August 30, 2004

Trying to Think Like an Economist

There was a bit of discussion long ago (two weeks is an eternity in blogging) about this post by Alex Tabarrok about how "nonwaivable warranty of habitability" makes renters and landlords worse off. Alex argues thus:

Let's suppose that after much bargaining the tenant and landlord have agreed upon the rent and the amenities - each party to the contract is profit maximizing, doing as well as they can given market conditions and the interests of the other. Now suppose that tenants value the hot water benefit at $100 and that it costs the landlord $150 to provide the hot water. At these prices the tenant does not buy the hot water. The law is passed; by how much does the rent increase?... Suppose that the rent increases by $120. Then the tenant gets a benefit worth $100 at a price of $120 and is worse off by $20 and the landlord gets a benefit of $120 at a cost of $150 and so is worse off by $30. The law makes both the landlord and tenant worse off!

(It's left to the reader to realize that, if the tenant values hot water at more than it costs the landlord to provide it, then the landlord would provide it law or no law.)

Daniel Davies discusses it here, Atrios (an econ PhD) here; Brad DeLong endorses Atrios's position here (while suggesting that he, Brad DeLong, is the only person qualified to express an opinion on public policy).* Tabarrok responds here and here. In this one Tabarrok points out that there are features that can make the law benefit tenants; if tenants undervalue hot water (or if hot water has a positive externality), or if tenants want to keep out the poor. (I have more comments on this after the jump.)

But it seems to me--and I'm not an economist, so this might be completely wrong--that these laws could benefit tenants even in a perfectly functioning market.

The trick is in Tabarrok's assumption that there's one tenant, and one landlord. Suppose there are ten tenants, who each value hot water differently. Nine value hot water at $150/month, one values it at $100/month, and it costs $140/month to put in. There is also one landlord with ten apartments, identical until they have hot water installed (or not); all ten tenants value the apartments at $300/month without hot water. Without the law and absent transaction costs, you will have nine tenants paying $450/month for apartments with hot water and one tenant paying $300/month for an apartment without hot water.

Now suppose you have the same tenants, plus an enforced law requiring hot water. You'll have ten identical apartments with hot water. How much will they rent for? As I understand economic theory, the assumption you make is that they will all rent for the same price. Suppose that the one tenant who values hot water at $100/month will just move to another city if forced to pay over $430/month. (To be explicit; she prefers paying $430/month for an apartment with hot water to moving to another city, but she would prefer paying $300/month for an apartment without hot water to both of those.) Suppose that it's better for the landlord to rent at $430/month than to let one apartment lie fallow.

Then, if I'm right about how economists think, the rent for all ten units should be $430/month. The landlord loses $190/month ($20 for each of the nine apartments that were already heated + $140 for installing heating in the tenth apartment - $130 extra rent for the tenth apartment). The one tenant loses $30/month (she's paying $430 for an apartment she values at $400). But the other nine tenants each gain $20/month (they're paying $430 for apartments they value at $450).

Now, the net loss for everyone is $40/month, the difference between the one tenant's valuation of the hot water and the cost it takes to install it. But the tenants, as a group, have a net gain of $150/month. So the new law does benefit tenants as a whole, even given perfect markets, because the landlord winds up absorbing more of the cost of hot water.

At least, so I think--I'm not an economist, and I may have overlooked something. (It could be said that a direct cash transfer from landlords to tenants would be more efficient, but I hope that's not the best response.)

My further comments on when these laws benefit the tenants: Atrios seems to have it exactly right here:

When I go and look for an apartment, I don't have to spend the time to determine whether every apartment I visit has a working toilet, has hot water, has a working and safe electrical and heating system, and a whole set of charateristics which are roughly what we consider to be the basic necessities for modern life. In addition, there are the costs of writing and understanding a contract which spells out in great detail what the landlord will and won't guarantee. Having some bare minimum set of characteristics for an apartment takes all that off the table.

Or, as the great Katherine says in d-squared's comments:

people tend to sign contracts with a general assumption that the other party won’t be allowed to really screw them over. There is little scrutiny of the fine print, and little actual bargaining.... And before conservatives start in on renter’s “personal responsibility”, they should note that it would actually be much more inefficient to spend a lot of time bargaining in these situations than to assume that people want heat and hot water.

Bernard Yomtov in the same place:

this sort of rule is valuable when an apartment suddenly loses hot water, because the water heater fails, for example, since it forces the landlord to repair the situtaion in some sort of timely way.

Now, I'm pretty sure Alex Tabarrok recognizes at least some version of these points; as Kimmit points out, Tabarrok's course will go on to cover "asymmetries, transaction costs, externalities, and other relevancies." And he probably wanted to start off the term with a striking and counterintuitive example. But he should've come up with a striking example that actually works. The rental market with informational asymmetries (when you're looking at an apartment in July, it may be hard to check whether the heater will work in the winter) and transaction
costs (I suppose there are worse pains in the ass than moving, but I've hardly encountered one). In what I think is also an informational asymmetry, I've often been unable to examine the exact terms of the lease until after informally agreeing to take an apartment, and on one occasion not until showing up; it would have been very inconvenient to have looked for a new one at that time.

So this is a market where you should expect failures--of the sort that could be remedied by legally requiring the sort of minimum standard that almost everyone will want reliably delivered. Tabarrok's using this as a case of regulation creating a deadweight loss (have I got that term right?) seems designed to bias students toward knee-jerk libertarianism.

*Well, I'm exaggerating, and I assume Brad is too, but if it's true that "[i]f you're an economist but not a left-of-center one you don't believe in market failures" then economics is worse off than the worst thing anyone's ever said about literature departments, and with much worse effects.

Posted by Matt Weiner at August 30, 2004 11:45 AM