Rent Control and the Price System

February 20, 2011

Those who love New York and love talking about it will occasionally hear legends of individuals or couples who have become the big winners of the rent control system. $600 for a penthouse on the Upper West Side, $800 for a two-bedroom in Park Slope, whatever the legendary deal is, the implication is clear: the lucky renter can never move, since he or she is unlikely to ever find such a good deal again.

An important feature of the price system, as pointed out by Harold Demsetz in his article “Toward a Theory of Property Rights,” (PDF) is that it forces people to take into account the costs that their actions impose upon other people. Take the rent-controlled apartment as an example, and let’s make up some numbers.

Say a couple, the Mieters, own an apartment and have an arrangement with the bank whereby they pay $800 a month to maintain ownership. Now introduce another couple, the Einzers, who are willing to pay $3000 for that same apartment. The Mieters can decide how to use the apartment, whether to live in it themselves or allow the Einzers to move in and live there instead. If the Mieters choose to live there themselves, they will be imposing a cost on the Einzers. That they are “imposing a cost” doesn’t mean they are doing anything wrong. By assumption, the Mieters have the right to decide who gets to use the apartment. As a simple fact, though, the Einzers are prevented from using the apartment by their decision.

If you can trade and sell property rights, though, that’s not the end of the story. The Mieters are not just imposing a cost on the Einzers, they are also imposing that same cost on themselves. How? Because every month that they decide to stay in the apartment, they are effectively giving up the rent that the Einzers would have paid them to stay there. The Mieters have to decide what they would rather have, the apartment or the money.

What if we change the situation and there are rules stipulating that people are not allowed to sell the right to live in an apartment to anyone else. The preferences have not changed. The Einzers would still be willing to pay the $3,000 for the Mieters’ apartment. But now the Mieters say, basically, “Who cares?” Sure, the Einzers would be willing to pay $3,000, but that option is blocked. They’re imposing the same cost as before (not that there’s anything wrong with that!), but now they are no longer made to feel the effect of the cost they are imposing.

A system of property rights is all about, to use Demsetz’s phrase, “internalizing the externalities.” Every time you use a resource, you are imposing a cost, an externality, on someone else who can’t use it at the same time. But if you can sell your right to use it, even if you don’t actually exercise that option, the full effect of your choice is brought to bear on you, either in the monetary compensation when you actually do sell it, or by the fact that you are giving up that compensation when you choose not to.

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