Topic 5. Shortages

Perhaps the most important use of the tools of supply and demand is for analyzing situations in which there is government interference in markets. Such interference, motivated nearly always by the desire to benefit certain market participants, often results in shortages or surpluses at observed market prices. Shortages and surpluses result when the market price is not free to adjust to supply and demand conditions. This topic deals with shortages, considering as an example the role of rent controls in creating housing shortages. The next topic will deal with surpluses.

Consider a situation common to very many of the world's major cities. It is inevitable with the passage of time that there will be at some point an influx of new residents---this always shifts the demand curve for housing to the right. Since there is limited space within easy commuting distance to the city core, the supply of rental accommodations will necessarily be upward sloping---construction of more and more housing units on a fixed stock of land involves increasing costs. When the demand curve shifts to the right and the supply curve is upward sloping, rents increase. In many instances such increases in the equilibrium rents have been very substantial.

These increases in market rents can create hardships (that is, have significant real income effects) for those who spend substantial fractions of their incomes on housing. As one local activist remarked: "Just when people need housing, landlords increase rents." Almost inevitably there will emerge a demand for the government to "do something"---that is, to fix rents at levels that the average person can "afford". The effects of such a policy can be analyzed with reference to Figure 1.

Figure 1

The demand curve for rental accommodations after the influx of new residents into the area is given by  DD  and the supply curve of rental accommodation is given by  SS.  The local authorities fix rents at a level indicated by the thick horizontal line. At that legal rental rate the quantity demanded by potential renters of apartments will be  Q2  and the quantity supplied will be  Q1.  The actual quantity of accommodations made available will be  Q1.  At that quantity, potential renters would be willing to pay the rent  R1  for another unit of accommodation.

At the legal rental rate there will be a housing shortage equal to the excess of  Q2  over  Q1.  This shortage will disappear if rent controls are abolished. In that case rents would rise to the market rate of  R0  and the quantities of accommodations supplied and demanded would become equal at  Q0Shortages of housing can only occur if rents cannot adjust to market forces. By shortages we mean that people wanting to rent accommodations at the rents being charged cannot find them. When the market for accommodations is allowed to function properly, rents will rise until shortages disappear.

It is interesting to reflect upon the nature of the adjustments that occur as rents rise to their equilibrium level. On the supply side, it becomes worthwhile to construct new apartment buildings. In addition, it becomes worthwhile for people to make unused areas in owner-occupied houses into apartments and rent them out. On the demand side, it becomes increasingly costly for couples to maintain three bedroom apartments when they could get by with one or two bedrooms. They will tend to move to smaller apartments, increasing the amount of rental space available in the market. It also becomes more costly for young people to leave home, inducing them to stay longer with their parents. When there is a housing shortage but rents are not allowed to rise, there are no incentives for people to make these sorts of adjustments.

Where, then, does everyone live when rents are controlled? How does the economic system adjust to these shortages? One possibility is that people end up living on the street, though this is generally not the reason why most big cities have "street people". More frequently, families double up in lower quality accommodations, sharing the rent---in effect, people rent out portions of their space to relatives or others. Owners of high quality apartment buildings will not permit this because it reduces the value of their buildings, but slum landlords may gain by allowing it---in return, of course, for an illegal side payment.

Note from the above Figure that under rent control some potential renters are willing to pay  R1  to obtain accommodations, and all demanders along the demand curve between  Q1  and  Q2  are willing to pay more than the legal rental rate. It pays landlords to break the law and accept bribes in return for putting potential renters "at the top of the waiting list". Indeed, if the landlords of large buildings do not do this, their superintendents or property managers very likely will.

Another adjustment mechanism is created by the practice of exempting furnished accommodations from rent control laws in order to foster tourism and in recognition that it is full-time residents that these laws are designed to protect. Landlords can then circumvent the law by putting a few pieces of old furniture in an apartment and calling it a furnished place.

It is also interesting to reflect on the question of who benefits and who loses from rent controls. Clearly, landlords are worse off because they earn less from their property when rent controls are in force than they would otherwise. People who are lodged in accommodations at the time rent controls are instituted are clearly better off because they are protected from future increases in rent. New arrivals in the area are worse off because they have difficulty finding any type of rental accommodation.

While existing permanent residents benefit initially from rent controls, the fraction of the city's residents that benefit in this way has a tendency to get smaller and smaller, the longer the law is in force. Young people who marry and set up homes will find it difficult to find places to rent. People who get transferred to jobs in distant areas of the city find that they can't change their residence easily. They would have to give up their rent controlled apartments with little chance of finding appropriate quarters closer to work.

It is sometimes argued that the poor are better off with rent controls in force because otherwise they would not be able to afford a place to live. But this argument only applies to poor with accommodations at the time the rent controls are instituted who can remain in them. The rest will have a harder time obtaining accommodations than will rich people because, having less income and wealth, their ability to pay their rent in the future is less certain and they are thus poorer risks. People with large families (who are also often poor), those of a different race, or with unconventional lifestyles also will have difficulty since it costs landlords nothing to discriminate---when the rental market is allowed to operate freely a landlord who rejects a tenant on racial or other grounds has to give up an opportunity to rent his property.

Regardless of who gains and loses, rent controls are much easier to institute than remove. Politicians seeking election soon realize that the number of voters in rent controlled accommodations who stand to lose if rent control is abolished will far exceed the number of landlords who stand to gain. Only if the number of people who can't obtain rent-controlled accommodations and are also able to vote is large compared to those in rent-controlled apartments will there be substantial pressure for the removal of rent controls.

It is test time again. Think up your own answers before looking at the ones provided.

Question 1
Question 2

Choose Another Topic in the Lesson.