How a Price Ceiling Causes Inefficiency

The housing shortage shown in Figure 4-2 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.

  1. It reduces the quantity of apartments rented below the efficient level.

  2. It typically leads to inefficient allocation of apartments among would-be renters.

  3. It leads to wasted time and effort as people search for apartments.

  4. It leads landlords to maintain apartments in inefficiently low quality or condition.

In addition to inefficiency, price ceilings give rise to illegal behavior as people try to circumvent them. We’ll now look at each of these inefficiencies caused by price ceilings.

Inefficiently Low Quantity Because a price ceiling reduces the price of a good, it reduces the quantity that sellers are willing to supply. Buyers can’t buy more units of a good than sellers are willing to sell; a price ceiling reduces the quantity of a good bought and sold below the market equilibrium quantity.

Because rent control reduces the number of apartments supplied, it reduces the number of apartments rented, too. The low quantity sold is an inefficiency due to missed opportunities: price ceilings prevent mutually beneficial transactions from occurring, transactions that would benefit both buyers and sellers. Figure 4-3 shows the inefficiently low quantity of apartments supplied with rent control.

A Price Ceiling Causes Inefficiently Low Quantity A price ceiling reduces the quantity supplied below the market equilibrium quantity. Because buyers can’t buy more units of a good than sellers are willing to sell, a price ceiling reduces the quantity of a good bought and sold.

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 4-2, 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 one badly and are willing to pay a high price to get it. 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.

Price ceilings often lead to inefficiency in the form of inefficient allocation to consumers: some people who want the good badly and are willing to pay a high price don’t get it, and some who care relatively little about the good and are only willing to pay a low price do get it.

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 $1,500 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 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 visits New York.

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, $1,200 a month to sublease 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 sublease 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 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 somewhere else, 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. As a result, the problem of inefficient allocation of apartments remains.

Price ceilings typically lead to inefficiency in the form of wasted resources: people expend money, effort, and time to cope with the shortages caused by the price ceiling.

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 wait on lines at gas stations for hours each week. 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 have spent working or in family activities. That is, there is an opportunity cost to the Lees’ prolonged search for an apartment—the leisure or income they had to forgo.

If the market for apartments worked freely, the Lees would quickly find an apartment at the equilibrium rent of $1,000, 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.

Price ceilings often lead to inefficiency in that the goods being offered are of inefficiently low quality: sellers offer low-quality goods at a low price even though buyers would prefer a higher quality at a higher price.

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 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, sometimes even hazardous to inhabit. As one former manager of Manhattan buildings described: “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.”

!worldview! FOR INQUIRING MINDS: Mumbai’s Rent-Control Millionaires

Just how costly is rent control for landlords? In Mumbai, India, the answer is very high indeed. It is so high that thousands of rent-controlled tenants have become millionaires upon vacating their apartments.

In Mumbai, a magnet for a rapidly expanding number of high-income Indians, property prices rose by almost 70% in four years, from 2009 to 2013. According to real estate developer Pujit Agarwal, the highly desirable area of South Mumbai, hugging the Arabian Sea, is home to about 500 severely dilapidated stone structures which, once redeveloped, would be worth about $40 billion. But landlords and real estate developers have to address the fact that those dilapidated structures are occupied by rent-controlled tenants.

Take the case of Mea Kadwani, age 78, who had been living since he was a toddler in the same 2,600-square-foot apartment where he paid just $20 a month in an area where rents typically top $2,000 per month. His unit was so dilapidated that his roof collapsed. But he stayed put, which turned out to be a profitable decision: after three years of negotiations with the landlord, he was paid $2.5 million to vacate the apartment. As Agarwal says, “For generations, most tenants were living a hand-to-mouth existence, barely making two ends meet. Now, with redevelopment, these tenants have become multimillionaires overnight as capital values of the properties they occupied soared.” According to him, it is still a good deal for landlords, as newly constructed five-bedroom apartments are selling for $12.5 million.

But not all rent-controlled tenants agree to leave. In one famous story, three people were killed when four floors of a rent-controlled apartment building collapsed. Despite demands by the city to vacate the damaged building, 58 tenants camped out, refusing to go even though they were locked out of their apartments, and were subjects of a police raid.

In Mumbai, soaring property values have made multimillionaires of some, although many more Indians live in slums.

Rent control began in Mumbai in 1947 to address a crucial shortage of housing caused by a flood of refugees fleeing conflict between Hindus and Muslims. Clearly intended as a temporary measure, it was so popular politically that it has been extended 20 times and now applies to about 60% of the buildings in the city’s center. Tenants pass apartments on to heirs or sell the right to occupy to others. Landlords, who often are paying more in taxes and upkeep than they receive in rents, suffer financially and sometimes simply abandon their properties.

So although it’s a world away, the dynamics of rent control in Mumbai are similar to those in New York where many rent-controlled tenants have also extracted tens of thousands of dollars from landlords eager to redevelop their properties (although the situation in Mumbai has been much more extreme).

So common is the experience in New York and other cities that it was the subject of a Law and Order episode in which a landlord is investigated for the murder of a rent-controlled tenant who had been blocking the lucrative sale of the building. Fortunately, we were unable to find evidence to suggest that this episode was based on a true story.

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.

A black market is a market in which goods or services are bought and sold illegally—either because it is illegal to sell them at all or because the prices charged are legally prohibited by a price ceiling.

Black Markets In addition to these four inefficiencies there is a final 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.

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.