Sunday, 6 March 2011

Imperfect Competition

NOTE: All curves should be straightly downward facing or upward facing. The gaps or "imperfections" in them are solely due to yours truly's status as an novice when it comes to making supply and demand curves on excel.

A lot of words have been shed over the new rent control study, conducted by Dr. Hugh Grant. The RAG machine, particularly the Frontier Centre for Public Policy, has been spewing out much venom over this inconvenient study. So, before addressing their claims I think it'd be nice to explain to the readers of this blog some basic concepts relating to the debate.

PERFECTLY COMPETITIVE MARKETS

The average economic opinion columnist, particularly the average Rightwing economic opinion columnist, typically bases their arguments on something called "Perfect Competition". Perfect competition is mentioned in first year microeconomics courses as an example of a really, really oversimplified model for understanding the economy.


Figure 1: A perfectly competitive (and nonexistent) rental market.

The model assumes that there are many hundreds of thousands of small firms selling completely identical goods. So, hundreds of thousands of pencil businesses selling identical pencils (same thickness, same composition, same lead, etc), hundreds of thousands of soda pop businesses selling the exact same soda (same colour, same flavour, same packaging, etc), and hundreds of  thousands of rental businesses selling exactly the same type of apartments!

Because there is so much competition an individual firm can't charge more than the optimal amount - the point where the supply and the demand curves meet.

DEMAND, SUPPLY, AND WHERE THEY MEET


Figure 2: Quantity of rental units demanded for each given price of rent. This is a demand curve for "the industry" as a whole (see figure 5 for an individual rental firm's demand curve). Numbers are not based on empirical studies, for demonstration only.

Image Source: Created by The Analyst
 In a perfectly competitive rental market landlords would charge rent and the higher the rent, the less tenants they would get. The lower the rent, the more demand for apartment units there would be (see figure 2). Conversely, the higher the rent the more supply of apartment units there would be, as landlords would be more eager to sell more if there is more profit to be made (see figure 3).


Figure 3: Number of rental units supplied at each price of rent. The higher the rate of rent, the more landlords are willing to supply. Numbers are not based on empirical studies, for demonstrative purposes only.

Image Source: Created by The Analyst

 In this Free Market Utopian's dream world, landlords would be constrained by the fact that the higher the rent they charged the less tenants they would sign up because, in a world with hundreds of thousands of other competing landlords selling the exact same apartment units thousands of others would be offering a much better rate and prospective tenants would be flocking to them.

So in this uber-simplified universe, the demand and supply curves would meet at one point, the equilibrium point. This point would represent the best possible price, the optimal rate, at which both a given amount of landlords and a given amount of tenants are satisfied. A landlord couldn't possibly charge above this point, because hordes of tenants would, as stated earlier, flock to other landlords. If some government agency, like the Residential Tenancies Branch (RTB), tried to force the rent charged below this "equilibrium price" (a move economists call installing a price ceiling) then less landlords would rent and there'd be fewer possible units for prospective tenants to rent.
Figure 4: In a perfectly competitive market, charging less than the equilibrium price causes shortages, as not as many landlords will supply as many units as there are tenants demanding.
 In figure 4, for instance, at the "best price" of $24 per month, 75 000 apartments would be rented out by landlords to tenants. If the RTB nefariously tried to reduce the rent, through legislation, to $16 per month, then only 37 000 rental units would be provided. Tenants would struggle with each other, waiting in long lines, to get an apartment and landlords would be choosy, picking only the very "best" candidates to rent their apartments ("best" being in the eye of the landlord -i.e. no bad credit history, very quiet, lacking noisy children, etc).


Figure 5: A given landlord, let's call him "Mr. Smith", cannot charge more than the equilibrium price of $24/month. If he does so, prospective tenants will look elsewhere to the hundreds of thousands of other landlords selling the exact same apartment unit.

Image Source: Created by The Analyst


ONE MORE ASSUMPTION: PERFECT INFORMATION

Oh, there's one more assumption perfectly competitive models employ. Tenants and landlords have access to perfect information. The landlord knows everything about the tenant (in terms of their characteristics as a tenants). For instance, landlords know if tenants won't pay rent in twelve months or have an impulse that leads them to smashing the walls. Tenants, in turn, know everything about the unit they are renting - exactly how large it is, exactly what type of wear and tear it can take, how good the walls are at blocking out noise, and whether or not the landlord will fix a leaky faucet or toilet in twelve months.

IMPERFECT COMPETITION

Why rent control is even considered is because markets are not, never have been, and never will be perfectly competitive! There will never been thousands of landlords renting out exactly the same unit, tenants will never know everything about landlords and landlords will never know everything about prospective tenants. There will always be information asymmetries (some people will know more than others) and market power (this enables a buyer or seller to charge or ask for a price below or above the "best price" or "equilibrium price"). 

Many standard theoretical economic models of rent control assume something approaching a perfectly competitive market. However, if there is only one rental firm (monopoly), a few (oligopoly), or many selling slightly different units (monopolistic competition) then matters can be drastically different. In any of these situations it's possible for landlords to charge more than the equilibrium price.

One peer-reviewed paper, by Richard Arnott and Masahiro Ignarashi in the Regional Science and Urban Economics journal, relaxed the assumption of perfect competition. They looked at what it would be like if rental units were slightly different (or, have "idiosyncratic characteristics") - a monopolistically competitive model.

 The model employed was simple. Housing units cost the same but differ in idiosyncratic characteristics; similarly, households are identical except for idiosyncratic differences in tastes. As a consequence, a household will like some units more than others, and the longer and the more effectively it searches the more likely it is to find a unit that suits its tastes well. ..

Because search is costly and housing match quality is idiosyncratic, landlords have market power which they exploit by pricing above cost. The vacancy rate adjusts so that zero (expected) profits are made in long-run equilibrium. The uncontrolled equilibrium vacancy rate is inefficiently high. Thus, a reduction in rent below its uncontrolled equilibrium level is welfare-improving; mild rent control is beneficial...
However, they urged caution and pleaded that people look at local conditions (as Hugh Grant did) before applying any given model.


REFERENCE
Arnott, Richard, and Masahiro Igarashi. 2000. Rent Control, Mismatch Costs, and Search Efficiency. Regional Science and Urban Economics 30: 249-288.

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