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Introduction of Principles of Economics
Principles of Economics, On April 26, 2015, the leadership of the labor party mentioned that they will introduce rent control if they are able to form the government. They have taken this decision on the basis of a public poll; who may not have sound knowledge of economics. However, the economists in the country believe that the policy is unsound economically as it can lead to inefficiencies in the market. It is generally well known that the competitive markets run efficiently when they are free from any price ceiling or price floor. The price ceiling creates inefficiencies when it is set below the equilibrium price and price floor creates inefficiencies when it is set above the equilibrium price.
The rent control is a type of price ceiling below the equilibrium price because government aims to control the rents within a specified range so it can lead to inefficiencies in case of competitive markets (Jehle and Reny, 2001). The effect of a price ceiling below the market equilibrium is shown in the figure below:
Figure 1 – Impact of Price Ceiling
(Source: Bade and Parkin, 2013)
The figure highlights that the price ceiling results in shortage of the good available in the market as demand increases at lower price and supply eventually decreases. The figure also shows that the markets become inefficient when such price ceilings are introduced in any given market so if the government introduces policies for rent control then the results of such policies will be same (Bade and Parkin, 2013).
Market Structure of Housing Market
The nature and market structure of housing market is identical in almost every country; the industry is recognized by low barriers to entry and large number of firms operating in the industry. The industry is highly concentrated as a research reveals that top 100 real estate companies had a collective market share of 17% in USA in 2005. The results of this research clearly indicate that the housing market in USA is very competitive and highly concentrated; Principles of Economics it must be noted that the housing markets around the world are similar in market structure (National Association of Realtors, 2005). The market structure of housing market is perfectly competitive as indicated by the factors discussed above.
In the view of Beck, Scott and Yelowitz (2012), there are two school of thoughts regarding the competitive nature of the housing market in different countries; Principles of Economics one school of thought believes that the market forces determine the prices in housing market based on demand and supply while other group believes that the prices are determined by authorities and companies operating in the industry. As identified earlier, different factors show that the market structure of the housing market is perfectly competitive so the companies / businesses operating within the industry cannot determine prices but the prices must be determined by the competitive forces such as quantity demanded and quantity supplied within the industry.
On the other hand, Paciorek (2013) believes that there is often a shortage of supply in the housing market which leads to higher rents and prices of the houses in the industry. He also believes that the markets are competitive and the prices are determined by the market forces but the supply is inelastic in the short run so it often leads to shortage of supply in the housing market as a whole and prices increase as a result. These findings imply that there is a need for rent controls in the housing industry; however it will lead to inefficiencies as the suppliers will not be willing to rent their homes at the price determined by the government. Overall, it can be stated that the housing markets are perfectly competitive and the firms operating in the industry are price takers; Principles of Economics there is intense competition within the industry.
Allocative / Pareto Inefficiency due to introduction of Rent Controls
In the view of Stilwell (2014), Allocative efficiency refers to the state of economy where the goods produced represent the taste of the consumers; only those goods are produced which provide utility to the consumer and whose marginal benefit is more than or equal to the marginal cost of the purchasing the product. When these conditions are not met, Principles of Economics it can be said that there is allocative inefficiency in the society. The figure below explains the allocative efficiency and shows that the optimal allocative efficiency is achieved when the price equal marginal cost and the market is in equilibrium. It depicts that there is some allocative inefficiency in the market when the market is not in equilibrium.
Figure 2 – Allocative Efficiency
(Source: Stilwell, 2014).
As discussed earlier, the policy proposed by the government will lead to excess demand of the houses and reduction in supply. There will be shortage in the market and market cannot operate at equilibrium with policies such as rent control so it will lead to allocative efficiencies in the housing market. This justifies the statements provided by the economists in the country as they called the proposed policy disastrous.
Another type of efficiency is known as Pareto efficiency; it states that it is impossible to make an individual better off without making one worse off. It states that it is impossible to make both buyer and seller of a good happy; one party has to lose in order to create benefits for the other party. Pareto efficient frontier is similar to production possibilities frontier in shape; the value to seller increases only when the value to buyer decreases (Jehle and Reny, 2001). The figure below shows the Pareto efficient frontier for any general micro market and indicates that the slope of the frontier varies at different occasions so the value lost by one party must not equal value gained by other party.
Figure 3 – Pareto Efficient Frontier
(Source: Jehle and Reny, 2001).
This figure indicates that the slope of Pareto efficient frontier keeps changing; it means that the value compromised by buyer (seller) may not match value gained by the seller (buyer). If we look at the proposed policy, it will increase value for buyer and reduce value for the seller; the extent to which the value will be lost / gained depends on the stage of efficient frontier the market is in.
Determinants of Inefficiencies due to the Policy
There are many factors in the policy which can impact the size of inefficiencies due to the policy. First and most important factor is the price / rent set for the houses to control rent in the housing industry. If the rent limit is set above the market equilibrium then there will be no inefficiency caused by the policy; however, if the rent set is below the market equilibrium then there will be some inefficiency in the housing market due to the proposed policy. The size of the inefficiency depends on the difference between the equilibrium rent and rent limit set by the government (Jehle and Reny, 2001). Apart from the rent itself, the inefficiency in the market also depends upon the price elasticity prevailing in the housing market. Higher the price elasticity prevailing in the market, higher will be the inefficiency caused by the policy. Because if the price elasticity of demand is high, a reduction in rent will cause the demand to go up significantly and if the price elasticity of supply is high then it will cause the supply to go down significantly with a small change in the rent set by the government. Also, other factors such as market structure can also lead to different market inefficiencies; for example: a price ceiling in monopoly market may have different impact than those of Oligopoly and Perfect Competition. In this case, the housing market is perfectly competitive market as discussed earlier so there will not be significant impact on the efficiency of the market because there are many players competing in the industry so many competitors will provide the houses on rent just for the sake of competition and capturing the market share in that crucial time (Bade and Parkin, 2013). So these all factors can impact the size of allocative inefficiency due to the proposed policy by the newly elected government.
Conclusion
On the basis of discussion, it has been found that the housing market in UK and across world is perfectly competitive market as there are low barriers to entry and large number of firms is competing to gain the market share. It has also been found that the concentration in the industry is too high; there are no significantly large players in the housing market which again depict the perfectly competitive nature of the market. The newly elected government has proposed a policy about the rent control as they believe that the rents are too high in the country. The economists in the country believe that the rent controls can be disastrous to the country’s economy as it will lead to inefficiencies in the market. It has been identified that the proposed policy can lead to both allocative and Pareto inefficiencies. The factors which will determine the size of the efficiencies include the rent limit set, price elasticity and market structure of housing market…
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