflicts over who owns what space with multiple property systems? Second, the ownership of monopolies is often carved up (subdivided) and owned by many different people who each own constituent parts. Though we usually call these company shares or stocks. 

So what then of the economic theory of monopoly?

As a starting point, a monopoly model avoids the assumption of free entry as the reason individual firms cannot observe their own-supply effect on price. This matches the reality of the private property system as it does not allow free entry. You can only compete in the property market by first buying property from the property market. This seems sensible.

The property market for any use, like housing, therefore looks this at a point in time.

Since costs are all sunk, we can simplify a bit by ignoring the stock of existing housing and look forward in time only. Think about redrawing the axes with the origin at the equilibrium current price and stock.

A change in the housing stock is the supply of new housing. The question of interest is how the stock of housing evolves over time in a property monopoly to determine an equilibrium rate of new supply?

In this model, if demand stays fixed and existing housing does not depreciate, then no new housing is built.

As demand shifts, new supply is added at a rate that maximises the revenue gain from selling those new properties rather than keeping them undeveloped in your balance sheet. It is the same monopoly maximisation principle applied at the margin. In other words, you sell new housing lots at a rate that maximises the present value of that flow of sales.

This logic is shown below. From the t=0 equilibrium, demand shift upwards. The green line shows the marginal revenue from the new supply (i.e. the change in the housing stock, Q, over that period). The new equilibrium is where the revenue from that flow of new property put to housing uses is maximised (i.e. where marginal revenue from that flow is zero).

This equates to a rate of supply that I explain in my absorption rate theory of housing supply (assuming a zero interest rate to simplify the inter-temporal trade-off).

The steeper (more price sensitive) the demand, the less supply responds to the same vertical demand shift. That’s because each property owner is sensitive to their bigger own-supply effect on the market price. Thin markets mean less supply.

Under this monopoly logic, the supply curve for property is not an independently-determined cost curve, but a derived curve based on the slope of the market demand curve.

But how do you get to the monopoly outcome? Is a conspiracy needed?

Not at all. All that is needed is trial and error. Remember, unlike the competitive market assumption of free entry, in the monopoly model, changes in firm output affect market output. If firms start near the competitive rate of supply per period in the face of a sloping (and rising) market demand curve, they will quickly learn to get to the monopoly rate of supply independently.

All that is needed is a learning rule of “win-stay, lose-shift”. This rule says that if the increasing the rate of supply last period increased your marginal revenue, then increase next period, otherwise decrease the rate of supply. If decreasing the rate of supply last period increased your marginal revenue, continue to decrease, otherwise increase.

When I simulate this learning rule with three firms, they quickly converge to the monopoly rate of supply, and hence the monopoly price. This convergence will occur even with 1,000 firms in the market. Property markets have been around for a while now. It seems likely that the current set of property owners has learnt this maximising equilibrium.

It seems logical to conclude that the monopoly model of property makes more sense than a competitive model. Indeed, monopoly was the traditional economic way of understanding property markets. In terms of understanding housing markets and effective policies to reduce prices, I think the following points are key.
  1. That the property system is a monopoly shows that the rate of new housing development is mostly a product of demand. Property owners don’t want to build faster. This is because supply is not independent of demand. Supply is merely a reflection of demand.
  2. Rezoning and changing planning rules might change where development happens (as it should—they are location regulations after all) but probably won’t change the rate of new supply. The rate is the one the market wants. Developers don’t want to flood the housing market.
  3. Making housing cheaper should be understood the same way we understand other monopolies. We regulate prices. We create public options. Pretending that we can somehow capitalise on competitive market forces that don’t exist won’t change things.

Tuesday, March 23, 2021

Luxury beliefs of YIMBYs and free markets

Yes In My Back Yard (YIMBY) is the belief that more housing density in your neighbourhood is good. But I argue that almost nobody who makes these arguments truly believes them. Mostly, it’s a case of Yes In Your Back Yard (YIYBY). I say that because even property developers who make a living building high-rise apartments hate it when these same types of apartments are built in their street. What about the politicians who impose massive density increases in the suburbs? They hate it when that policy arrives in their street. Sometimes YIMBYs will change their story when density comes to their neighbourhood to one about "missing middle density" or "urban design". Yet if their belief in the economics of more supply was genuine, it should trump these minor concerns.
Such hypocrisy also happens with immigration policy. Those who support turbo-charged immigration policies do so because they personally are insulated from the effects. But when those effects come to their own leafy town, they turn their beliefs 180 degrees to be against it. All those apparent benefits used to justify the belief exist only when others bear the cost.

These are classic examples of what Rob Henderson has called luxury beliefs. Things you don’t really believe, but use to signal group loyalty and status. Luxury beliefs are “ideas and opinions that confer status on the rich at very little cost, while the main price is paid by those less fortunate.” 

In economics, I think the efficiency of markets is a classic luxury belief. Even the most pro-free-market economist, like Milton Friedman, are out there speaking for status, rather than reflecting true beliefs. Friedman might even have himself fooled most of the time.

For example, when speaking to a group of Chicago economics colleagues, he “was bemoaning the fact that Chicago price theory was dying out.” One colleague responded “Milton, I thought you believed in markets. It sounds to me like price theory is losing.” At least according to Steven Levitt who said that “even Milton Friedman, in the end, didn’t really believe in markets when markets moved against him” (from 52.00 here).

In fact, markets are the last resort for resource allocation. As a society we really hate markets. We avoid them as much as possible by creating firms to bring market transactions within a hierarchy, and when we have markets, we regulate them heavy-handedly to ensure they function in a very un-market-like way. Only those expressing luxury beliefs who are insulated from the costs pretend otherwise.

I would even go so far as to say COVID policy has been fuelled by these luxury beliefs. Pro-lockdown politicians repeatedly violated their apparently strong beliefs when it came to their personal lives. Perhaps they were expressing status and loyalty with their lockdown comments, not their genuinely held beliefs.

The fact that people say things that contradict their actions is one reason why many economists are sceptical of survey responses. You can ask people “is it a good idea to build more dense housing in this neighbourhood” but then those who agree will end up spending thousands on lawyers defending the status quo situation in court. Their response was not genuine. It was a luxury belief. Better to ask survey questions that are more personal, like "it is a good idea to build high-density housing next door to your house?"

What can be done to weed out luxury beliefs?

One thing is to align decision-makers with the costs of policy change. Put them personally on the receiving end of the costs of the policy and you will see their true beliefs emerge. High immigration and housing density in the suburbs where politicians live needs to be a prerequisite for the same policy elsewhere. Alternatively, we could randomise the decision-makers through sortition—a type of random jury system to become a politician—ensuring that those who bear the costs of a policy are part of the political process. 

Monday, March 8, 2021

Evil rent control revisited

A new report is out looking at the Berlin experience with rent control (original German report here). The basic idea is that dwellings built prior to 2014 now have regulated rents and caps on rental increases. All very standard price-cap regulation. New dwellings are not regulated. 

What I find funny are the contortions that economists make to explain good things as evil things because of their cultural taboo about rent control. With the help of another recent paper on rent control, I want to straighten out some of these contorted arguments.

Rents in the unregulated market don’t fall. This is evil. 

High rents are bad. This is the foundation of the claim that rent control is bad. Yet the enormous benefit of rent growth at a rate 60% less for roughly half of all households in Berlin is ignored and downplayed.

There aren’t many other policy interventions that get this size outcome. Even doubling home building for a decade is at most going to see a 10% relative rent reduction in a decade's time, which in terms of growth rates would be a tiny effect. This rent control case study appears to be one of the most successful affordable housing policies I've ever seen.
Even if you assume that market rental increases of the past year are related to rent-control policy (rather than being a continuation of previous market trends, which my eyeballs tell me is the case, especially in the original report chart with error bars marked) the welfare calculation is hugely in favour of rent control.
The basic welfare calculation is:
With a 0.5 share of households renting pre-2014 buildings with rent rising 2% per year instead of, say 5%, saves each household about half of the current year’s rent over 5 yrs. That’s 0.25 “city rent years” of benefit to residents.

With a 0.05 share of households relocating each year paying at worse 0.08 more for their rent, we get 0.027 of “city rent years” of cost to residents over 5 yrs.

On pure "high rent is bad" benefit-cost terms the Berlin experience got a 10x economic return! This even assumes that all private market rental growth is due to rent control, which is implausible (more on new supply later).

You can’t just pretend that these orders of magnitude are similar.

Additionally, the macro-economic effects of additional non-housing renter spending in the local economy must be quite large. This is a diversion of half the rents in the city from landlords to tenants, with the downwards income distribution likely having large spending effects.  

Landlords sell to homeowners. This is evil.

“Landlords treated by rent control reduce rental housing supplies by 15 percent by selling to owner-occupants and redeveloping buildings.”

I find this statement hilarious. 

Landlords sold to owner-occupants. This is a good thing, not an evil thing. 

Many policies are aimed at getting more homeownership and the best way to do that is for landlords to sell to owners (even the tenant perhaps). 

If they do this, there is no effect on the supply of dwellings. This is because the former renter who buys the home is now also no longer a renter. It’s a minus one from the supply AND a minus one from the demand. 

Redeveloping buildings increases new housing supply. This is evil.

The whole economic schtick about rent-control is that it decreases new housing supply. But both the Berlin report and the Diamond et. al. paper show this is not the case. 

Diamond shows that rent-controlled housing is roughly 5% more likely to get additions and alterations, and 7% more likely to be redeveloped. But I thought rent control meant that landlords won’t invest in their buildings anymore? The charts below show these effects over time.

In fact, there is a whole movement of economists and urbanists who are itching for ways to get more housing supply because they believe it helps reduce the cost of renting in prime areas. Maybe try rent control?

Turning now to the supply of unregulated rental housing advertised in the market, it looks from the Berlin study that new apartment listings are outpacing peer cities. But this is labelled evil. They are "only slightly outpacing" other cities. Terrible!

Rent control stops poor people from being displaced. This is evil.

The final strange contortion happens in the Diamond paper when concerns over low supply (now invalidated) turn into concerns over gentrification and the rapid new supply of luxury market-priced housing. That rent-control works to stop the displacement of poor people during this process is then labelled as evil by saying that it widens income inequality. 
…it appears rent control has actually contributed to the gentrification of San Francisco, the exact opposite of the policy’s intended goal. Indeed, by simultaneously bringing in higher income residents and preventing displacement of minorities, rent control has contributed to widening income inequality of the city. 

The problem with rent control is that it works. This is evil.

The real issue is not that rent-control is an economic failure. The zeal with which the theoretical economic case against it is made, regardless of the evidence, is necessary because rent-control works. Without an economic story for why rents should not be regulated, all those landlords would constantly face the political risk of losing billions in rents. 

One argument that I’ve heard is that economists have tricked themselves with their own supply and demand theories. But I think that’s wrong. I argue that the theory is used to back-fill a convenient political story. I say that because supply and demand logic can just as easily be used to show why rent-control should be a huge success with no changes to investment incentives around new housing. 

Let me show you. In the first supply and demand diagram below I include total housing supply and demand, with a kinked supply curve to represent the existing stock of dwellings that don’t get demolished because prices might fall. This the way Ed Glaeser describes housing supply curves.  

All we then do is split the demand curve into existing and new demand. We subtract out the tenants of existing houses from new demand, and their existing homes from new supply, and are left with the following, where the dashed blue line is the demand curve for existing housing and the solid blue line is the demand curve for new housing. It’s the same equilibrium. We merely cut off all demand and supply to the left of the market equilibrium and put it in the regulated system.

The economics of rent control is evil.

The taboo topic of rent control is so screwed up that the evidence it works must be contorted into something evil.

And that's all folks. 

Sunday, March 7, 2021

Merit doesn't cause income

In a podcast interview with the terrific Joseph Walker, geneticist Robert Plomin said something that stuck in my mind—"in a meritocracy there will still be large deviations of income due to genetic variation in abilities."

I also stumbled onto an economics blog about capital taxation that relied on the idea that high capital incomes come from previous savers who therefore deserve that higher income (I can't seem to find it again, but I'm sure you've heard the idea before). To bring Plomin's comment into the mix, we could say that if genetics determines time-preferences or risk-taking attitudes, then capital incomes are also determined genetically. Taxing those capital incomes is therefore taxing the "merit" of saving.

Like much of the economic and political debate about poverty and inequality, these ideas rely on a flawed understanding of how income is distributed in human societies. That flaw is to pretend that there is something called "merit" or "value" (or "productivity" for that matter) that is independent of the ability to be rewarded via payments.

Think about it like this. We often look at the characteristics of people who earn more money—their education, their patience, their leadership skills, their attractiveness—and then label those attributes that correlate with incomes as "merit", or "value", or "productivity". This approach merely defines "merit" based on current income. If "merit" causes incomes, there must be a way to define and measure it independently before looking at any correlations.

Imagine LeBron James was born in 1784. His genetic gifts are identical—his athleticism, work ethic, and his overall intelligence on every dimension. His genetic "value" or "merit" assessed without reference to his income is identical to what it is now.

But society at that time would be structured in a way that his genetic gifts would make him a high-value slave. His personal reward would be the pleasure of working hard manual agricultural tasks for longer, and the slave owner would get the income for having the "merit", "value", and "skills" of cultivating high productivity slaves. (Do you see the parallel with capital owners generally? Their "skill" and "value" is choosing investments. In practice, that means choosing what tasks other people do when they work for their income.)

Here's another example. In-breeding of royal families historically led to genetic variation that made many of them useless in the productive activities of the day. Despite this, their incomes and power remained nearly identical to their genetically superior siblings. If our social structures mean that "merit" determines income, and "merit" is heavily genetically determined, this should not happen.

In fact, if you follow the logic that genetic variation causes merit variation, which causes income variation, then genetically diverse places should naturally have more inequality. That "homogenous Nordics" argument rears its head again. Compression of genetic variability or some other attribute we have labelled "merit", like education, is therefore seen as the best way to compress the income distribution.

But in reality, the Nordics compress their income distribution through welfare state policies. Their market income distribution is much the same as peer nations. They merely choose to create a social structure that keeps the income distribution more compressed regardless of any underlying variation in individual attributes, genetic or otherwise.

We also know that income and wealth inequality has grown tremendously in the past four decades. This has nothing to do with changing genetic variation. It has nothing to do with a changing distribution of an independently-assessable concept of "merit". School teachers make lower relative salaries today because we chose not to raise their salaries faster. Some countries didn't do this, and their school teachers make more money. 

Some of you might be thinking that places with high-income school teachers have better teachers. But you are again failing at basic logic by reversing out "merit" from income. 

We know that increasing incomes actually causes changes in personal attributes that are usually labelled as "merit" and assumed to be determined independently from income. Basic income experiments show that higher incomes cause people to become more confident, trusting, healthy, less depressed and more able to concentrate, for example.

It seems logical to me that if there is no such thing as an independent concept of "merit" or "value", then we should simply choose a more compressed income distribution in society rather than the unequal one we have chosen. That more compressed distribution will help avoid the pitfalls of high inequality by ensuring that regardless of variation in genetics or "merit", people can live comfortable lives and take opportunities that low incomes often prevent them from doing. 

In practice, this comes about by setting an income range via the tax and transfer system. Very high marginal tax rates on high incomes, coupled with generous unconditional payments for low-income households, will compress incomes.

Perhaps the minimum income could be roughly $20,000 per person (with variation depending on household size and type), with a maximum of $2,000,000 per person. That leaves a 100x income range within which market-based incentives can operate. I see no reason why the range of variation should be any higher than that. Can individual merit, however defined, really explain a 1000x variation in income? Will some people not go to work because they earn $8,000 per day instead of $20,000 per day, even if there are no $20,000/day options because of the tax system? I doubt it. People won't even see a change in their rank within the distribution.

Income compression should be the focus of policies for dealing with poverty and inequality. Ideas that rely on "merit", "value", or "productivity" are going to be failures as they implicitly (or explicitly) define merit by income.