Prof. Bryan Caplan

Econ 103

Spring, 2000


Week 7: Housing Markets, Credit Markets, and Price Controls

I.                     The Market for Housing

A.                 It is straightforward to analyze the market for housing in S and D terms.

B.                 Housing demand: this is just the quantity of housing that people would like to buy at all conceivable prices. 

C.                Particularly if one is considering housing demand for a relatively small region (e.g. Berkeley), housing demand is likely to be quite elastic.  If Berkeley gets a little cheaper, there are a lot of people who already live in the area who might want to move there.  Current residents, similarly, may want to remain but move to more spacious lodgings.

D.                Housing supply: this is just the quantity of housing that people would like to sell at all conceivable prices.

E.                 Especially in regions that are already somewhat developed, housing supply is likely to be quite inelastic - at least in the short-term.  This is because land within a specific region is a fixed resource.  NYC housing, by definition, has to be produced using NYC land.

1.                  Moreover, once housing is built, it is relatively durable, making its supply downwardly inelastic.

F.                 What shifts housing demand?  Everything that makes living in a certain area particularly pleasant or unpleasant:

1.                  Weather

2.                  Crime

3.                  Traffic

4.                  Commute to employment

5.                  Proximity of shopping

6.                  The view

G.                What shifts housing supply?

1.                  Cost of production of housing

2.                  Availability of land (how Manhattan grew during WWII)

3.                  Zoning and other regulations

H.                 If housing demand is fairly elastic, and housing supply is fairly inelastic, what happens if:

1.                  Crime rates fall?

2.                  A local ordinance bans warehouse clubs?

3.                  Pre-fab housing technology improves?

4.                  Zoning regulations set aside 20% of land for wildlife preserves?

II.                   Rent Control

A.                 Price controls in the housing market, usually know as "rent control," have been quite popular.  Almost invariably, these controls impose maximum prices, not minimum prices.

B.                 A common variant: Don't actually reduce rents, but fix the maximum rent increase.  E.g. in Berkeley, maximum was 60% of inflation.  The result is that initially the rent controls make little difference, but effectively get stricter every year.

C.                The short-run effect: Admittedly, the physical stock of housing doesn't decline much, but quantity demanded rises substantially.  The result: rationing.

D.                Standard form of rationing: landlords retain their pick of tenants, but tenants get to stay as long as they keep paying the regulated rent.

1.                  Inheritance and rent control in NYC

E.                 The long-run effect: Housing supply gets much more elastic.  New construction falls off, as does maintainence.  Shortage gets more and more aggravated over time.

F.                 Hidden margins: While the physical housing stock takes time to deteriorate, there are numerous ways for landlords to respond more rapidly.  General strategy: cut quality.  With a shortage of housing, you will still be able to get tenants.

G.                Examples:

1.                  Eliminate free services

2.                  Charge extra for furniture

3.                  Cut back on safety and maintainence

H.                 What does the decline in quality do?  If it proceeds unchecked, it can actually bring the market back to a market-clearing point!

1.                  As quality falls, demand falls.

2.                  As quality falls, supply increases.  (People are more willing to supply a lower-quality good as a lower price).

I.                     Other ways to get around rent control:

1.                  Quit taking in boarders

2.                  Evict your tenants and sell to owner-occupants

3.                  "Go co-op"

4.                  Bribery

5.                  Finders' fees

J.                  Few rent control authorities take these responses lying down.  They often pass additional regulations concerning quality, set up armies of building inspectors, make it difficult to evict tenants, and prevent landlords from converting their buildings to new uses.

III.                  The Market for Credit

A.                 Important to distinguish nominal and real interest rates.  Nominal interest rates are don't adjust for inflation; real rates do.  For example, if you borrow $100 today and agree to pay back $110 in a year, the nominal rate is 10%.  But the real rate is 10%-inflation rate.

B.                 Standard assumption: Borrowers and lenders care about real rates, not nominal rates.

C.                Credit demand: just the amount borrowers would like to borrow at given real interest rates.  The higher the rates, the less they want to borrow.

D.                Credit supply: just the amount lendors would like to lend at given real interest rates.

E.                 What shifts credit demand?

1.                  Default risk - as the probability they won't have to repay their debts increases, borrowers' demand for credit shifts up.  Many sources of default risk: History, net worth, collateral...

2.                  Future income growth - borrowers who expect to be richer in the future (e.g. medical students) are more willing to borrow.

3.                  Impatience - the more impatient borrowers get, the more they want to borrow now.

F.                 What shifts credit supply?  Mostly, the same things that shift credit demand, but in the opposite direction:

1.                  Default risks - as the probability they won't be paid increases, lenders supply of credit decreases.

2.                  Future income growth - lenders who expect to get richer in the future are more likely to "live it up" now.  Why save for the future if you are already going to be better off in the future?

3.                  Impatience - the more impatient lenders are, the less they will be willing to curtail their current consumption to make loans to others.

4.                  Also:  Liquidity - the easier it is to resell promises of repayment, the greater the supply of credit.  (Ex: Mortgage securitizations)

G.                Note: If you put nominal interest rates on the y-axis instead of real interest rates, you should also adjust for expected inflation.  Expected inflation increases borrower demand while decreases lender supply.

IV.               Usury Laws and Loan-Sharking

A.                 Historically, price controls in the market for credit have been common.  Again, these are mostly price maxima, and are usually known as "usury laws."

B.                 The medieval version: Fix the legal nominal rate at 0%!  When strictly enforced, the result is predictable: The whole market for credit dries up.

C.                Even in the medieval version, though, there were a lot of loopholes.  The Church made an exception for default risk; this made it possible to pay interest discreetly by over-compensating for default risk.  Alternately, you could legally define your lender as an "investor."

D.                The modern version: Declare nominal interest rates above x% illegal.  Ex: Most states have "usurious" rates, above which is it illegal to charge.

E.                 This generates the usual black market, known in this case as "loan-sharking."  Loan sharks charge rates in excess of the usurious rate to the less credit-worthy (i.e. people less likely to pay the money back).  They then enforce the contracts outside the law - as they must since the contracts are illegal.

F.                 Loan sharks charge extra to compensate them for legal risk, etc.

V.                 Bankruptcy Laws

A.                 Bankruptcy laws are one main factor behind default risk.  The easier it is to declare bankruptcy, the higher default risk will be.

B.                 While typically cast in terms of "pro-debtor" versus "pro-creditor," this is a classic case where incidence matters.  Raise default risk, and interest rates rise to compensate lenders for extra risk.

C.                Typically bankruptcy laws protect a lot of assets from creditors, including one's house.

D.                Exception: Default on a bank loan allows a bank to repossess your house (even though default on a credit card does not allow this!).  What would happen to mortgage interest rates if banks could not repossess homes?

E.                 Key feature of bankrupty laws: They are a "non-waivable" right.  You can't sign an enforceable contract saying "I waive my right to declare bankruptcy" to get your interest rate reduced from 10% to 7%.  As with most cases where incidence is relevant, "protection" of borrowers wind up harming borrowers.