In this paper I will demonstrate: A) that the standard economics theory of rent (and most of the rest of mainstream economics) is ideological fiction, and offer a more realistic alternative analytical framework for understanding rent, and B) why rent payments to landlords (and “rentiers” more broadly for finance, insurance and monopoly products) are mostly property-based extractions without moral or economic justification.
A) The Standard Economic Theory of Rent is Ideological Fiction
The standard intro economics story on rent control is presented as an application of the Supply and Demand Model (SDM) that is a core part, with the “Ricardian Comparative Advantage” parable for international trade, of the “free market” indoctrination that forms most of the substance of the “Neoclassical” (NC) economics curriculum. But the SDM story is fictional for most of the production economy as the “Supply Curve” (SC) part of the SDM does not generally exist. This is easy to demonstrate. If you’re asked to manage a pizza shop and don’t know anything about the normal demand for pizzas from that shop, you will have no ability to offer an estimate of how many pizzas to make at any given price. For example, you will not be able to estimate how much pizza to produce at $15 a pie. But the hypothetical SC of the SDM is premised on the assumption that producers can estimate a hypothetical “quantity supplied” amount to produce at any given price. In other words, the SDM assumes that you will be able to determine how many pizzas you will make at $15 a pie, independent of, or without any knowledge of, demand conditions. Because, in almost all cases, producers cannot do this, SCs are ghost curves that do not exist in most of the production economy.
Moreover, the “Supply and Demand Model” (SDM) sleight of hand is profoundly ideological. The SDM is ideological as it provides pseudo “scientific” legitimation by means of a simple analytical, or formal mathematical, parable, dressed up in graphs (and sometimes equations), for: a) objective “market forces” determining a unique, b) stable, or self-adjusting, equilibrium, that is also c) socially optimal. These points are highlighted in introductory economics courses, the only economics classes taken by most people, so that the SDM meme of objective, self-regulating and socially beneficial market forces is firmly inculcated into the minds of students and the general public, where it is indeed pervasive in politics, law, regulation, business theory, and in the general popular understanding of economics. For example, at the start of my MBA economics classes, I often ask my students what is the most important thing that they remember from prior economics courses that they may have taken. The almost universal answer is “supply and demand.”
An example of the standard NC SDM theory of rent is seen in Gregory Mankiw’s very popular introductory economy textbook. Mankiw posits a short-run SDM of rent with a vertical supply curve and a long-run SDM of rent with an upward sloping supply curve. The major conclusion of his story is that while rent control can make housing more affordable in the short-run it will reduce the production of new housing and cause shortages that will unfairly prevent new residents from finding housing in the long-run.
The Mankiw story, that is similar to that in almost every other introductory text, thus reinforces the overarching message that is at the core of the standard NC economics curriculum. “Soft hearted” interference with markets to produce beneficial social outcomes will likely backfire and have negative unintended consequences. More generally the standard view presents the “market equilibrium” point where the supply and demand curves of the SDM cross, as a socially efficient outcome towards which free markets will gravitate. In this standard NC economic view, the SDM equilibrium point is a fair and efficient point of “equal exchange” where incremental costs for suppliers and incremental benefits for renters are equal. As shown in Figure 1 below, it is also an optimal point that maximizes social welfare as measured by the sum of producer and consumer surplus.
All of this breaks down in the more realistic Demand and Cost Model (DCM) with a real “Cost Curve” (CC) replacing the ghost SC curve. The DCM is presented in Figure 2 below.
The blue “Demand Curve” shows hypothetical “quantities demanded” of apartment units on the horizontal “Quantity” axis in a given locality at different possible rents or “Price” on the vertical axis. The red “Cost Curve” shows hypothetical average costs per unit for landlords in this location. Like the SDM, the DCM presents a hypothetical picture at one point in time. If rents are lower, there will be more demand from renters for units but average costs per unit will remain the same. Landlord profit per unit will equal the “mark-up”, or difference between cost and rent per unit.
If there is only one monopoly landlord who wants to maximize his/her profit on existing units, he or she can maximize their profit in this simplified linear downward sloping demand curve and flat horizontal average cost curve model, by charging a rent of $15.50, or by setting a price that is halfway between constant average cost ($9.00) and the vertical intercept of the demand curve ($22.00). This is a consequence of housing unit quantity demanded falling as rents go up, so that there is an optimal rent increase beyond which the loss of profit due to fewer units being rented will be greater than the increase in profit from higher rents (for a mathematical derivation see this). Generally however there will be more than one landlord, and competition will prevent landlords from maximizing their short-run profit, so that rents will, depending on landlord strategies, cluster in the heavily shaded blue region of the demand curve between the two arrows, above the cost curve ($9.00) and below profit maximizing rent ($15.50).
In the short-run, when demand for units in this location goes up, the supply of units will be restricted by the supply of existing open units available, with some flexibility from landlords offering more units due to the possibility of finding tenants willing to pay higher rents. Increased demand will be depicted by a demand curve shifting up and to the right representing a hypothetical demand schedule with higher rents for any given number of units supplied. The outcome in this case will thus be similar to that depicted by a vertical supply curve SDM model as described in Mankiw’s text, though with no SC and a narrow range of outcomes on the demand curve rather than a single point. This cluster of outcomes would represent landlord offers of a limited number of new units, without the production of new apartments, due to the inducements of tenant demand for units at higher rents. In this situation landlords will enjoy windfall increases in profit from higher rents but the number of units available for rent will not increase very much.
In the long-run, if developers and landlords expect the demand curve to continue to shift up and to the right, they will construct new units. The upward shifting demand curve will drive up rents, and demand by developers and landlords will drive up costs for new choice locations that can be developed or redeveloped, driving up the average cost curve. At any given point in time depending on competition and costs, the range of outcomes will again be represented by a cluster of points along the bold part of the blue demand curve in Figure 2.
If expectations are correct, all of these possible outcomes will be “market clearing” in the sense that the supply of new units will equal the demand for new units, but there will be nothing inherently optimal about the level of rent, or the supply of new units, resulting from any of these possible market outcomes. To the contrary, in a location where demand for units is rapidly going up, rents will go up, apartments will be rationed by ability to pay, and landlords and developers will make windfall profits until the boom ends, or until costs and rents become unfinanceable for developers or unaffordable for renters.
Instead of the socially optimal market outcome depicted in Figure 1 above that shows that the sum of consumer and producer surplus is maximized at market equilibrium price and quantity where the demand and supply curves cross (more on the definitions of “consumer surplus” and “producer surplus” and why the sum of these is considered an approximate measure of “consumer welfare” in NC economics here), when the ghost supply curve is removed and replaced by an average cost curve, the consumer and producer surplus outcome at any given point in time will be as represented in Figure 3 below.
In this picture the sum of consumer and producer surplus, or NC social welfare, is not maximized, and “dead weight loss” does not disappear at some hypothetical and non-existent market equilibrium, but rather consumer surplus (a more appropriate non-NC static measure of social welfare) is maximized to the extent that mark-ups or landlord profits are reduced, i.e. given the supply of units, mark-ups or rents should be constrained so that housing is affordable.
B) Rent is Mostly Property-Based Exploitation Without Moral or Economic Justification
Markets can be useful and powerful tools for progress when the incentives that they create align with just, efficient, and sustainable, economic growth and allocation. This usually means that they have to be constrained and regulated through democratic social choice. Property-based extraction of income, the political economic definition of “rent,” has long been reviled in classical political economy at least as far back as David Ricardo who made a fortune in bond trading but focused on land rent, and in modern political economy, as parasitical and unproductive. Land rent, or “real estate” rents are a classic example of property-based income extraction that has been recognized as unjustifiable and inefficient since the primary driver of the value of land and property is location, and the unique incremental value of a particular location is largely a result of nature or society, that is only marginally, if at all, related to the efforts and investments of individual owners.
In recent history Henry George was perhaps the most well-known advocate of taxing away the windfall profits of landlords that accrue from the rising value of real estate property that is largely the result of general economic growth and social and community development, but contemporary radical political economists like Hyman Minsky, Michael Hudson, Steve Keen, and Ron Baiman have expanded this “rentierist” perspective to the general “Finance, Insurance, and Real Estate” (FIRE) sectors, as well as tech platforms and other monopoly sectors of the economy. As pointed out originally by Minsky, capitalist economies are prone to financial crisis from self-perpetuating bubbles of exuberance, from private bank lending creating credit that drives up the price of housing, which increases the value of collateral for more lending, in a feed-back loop that drives up credit creation, capital appreciation, rents, interest payments, profits and fees, until prices stop rising and a collapse ensues. Hudson has shown that rentierism has been a primary cause of civilization collapse throughout antiquity. Keen has focused on the private debt overhang that persists when financiers/rentiers are bailed out (as in 2008) causing long-term stagnation and economic polarization.
And Hudson, Keen, and Baiman have urged that democratic socialists expand the classic Marxian capital-labor class struggle paradigm to a three-way “rentiers, capital, labor” analysis of the contradictions, conflicts, and possible imminent collapse of modern capitalism from unbridled rentierist exploitation of people and planet. In fact, as John E. Roemer and the Analytical Marxists have pointed out, capitalists could be considered to be a particular type of rentiers who use their monopoly ownership power over the means of production to exploit workers. The key difference between such classical “capitalist-rentiers” and modern “rentierist-rentiers” being that the former group exploits labor through capitalist “equal-exchange” and the creation of surplus value in real production, whereas the later exploits both labor and capital through “unequal-exchange” without necessarily producing any real new goods or services.
The DCM model lifts the bourgeois equal-exchange ideological veil of the SDM model by demonstrating the arbitrary nature of rent mark-ups based on market power that are unrelated to costs of production or investment (or current or past labor). In a more equal society it might make sense to allocate housing based on how much households are willing to spend of their income and wealth for desirable housing as opposed to other goods or services. However in the vastly and increasingly unequal and rentierist modern capitalist societies of today, it makes little sense to allocate housing purely on the basis of ability and willingness to pay, especially as housing is widely recognized as a basic human right. There are numerous reasons why housing should be affordable, and as much as possible, widely available across communities and regions. Affordable housing is vitally important for basic human and family welfare, for maintaining and enhancing community diversity and democracy, and to prevent geographic, economic and social polarization. It makes little sense to tie housing development to for-profit “market signals.” Rather, large scale investment in public and not-for profit public housing, as well as rent control and other measures, should be the primary drivers that ensure an adequate and geographically diverse supply of affordable housing, and this goal should be the guiding principle of housing “markets.”
Biographical Note: Ron Baiman teaches Economics in the MBA program at Benedictine University in Lisle, IL outside of Chicago. He is the author of two recent books: The Global Free Trade Error: The Infeasibility of Ricardo’s Comparative Advantage Theory (Routledge, 2017), and The Morality of Radical Economics: Ghost Curve Ideology and the Value Neutral Aspect of Neoclassical Economics (Palgrave Macmillan, 2016); and co-author of Political Economy and Contemporary Capitalism (M.E. Sharpe, 2000). He has published theoretical and policy papers on international, national, and local political economy in numerous heterodox and neoclassical journals; has been a member of the Editorial Board of the Review of Radical Political Economics for many years, and is a founding member of the Chicago Political Economy Group (CPEG) (www.cpegonline.org) where many of his policy analyses and blog postings can be found.