Rent control continues to exist to some degree in Ontario, Quebec, British Columbia, Manitoba, and Prince Edward Island. In Ontario, units that were built, or came onto the rental market, after November 1, 1991 are exempt from rent controls. Units on the market prior to that date tend to have rent increases tied to the growth rate of the consumer price index (CPI), but when a tenant moves out rents can be raised to whatever the market will bear. (The Ontario New Democratic Party (NDP) has recently proposed extending rent controls to all Ontario rental apartments.) In Quebec, rent increases are tied to landlord cost increases, but can be lower than these cost increases and, as in Ontario, once a unit is vacated the landlord has some ability to raise the rent. In British Columbia, provincial government guidelines cap rent increases at the growth rate of the CPI plus 2%. In Manitoba, the government mandated maximum rent increase is usually set below the growth rate of the CPI. In Prince Edward Island, maximum percent rent increases are set annually based on the type of dwelling.

Aside from rent control, there are other price ceilings in Canada today. Currently some form of price controls exists in Canadian markets for pharmaceutical drugs, electricity, basic residential phone services, and agricultural commodities (such as eggs, chicken, turkey, and dairy). In the case of patented prescription drug prices, there are two stages of control. The federal government grants monopoly rights to the patent holder to be the sole supplier of a particular drug formulation, but in return the government imposes a price ceiling that the supplier can’t exceed. The provincial and territorial governments, which are responsible for delivering health care services within their borders, use their market power as purchasers of large volumes of drugs to negotiate prices that can be well below the ceiling price.

At times, price ceilings have been widespread. They are typically imposed during crises—wars, harvest failures, natural disasters—because these events often lead to sudden price increases that hurt many people but produce big gains for a lucky few. The Canadian government imposed ceilings on many prices during World War II: the war sharply increased demand for raw materials (such as aluminum and steel) and necessities (such as home rentals, sugar, milk, and coal), and price controls prevented those who supplied these goods and services from earning huge profits. World oil prices spiked in 1979–1980 due to uncertainty caused by the Iranian revolution in 1979 and the 1980 outbreak of war between Iran and Iraq (both large oil producing nations). Price controls on oil were imposed in 1980, when Prime Minister Pierre Trudeau’s government introduced the National Energy Program to help Canada achieve energy self-sufficiency, redistribute the wealth from non-renewable energy production to all parts of the country, and increase Canadian ownership of the oil industry.

Rent control in New York City is a legacy of World War II: it was imposed because wartime production produced an economic boom, which increased demand for apartments at a time when the labour and raw materials that might have been used to build them were being used to fight the war instead. Although most price controls were removed soon after the war ended, New York’s rent limits were retained and gradually extended to buildings not previously covered, leading to some very strange situations.

You can rent a one-bedroom apartment in Manhattan on fairly short notice—if you are able and willing to pay several thousand dollars a month and live in a less-than-desirable area. Yet some people pay only a small fraction of this for comparable apartments, and others pay hardly more for bigger apartments in better locations.¹

Aside from producing great deals for some renters, however, what are the broader consequences of New York’s rent-control system? To answer this question, we turn to the model we developed in Chapter 3: the supply and demand model.

To see what can go wrong when a government imposes a price ceiling on an efficient market, consider Figure 5-1, which shows a simplified model of the market for apartments in a large city. For the sake of simplicity, we imagine that all apartments are exactly the same and so would rent for the same price in an unregulated market. The table in the figure shows the demand and supply schedules; the demand and supply curves are shown on the left. We show the quantity of apartments on the horizontal axis and the monthly rent per apartment on the vertical axis. You can see that in an unregulated market the equilibrium would be at point E: two million apartments would be rented for $1000 each per month.

Now suppose that the government imposes a price ceiling, limiting rents to a price below the equilibrium price—say, no more than $800.

Figure 5-2 shows the effect of the price ceiling, represented by the line at $800. At the enforced rental rate of $800, landlords have less incentive to offer apartments, so they won’t be willing to supply as many as they would at the equilibrium rate of $1000. They will choose point A on the supply curve, offering only 1.8 million apartments for rent, 200 000 fewer than in the unregulated market. At the same time, more people will want to rent apartments at a price of $800 than at the equilibrium price of $1000; as shown at point B on the demand curve, at a monthly rent of $800 the quantity of apartments demanded rises to 2.2 million, 200 000 more than in the unregulated market and 400 000 more than are actually available at the price of $800. So there is now a persistent shortage of rental housing: at that price, 400 000 more people want to rent than are able to find apartments.

Do price ceilings always cause shortages? No. If a price ceiling is set at or above the equilibrium price, it won’t have any effect. Suppose that the equilibrium rental rate on apartments is $1000 per month and the city government sets a ceiling of $1200. Who cares? In this case, the price ceiling won’t be binding—it won’t actually constrain market behaviour—and it will have no effect.

Over time, a binding price ceiling can become non-binding if the demand and/or supply curves shift enough to make the equilibrium price less than or equal to the price ceiling. In our rental apartment example, a decrease in demand due to falling house prices, making owning a home more attractive than renting, would shift the demand curve to the left. Similarly, if more apartment buildings are constructed, then the supply of rental apartments increases, shifting the supply curve to the right. In Figure 5-2, if these shifts move the intersection of the demand and supply curves to $800 or less, then the rent control is a non-binding price ceiling.

The housing shortage shown in Figure 5-2 is not merely annoying: like any shortage induced by price controls, it can be seriously harmful because it leads to inefficiency. In other words, there are gains from trade that go unrealized. Rent control, like all price ceilings, creates inefficiency in at least four distinct ways. It reduces the quantity of apartments rented below the efficient level; it typically leads to misallocation of apartments among would-be renters; it leads to wasted time and effort as people search for apartments; and it leads landlords to maintain apartments in inefficiently low quality or condition. In addition to inefficiency, price ceilings give rise to illegal behaviour as people try to circumvent them.

Inefficiently Low Quantity In Chapter 4 we learned that the market equilibrium of an efficient market leads to the “right” quantity of a good or service being bought and sold—that is, the quantity that maximizes the sum of producer and consumer surplus. Because rent controls reduce the number of apartments supplied, they reduce the number of apartments rented, too.

Figure 5-3 shows the implications for total surplus. Recall that total surplus is the sum of the area above the supply curve and below the demand curve. If the only effect of rent control was to reduce the number of apartments available, it would cause a loss of surplus equal to the area of the shaded triangle in the figure. The area represented by that triangle has a special name in economics, deadweight loss: the lost surplus associated with the transactions that no longer occur due to the market intervention. In this example, the deadweight loss is the lost surplus associated with the apartment rentals that no longer occur due to the price ceiling, a loss that is experienced by both disappointed renters and frustrated landlords. Economists often call triangles like the one in Figure 5-3 a deadweight-loss triangle.

Deadweight loss is a key concept in economics, one that we will encounter whenever an action or a policy leads to a reduction in the quantity transacted below the efficient market equilibrium quantity. It is important to realize that deadweight loss is a loss to society—it is a reduction in total surplus, a loss in surplus that accrues to no one as a gain. It is not the same as a loss in surplus to one person that then accrues as a gain to someone else, what an economist would call a transfer of surplus from one person to another. For an example of how a price ceiling can create deadweight loss as well as a transfer of surplus between renters and landlords, see the upcoming For Inquiring Minds.

Deadweight loss is not the only type of inefficiency that arises from a price ceiling. The types of inefficiency created by rent control go beyond reducing the quantity of apartments available. These additional inefficiencies—inefficient allocation to consumers, wasted resources, and inefficiently low quality—lead to a loss of surplus over and above the deadweight loss.

Inefficient Allocation to Consumers Rent control doesn’t just lead to too few apartments being available. It can also lead to misallocation of the apartments that are available: people who badly need a place to live may not be able to find an apartment, but some apartments may be occupied by people with much less urgent needs.

In the case shown in Figure 5-2, 2.2 million people would like to rent an apartment at $800 per month, but only 1.8 million apartments are available. Of those 2.2 million who are seeking an apartment, some want an apartment badly and are willing to pay a high price to get one. Others have a less urgent need and are only willing to pay a low price, perhaps because they have alternative housing. An efficient allocation of apartments would reflect these differences: people who really want an apartment will get one and people who aren’t all that anxious to find an apartment won’t. In an inefficient distribution of apartments, the opposite will happen: some people who are not especially anxious to find an apartment will get one and others who are very anxious to find an apartment won’t.

Because people usually get apartments through luck or personal connections under rent control, it generally results in an inefficient allocation to consumers of the few apartments available.

To see the inefficiency involved, consider the plight of the Lees, a family with young children who have no alternative housing and would be willing to pay up to $1500 for an apartment—but are unable to find one. Also consider George, a retiree who lives most of the year in Florida but still has a lease on the New York City apartment he moved into 40 years ago. George pays $800 per month for this apartment, but if the rent were even slightly more—say, $850—he would give it up and stay with his children when he is in the city.

This allocation of apartments—George has one and the Lees do not—is a missed opportunity: there is a way to make the Lees and George both better off at no additional cost. The Lees would be happy to pay George, say, $1200 a month to sublet his apartment, which he would happily accept since the apartment is worth no more than $849 a month to him. George would prefer the money he gets from the Lees to keeping his apartment; the Lees would prefer to have the apartment rather than the money. So both would be made better off by this transaction—and nobody else would be made worse off.

Generally, if people who really want apartments could sublet them from people who are less eager to live there, both those who gain apartments and those who trade their occupancy for money would be better off. However, subletting is illegal under rent control because it would occur at prices above the price ceiling.

The fact that subletting is illegal doesn’t mean it never happens. In fact, chasing down illegal subletting is a major business for New York City private investigators. An article in the New York Times described how private investigators use hidden cameras and other tricks to prove that the legal tenants in rent-controlled apartments actually live in the suburbs, or even in other states, and have sublet their apartments at two or three times the controlled rent. This subletting is a kind of illegal activity, which we will discuss shortly. For now, just note that landlords and legal agencies actively discourage the practice of illegal subletting. As a result, the problem of inefficient allocation of apartments remains.

Wasted Resources Another reason a price ceiling causes inefficiency is that it leads to wasted resources: people expend money, effort, and time to cope with the shortages caused by the price ceiling. Back in 1979, U.S. price controls on gasoline led to shortages that forced millions of Americans to spend hours each week waiting in lines at gas stations. The opportunity cost of the time spent in gas lines—the wages not earned, the leisure time not enjoyed—constituted wasted resources from the point of view of consumers and of the economy as a whole.

Because of rent control, the Lees will spend all their spare time for several months searching for an apartment, time they would rather spend working or in family activities. That is, there is an opportunity cost to the Lee’s prolonged search for an apartment—the leisure or income they would have to forgo. If the market for apartments worked freely, the Lees would quickly find an apartment at the equilibrium rent of $1000, leaving them time to earn more or to enjoy themselves—an outcome that would make them better off without making anyone else worse off. Again, rent control creates missed opportunities.

Indeed, in the long run, the time and resources that families like the Lees spend searching for a rental apartment might increase as the city population rises. All other things equal, a larger population increases the demand for rental apartments. Following an increase in demand, the shortage of units grows and renters find it more difficult to locate a rental unit. Also, it is often the case that the demand and supply curves become flatter over time (i.e., for a given price change, the quantity supplied or demanded changes more in the long run than it does in the short run). So in the long run, the size of a shortage caused by a price ceiling tends to grow—with or without an increase in demand.

Inefficiently Low Quality Yet another way a price ceiling creates inefficiency is by causing goods to be of inefficiently low quality. Inefficiently low quality means that sellers offer low-quality goods at a low price even though some buyers would rather have higher quality and would be willing to pay a higher price for it.

Again, consider rent control. Landlords have no incentive to provide better conditions because they cannot raise rents to cover their repair costs but are able to find tenants easily. In many cases, tenants would be willing to pay much more for improved conditions than it would cost for the landlord to provide them—for example, the upgrade of an antiquated electrical system that cannot safely run air conditioners or computers. But any additional payment for such improvements would be legally considered a rent increase, which is prohibited. Indeed, rent-controlled apartments are notoriously badly maintained, rarely painted, subject to frequent electrical and plumbing problems, and sometimes even hazardous to inhabit. As one former manager of Manhattan buildings described the situation: “At unregulated apartments we’d do most things that the tenants requested. But on the rent-regulated units, we did absolutely only what the law required. … We had a perverse incentive to make those tenants unhappy.”

This whole situation is a missed opportunity—some tenants would be happy to pay for better conditions, and landlords would be happy to provide them for payment. But such an exchange would occur only if the market were allowed to operate freely.

Black Markets And that leads us to a last aspect of price ceilings: the incentive they provide for illegal activities, specifically the emergence of black markets. We have already described one kind of black market activity—illegal subletting by tenants. But it does not stop there. Clearly, there is a temptation for a landlord to say to a potential tenant, “Look, you can have the place if you slip me an extra few hundred in cash each month”—and for the tenant to agree if he or she is one of those people who would be willing to pay much more than the maximum legal rent. Let’s look again at Figure 5-3. If there is subletting, then the monthly rent for a sublet apartment would be $1200—the so-called demand price given the number of units available. Alternatively, the landlord could demand an extra cash payment of $400 each month as a “bribe” to rent out the apartment—thereby making the total rental payment actually $1200 per month.

What’s wrong with black markets? In general, it’s a bad thing if people break any law, because it encourages disrespect for the law in general. Worse yet, in this case illegal activity worsens the position of those who are honest. If the Lees are scrupulous about upholding the rent-control law, but other people—who may need an apartment less than the Lees—are willing to bribe landlords, the Lees may never find an apartment.

We have seen three common results of price ceilings:

Given these unpleasant consequences, why do governments still sometimes impose price ceilings? Why does rent control, in particular, persist in New York City?

One answer is that although price ceilings may have adverse effects, they do benefit some people. In practice, New York’s rent-control rules—which are more complex than our simple model—hurt most residents but give a small minority of renters much cheaper housing than they would get in an unregulated market. And those who benefit from the controls are typically better organized and more vocal than those who are harmed by them.

Also, when price ceilings have been in effect for a long time, buyers may not have a realistic idea of what would happen without them. In our previous example, the rental rate in an unregulated market (Figure 5-1) would be only 25% higher than in the regulated market (Figure 5-2): $1000 instead of $800. But how would renters know that? Indeed, they might have heard about black market transactions at much higher prices—the Lees or some other family paying George $1200 or more—and would not realize that these black market prices are much higher than the price that would prevail in a fully unregulated market.

A last answer is that government officials often do not understand supply and demand analysis! It is a great mistake to suppose that economic policies in the real world are always sensible or well informed.