Unit 8 Supply and demand: Markets with many buyers and sellers

8.13 Price controls

We know that total surplus is maximized at the market-clearing price. But governments may nevertheless decide to intervene in a market to change the price to achieve other objectives, such as fairness.

In some countries, local or national governments control housing rents. Sometimes this is to protect tenants, who may have little bargaining power in their relationships with landlords, or sometimes because urban rents would be too high for groups of workers who provide essential local services.

Figure 8.25 shows a situation in which the local government might decide to control the housing rent in a city. (Note that here we mean rent in the everyday sense of a payment from tenant to landlord for the use of accommodation.) Initially, the market is in equilibrium with 8,000 tenancies at a rent of €500. Now suppose that there is an increase in demand for tenancies. Rents will rise, because the supply of rental housing is inelastic, at least in the short run: it would take time to build new houses, so more tenancies can only be supplied immediately if some owner-occupiers decide to become landlords and live elsewhere themselves.

rent ceiling

The maximum legal price a landlord can charge for a rent.

Suppose that the city authorities are concerned that this rise would be unaffordable for many families, so they impose a rent ceiling at €500. Follow the steps in Figure 8.25 to analyse what happens.

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https://www.core-econ.org/microeconomics/08-supply-demand-13-price-controls.html#figure-8-25

Figure 8.25 Housing rents and economic rents.

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https://www.core-econ.org/microeconomics/08-supply-demand-13-price-controls.html#figure-8-25a

The market clears

Initially, the market clears with 8,000 tenancies at rent of €500.

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https://www.core-econ.org/microeconomics/08-supply-demand-13-price-controls.html#figure-8-25b

An increase in demand

Now suppose that there is an increase in demand for tenancies.

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https://www.core-econ.org/microeconomics/08-supply-demand-13-price-controls.html#figure-8-25c

Rent increases

The supply of housing for rent is inelastic, at least in the short run. The new market-clearing rent, €830, is much higher.

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https://www.core-econ.org/microeconomics/08-supply-demand-13-price-controls.html#figure-8-25d

A rent ceiling?

Suppose the city authorities impose a rent ceiling at €500. Landlords will continue to supply 8,000 tenancies, so there is excess demand.

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https://www.core-econ.org/microeconomics/08-supply-demand-13-price-controls.html#figure-8-25e

The short side of the market

When the price is below the market-clearing level, supply is less than demand. We say that the suppliers are on the short side of the market. They determine the number of tenancies.

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https://www.core-econ.org/microeconomics/08-supply-demand-13-price-controls.html#figure-8-25f

Some people would pay much more

When the price is $500, there are 12,000 people on the long side of the market. Only 8,000 obtain tenancies. There are 8,000 people willing to pay €1,100 or more, but tenancies are not necessarily allocated to the people with highest willingness to pay.

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https://www.core-econ.org/microeconomics/08-supply-demand-13-price-controls.html#figure-8-25g

Opportunities for rent-seeking

If it were legal, some tenants could sublet their accommodation at €1,100, obtaining an economic rent of €600.

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https://www.core-econ.org/microeconomics/08-supply-demand-13-price-controls.html#figure-8-25h

The long-run equilibrium

In the long run, the city authorities could make more tenancies available at a reasonable rent by encouraging housebuilding, to shift out the supply curve.

In general, a controlled price will not clear the market, and trade will then take place on the short side of the market: that is, the quantity traded will be whichever is lower of the quantities supplied and demanded. In Figure 8.25, the price is low and suppliers are on the short side.

When the rent is €500, the number of tenancies will be 8,000. Of the 12,000 people on the long side of the market, 8,000 would pay €1,100 or more, but tenancies are not allocated to those with highest willingness to pay. Those lucky enough to obtain tenancies may be anywhere on the new demand curve above €500.

The rent control policy puts more weight on maintaining a rent that is seen to be fair and affordable (by existing tenants who might otherwise be forced to move out), than it does on Pareto efficiency. The scarcity of rental accommodation gives rise to a potential economic rent: if it were legal (it usually isn’t), some tenants could sublet their accommodation for €1,100, obtaining an economic rent of €600.

If the increase in demand proves to be permanent, the long-run solution for the city authorities may be policies that encourage housebuilding, which shifts out the supply curve so that more tenancies are available at a reasonable rent.

Exercise 8.14 The distributional impact of rent control

The diagram shows the rental market before rent control, where in equilibrium (G), X₀ apartments are rented at the price, P₀. Suppose rent control lowers the price to P_R and the number of apartments supplied to X_R.

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1. Under the usual assumption that apartments are allocated according to willingness to pay, draw a copy of this diagram and indicate the following areas:
   • Renter surplus after rent control
   • Landlord surplus after rent control
   • Landlord surplus transferred to renters
   • Renter surplus lost
   • Landlord surplus lost.
2. Use your answer to the previous question to explain the effect of rent control on renters, landlords, and total surplus. Discuss some factors that affect the magnitude of gains or losses experienced by either party.
3. Suppose that renters could vote to remove rent control, but they would only be willing to do so if the landlords made a suitable transfer as compensation. Use your diagram to explain how this arrangement could leave both renters and landlords at least as well off as under rent control.