President Biden recently issued a plan to impose a 5% cap on annual rent increases by major landlords. Rent control is a notoriously counterproductive policy. The reason is simple: rent control discourages the construction of new housing units because it makes that construction less profitable. And a reduction in the housing supply is exactly what we want not want if our goal is widespread affordable housing. Only indeed 2% of economists surveyed agree that rent control has had a positive effect on “the quantity and quality of largely affordable rental housing in cities that have taken advantage of this.”
In an effort to avoid this outcome, Biden’s proposed price cap would not apply to new units. At first glance, it seems that this policy would provide the best of both worlds. The goal is to reduce the price of existing units without discouraging the construction of new units. While this proposal is an improvement over old-fashioned rent control, it suffers from two problems.
Firstly, policy uncertainty threatens to arise. Imposing rent control with an exemption for new units still shows that policymakers are willing to cap rents on old units. Crucially, however, new units become old units. If developers are concerned that policymakers will continue to favor caps on rent increases for old units, they have reason to fear that new units they build will eventually be capped. As a result, they will be discouraged from building new units as their expected long-term profitability will be reduced.
Second, even if new construction is not discouraged, rent control leads to housing being misallocated. Markets direct resources to the highest value uses. Suppose a seller has one bag of ice left. Alice needs the ice to cool her son’s insulin. Bob needs the ice to cool his daughter’s Mountain Dew. All else being equal, Alice will outbid Bob for the ice cream – and this is the efficient outcome. It’s better that her son refrigerated insulin than that Bob’s daughter refrigerated Mountain Dew. But if the price controls limit the amount Alice can bid for the ice cream, she cannot outbid Bob and he might end up with the ice cream instead.
Housing is no different. Suppose Caroline is an exceptionally talented surgeon who has landed a lucrative job at a large city hospital. She is looking for a house nearby. Dave is a professional Youtuber who films his content in an apartment near the hospital, although he could do his work anywhere. Without rent control, Caroline could outbid Dave for the apartment, which again would be the efficient outcome. It’s more important that a surgeon lives near the hospital so she can perform surgeries than it is for a Youtuber to live near the hospital because he likes the local coffee shops. But if rent controls limit the amount Caroline can offer for the apartment, she can’t outbid Dave and he may get the apartment instead. And if Caroline is unable to secure a home nearby, she may not be able to accept the job. This outcome is not only bad for her, it is also bad for the patients who would have benefited from her surgical expertise. So while rent control with exemptions is better than rent control without exemptions, it still falls short of the productive and allocative virtues of a free market.
Christopher Freiman is Professor of General Business Administration at the John Chambers College of Business and Economics at West Virginia University.