Monopoly & Inflation

Paul Glastris at the Washington Monthly magazine does an excellent and concise job of explaining why market concentration is playing a role in the current level of inflation. It has been strange indeed to see several prominent economists (e.g. Larry Summers, and more surprisingly, Dean Baker) confidently write off the very notion that market concentration could play a significant role. Strange because in just the last few years, study after study has shown how much larger than anticipated the market power effects are in a wide range of markets, from concentrated low-wage labor markets where workers are paid less than 75% of their value, to over-concentrated hospital systems that charge 4 times cost. Some estimates put excess charges in the U.S. health care system overall at $1 trillion per year.

Furthermore, the full-on rush to globalize business that started in the late 1990’s has left international markets highly concentrated as well, and high degrees of concentration leave vendors less nimble — as we see in the supply chain disruptions of the past two years.

I hope you’ll check out Paul’s article. Underestimating the effects of market power has been one of the biggest failings of the economic community over the past 30 years; it’s well past time to pull the wool from our eyes.

Why Biden’s Pro-Competition Order is So Important

The Biden administration just issued an executive order that makes an excellent start at increasing competition throughout our economy.  It targets several areas where a lack of competition has raised prices or suppressed wages, including health care, Big Tech, and labor markets across many industries. 

This focus on pro-competition protections is the best way to address many social issues – such as working poverty, skyrocketing health care prices, and more – because their root causes lie in the declining competitiveness of our markets.  Working poverty, for example, is caused by wage suppression due to the “monopsony” power (the buyer’s market equivalent of monopoly power) that arises in our very concentrated low-wage labor markets (see Working Poverty: Low Skills or Low Wages? for more details).  Hospitals now charge an average of 4 times cost (!), after decades of mergers and acquisitions.  Prescription drug companies have become one of the two most profitable industries in the country by exploiting lax enforcement of regulations designed to ensure that their patents expire on time and make way for less expensive generic versions.

None of these markets now resembles what a free marketer has in mind when they sing the praises of unregulated markets – those benefits only accrue when markets are highly competitive, with lots of competing vendors, full information available, and low barriers to entry.  We have very few such markets; instead, our typical market is highly concentrated and becoming more concentrated.  And these markets don’t self-correct toward more competition, as these advocates also promise: absent vigorous pro-competition protections, they tend to become more concentrated.

In short, decades of deregulation has left us with markets so highly concentrated that big business routinely extracts excessive profits (i.e. “supranormal” profits, in economics lingo) by overcharging consumers and underpaying workers. Low-wage employers extract tens of billions of dollars each year from their workers, as do middle-wage employers, and the heath care industry overcharges us by a trillion dollars per year.  For more details on these examples, and on why competition is so important to a strong economy, see The Free Market Fallacy (click here for a non-paywall version).

The good news is that, with actions like those in Biden’s recent executive order – such as banning non-compete clauses that create barriers to worker mobility and thus the competition for labor – we can simultaneously correct many of these inequities and strengthen economic growth at the same time, because correcting for market power increases output and growth.  Critics will argue the opposite, as Jay Timmons, CEO of the National Association of Manufacturers has, warning that these moves will “undo our progress by undermining free markets”, but this is just smoke and mirrors.  As the president said in his remarks, “Capitalism without competition isn’t capitalism. It’s exploitation.”  And free markets aren’t the goal either – markets, yes, but what’s good for society as a whole is competitive markets.

Biden’s Stimulus Costs Less Than Excess Corporate Profits

by David J. Lyon

Is $2 trillion a lot of money? At $250 billion per year for 8 years, you bet it is.

But would you be surprised to know that it is a mere fraction of the excess profits big business in the U.S. rakes in every year? By “excess”, I mean profits that are beyond the profits from investing in economies of scale, or from investing in innovation, or from process improvement, all of which can increase profits while improving things for consumers and workers, and expanding the economy at the same time. Excess profits are those that come from market power, the price- and wage-setting power that comes from dominating a market and raising prices (or suppressing wages). This means of increasing profits takes from consumers or workers, and is always a net loss for society overall.

I describe this difference between profits from market power and profits from scale economies or innovation in more detail in my paper, The Free Market Fallacy (non-paywalled version here), and I attempt to estimate the portion of excess (or “supranormal” in economics lingo) profits in six example industries. The results are, to put it mildly, eye-opening. 

Our low-wage labor markets are quite concentrated (giving the employer market power), and as my analysis in Working Poverty: Low Skills or Low Wages? found, that enables firms to suppress wages about 25%, or $4,500 per year — enough, if corrected, to bring such workers above the federal poverty line. Health care markets are similarly exploited, as we have allowed hospital mergers to continue apace for decades, giving them the market power to charge, on average, 4 times cost(!). Pharmaceutical companies fend off competitive forces partly through mergers as well, but mostly through various tactics I call “weaponized intellectual property”: for example, filing dozens of unnecessary patents for a single drug, for the sole purpose of keeping generic competition at bay. This gives the industry a ridiculously high average return to R&D of 90%, well above typical RORD levels. Princeton economists have estimated the total overcharge from our health care industry at an eye-popping $8,000 per family per year, or a total of $1 trillion a year in excess profits to the health care industry.

Excess profits from just these two areas are already several times higher than the cost of President Biden’s stimulus package, and they are only a fraction of the total. Fast food and retail almost certainly make excess profits similar to those they make from wage suppression by suppressing the prices they pay their suppliers; manufacturing industries are also highly concentrated industries, and have been quite successful at eroding the power of the main force that counterbalances their labor market power, unions, allowing them to push wages about $3,000 per worker per year below competitive-market rates; polluting industries have successfully weakened many environmental regulations, allowing them to externalize the cost of the associated harms, saving the fossil fuel industry, for example, about $150 billion per year. Not to mention wage suppression in health care (e.g. home health care aides), excess profits from the financial industry (one study pegs this at over $650 billion per year), or the amount lost to corporate tax avoidance.

So let’s not get too carried away over spending, for 8 years, a little over 1% of GDP to get our post-COVID economy back on track, when we already allow over 5 times that much to go to excess corporate profits. And let’s start right away establishing protections against market power to return those excess profits to where they belong – the pockets of consumers, workers and small businesses.

Why the PRO Act is Good for the Economy

by David J. Lyon

The Protecting the Right to Organize (PRO) Act is one of the most consequential pieces of pro-labor legislation in decades, and it’s halfway along its journey, having been passed by the House of Representatives.  It is sorely needed: while unions are a critical market correction to the wage-suppressing power of large employers, they have been decimated over the past 40 years, with membership falling by half, largely due to management’s relentless campaigns of both legal and illegal activities to stymie attempts to organize (for a good summary of these anti-union tactics, see the Economic Policy Institute’s short video on the topic here).   

For context, it is important to note that during this same period, big business has successfully lobbied for numerous deregulatory measures that increase its ability to organize ownership – measures that have dramatically reduced anti-trust enforcement – and this has resulted in ever-increasing market concentration that far exceeds “optimal scale” in many industries, as I document in my recent paper The Free Market Fallacy.  But this rise in market concentration increases the need for unions, because it increases market power, the ability to suppress wages or hike prices beyond competitive values. 

There is a lot of similarity between the economics of unionization and the economics of the minimum wage.  Both are important correctives in concentrated labor markets, because concentrated markets give companies market power that enables them to suppress wages below competitive-market rates.  Doing so increases corporate profits but hurts the economy overall, reducing output and what economists call “total surplus” or total gains to society. 

Correctives to market power, happily, unwind this situation, returning competitive-market wages to workers while increasing overall output and economic growth.  The money for those higher wages comes directly from “excess” or supranormal profits, the profits made off market power.  For example, in the manufacturing sector, excess profits from wage suppression amount to about $25 billion a year out of total industry profits of $240 billion a year, based on estimates from the Economic Policy Institute that the weakening of unions has cost manufacturing workers about $3,000 a year. 

Such correctives in concentrated labor markets can even increase employment as overall output goes up, as demonstrated pretty thoroughly at this point with regard to the minimum wage.  To date, the literature on employment effects from unionization mostly finds losses, but that may be because, unlike the case in fast food and retail, manufacturing plants are not tied to a particular location.  Since the Washington Consensus of the late 1980’s and 1990’s began allowing companies to move operations abroad, companies can simply move their operations to a low-wage country rather than negotiate with a union.  Intriguingly, one study found that unionization in the service sector (tied to place) has a positive employment effect. 

It is no surprise that the conventional wisdom about unions and their effect on the economy is pretty confused: corporate interests have been engaged in an “all-out and unrelenting battle” against unions since the 1935 passage of the National Labor Relations Act and continuing ever since.  They vastly outspend labor groups on elections and lobbying, by a ratio of 30:1, and promote the false narrative that unions hurt workers and the economy in general. 

One silver lining is that all this spending by corporations against organized labor still has not convinced a majority of American voters: as of 2017, Pew Research found that 60% of Americans view unions favorably (unions are becoming more popular even among Republican voters, 44% of whom now have a positive opinion).  By encouraging Congress to finish the job and pass the PRO Act, we can help workers and our economy at the same time.

The CBO is Stuck in the Past on the Minimum Wage

The Congressional Budget Office just released another analysis of the projected effects of raising the minimum wage to $15/hr, and while they acknowledge that it would provide income gains for millions, lifting many out of poverty, they are unfortunately still stuck in the past on the effect on jobs, claiming it would cost 1.4 million jobs. 

This claim, once traditional, is based on the outdated belief that these labor markets are highly competitive markets, where increasing pay automatically leads to higher prices and lower employment. This view takes as an assumption that firms have little monopoly or monopsony power, as this section of the CBO report makes clear:

"In some limited circumstances, increasing the minimum wage could boost employment if employers had what is known as monopsony power—that is, bargaining power that allows them to set wages below the rates that would prevail in a more competitive market." {emphasis added} 

But as I have shown in two papers, low-wage labor markets in particular, and many of our other markets as well, have become quite concentrated, giving firms significant market power (monopoly power on prices, monopsony power on wages).  As the Economic Policy Institute describes the CBO analysis, “… CBO nevertheless substantially overstates the costs…. it failed to appropriately weight the highest-quality studies in the vast academic literature on this issue.”  In fact, there is a growing consensus amongst economists that “… the employment effects of moderately sized minimum wage increases are quite close to zero”, sentiments shared by more and more researchers. 

The reason for this potentially surprising result is that concentrated markets respond differently to regulation than the highly competitive ones assumed by free market dogma.  Whereas a competitive labor market would respond to a higher minimum wage with a reduction in employment, that’s because competition has already ensured the wage is at competitive-market levels.  When firms in a concentrated market suppress wages below that level, they must accept reduced employment as a consequence; raising the minimum wage (up to the competitive level) simply corrects the market failure, bringing wages and employment back to their competitive-market levels.

As our politicians debate whether to raise the minimum to $15 / hour, it is critical to remember that, in concentrated markets such as our low-wage labor markets, this is a pro-competition intervention that returns wages to competitive market levels, and does so not by cutting jobs, but by returning supranormal profits to the workers who have earned them.

Drug prices, essential goods, and regulatory evasion

We see rising drug prices in the news a lot these days, from Martin Shrkeli’s infamous 4000% hike in the price of the antiparastic Daraprim (from $17.50 -> $750 per pill), to the average 250% increase in the price of insulin from the 3 major manufacturers between 2001 and 2015, a drug originally created in the 1920’s.  Overall, spending on prescription drugs in the U.S. increased 50% between 2005 and 2016, from $320 billion to $480 billion, and that’s almost entirely from price increases (utilization has not increased much, only 1% between 2011 and 2015).  These high prices naturally show up in profits, the industry’s average profit margin of around 17%, making it one of the very most profitable industries in the world.

What’s behind these high prices? Are they simply what’s necessary to incent the research needed for more new treatments? Or are these hikes the price gouging that’s enabled by very low elasticity markets?

The economics behind these questions centers on the tension between three key aspects of this industry: it is a high innovation, essential goods industry where insurance is prevalent. Essential goods industries pose a two-fold challenge. First, society has a particularly strong interest in making these goods accessible to all; for example, municipal governments generally directly provide water, another essential good, and state governments intervene with many electric utilities via price controls. Second, essential goods markets are, absent strong competitive forces, the most exploitable of markets. The “essentialness” of these goods means that their price elasticity — the reduction in quantity a vendor suffers if they raise the price of their product — is especially low, and that means that prices will be especially high without vigorous protections for consumers (researchers report elasticity values around -0.2).

Industries where insurance plays a large role pose their own challenge for market-based solutions: the fact that the consumer requesting a product or service only pays a fraction of the actual cost highly distorts the most fundamental signal a market relies on, the connection between price and the level of demand. And insurance is heavily involved in pharmaceutical payments, with private insurance and medicare together accounting for 72% of total pharma spending.

The patent protection, or “monopoly license”, we extend to inventors to encourage innovation also exacerbates the price challenge in the pharmaceutical industry, again due to the essential goods nature of the market. Patent protection is a government intervention in the market that gives the patent holder a one-firm monopoly on that invention; if there are no close substitutes, it is a de facto monopoly on an entire type of good (or treatment class, in the case of pharmaceuticals). We as society are not overly concerned with such monopolies in optional goods markets, since the goods are both non-essential and less exploitable: prices cannot be raised but so much above competitive levels, due to the higher price elasticity of non-essential goods. Unchecked monopolies in essential goods, however, can raise prices much higher above competitive levels, and inflict considerably more harm by doing so (thus the presence of price controls in other essential goods monopolies like electric utilities). Balancing this need to restrain predatory pricing with the need to encourage innovation is the key to an effective regulatory regime.

Further aggravating the patent monopoly issue, patent holders engage in numerous gaming activities to effectively lengthen their patents. The Orphan Drug Act, enacted in 1983 to encourage research and development into rare disease treatments, offers extended patent life for to reward such activites, but companies have found that they are able to claim that same protection for drugs they long ago developed if they find that it also treats a rare condition. For example, Humira, the best-selling drug in the world, is able to claim orphan drug protection because, in addition to the many other conditions it treats, it also has been found to treat a rare disease, Crohn’s disease. “Pay-for-delay” schemes are another method, where brand-name manufacturers pay generic manufacturers not to produce a generic version of their patented drug when its patent expires. Manufacturers also abuse REMS safety regulations by using them as a rationale to withhold the samples a generic producer would require to develop and get approval for a generic; just these abuses of REMS have been calculated to cost consumers $5.4 billion annually.

Patent “evergreening” or “product hopping” is another widely used strategy to delay entry of generic competition, that capitalizes on a combination of patent monopoly power, marketing and agency inefficiencies to effectively extend the life of the original patent. Before patent expiration, companies will file for patents on small changes to the drug (e.g. extended release), and then start marketing the new version heavily to physicians. Sometimes they will even stop producing the earlier version to force a switch to the new version. Potential generic entrants find themselves facing a much-reduced market for the now-replicable older version, and a physician education challenge in getting physicians to internalize the value of a generic version. The top 12 selling drugs, for example, have an average of 125 filed and 71 granted patent applications, and their prices have increased 68% since 2012.

For these reasons and others, many other countries intervene more energetically in pharmaceutical markets, with price controls (France and Italy), reimbursement limits from social insurance (Germany, Japan), and profit controls (United Kingdom). As a result, their per capita spending on pharmaceuticals is much less than in the United States; the U.S. spends between 2  and 3 times what other Western countries spend despite roughly equal drug utilization. Pharmaceutical profit margins in the U.S. average 4 times the margins of non-U.S. pharma companies.

The price issue has become important enough that even U.S. politicians, from both parties, are proposing stronger intervention in this market. Democrats in the House are working on a proposal to allow the government to match drug maker monopoly power with the buying power of Medicare, an idea very popular amongst the public, with support from 96% of Democrats, 92% of Republicans and 92% of Independents. The idea behind the proposal is similar to that behind using large insurers and pharmacy benefit managers (PBMs) to keep prices down: monopsony or buying power may be able to countervail supplier pricing power.

Direct price controls are also popular, such as limiting what companies can charge for high-priced drugs (support from 78% of Democrats, 79% of Republicans and 79% of Independents) and creating an independent group to oversee drug pricing (74% of Democrats, 71% of Republicans and 74% of Independents). Scholarly work in this area seems focused on value-based pricing.

The second most popular idea amongst the public for containing prescription drug costs is to make it easier for generic drugs to come to market (84% Democrat, 91% Republican and 91% Independent support), and as we saw with the patent extension strategies described above, this has significant potential to provide relief. Authors of this report from Brookings agree:

Over the last 10-15 years, however, industry participants have managed to disable many of these competitive mechanisms and create niches in which drugs can be sold with little to no competition. We argue in this paper that the first step toward bringing down pharmaceutical prices would simply be to fully apply the existing rules we already have.

Policies to rein in these abuses are starting to get attention, with calls like this one in the New England Journal of Medicine to reform the Orphan Drug Act, and efforts to limit “pay-for-delay” schemes and to require brand-name manufacturers to provide samples so generics can be developed.

Surprisingly, perhaps, even where there are generics available, prices are often not reduced as much as we would hope, due to industry consolidation, low numbers of competitors for a given drug, and possibly collusive behavior. Forty-four states are suing 20 large generic drug companies over an alleged price-fixing conspiracy:

“We have hard evidence that shows the generic drug industry perpetrated a multi-billion dollar fraud on the American people,” said Tong, in a prepared statement. “We have emails, text messages, telephone records, and former company insiders that we believe will prove a multi-year conspiracy to fix prices and divide market share for huge numbers of generic drugs.”

We can see some of the effects of both industry consolidation and any such market allocation schemes when we look at market concentration for specific drugs. Generic drug manufacturer market concentration measured across the industry at the national level isn’t high enough to activate special scrutiny from the DOJ, but when focusing on markets for specific molecular-dosage generic drugs, we find that 40% of them are supplied by only one manufacturer, and the median number of manufacturers is just 2. When you consider that prices don’t drop significantly until there are 3 manufacturers of the drug (a second manufacturer only brings the price down 6%), this makes numerous generic drugs considerably more expensive than what a competitive market would produce.

Returning to our original question, are these high prices, patent evergreening strategies and the like simply necessary to incent pharmaceutical research? Or do they combine with monopoly pricing power in a low elasticity market to enable price gouging and supranormal profits?  Two former pharma executives dismiss the notion that prices are set to recoup R&D costs: Hank McKinnell, a former CEO of Pfizer, says “It is the anticipated income stream, rather than repayment of sunk costs, that is the primary determinant of price”, and Raymond Gilmartin, former CEO of Merck, has commented that “The price of medicines is not determined by their research costs. Instead, it is determined by their value in preventing and treating disease.”  Inmaculada Hernandez, a professor at the University of Pittsburgh’s School of Pharmacy, notes that “usually research and development is paid for in the first years of life of a drug.”

Indeed, when we look at industry profit levels and total R&D investment, we see a wide gap between the two. The total pharmaceutical spending of about $480 billion is split 74%/36% between the branded and generic categories, and branded manufacturers receive about 76% of total branded product revenue (after insurers, PBMs, pharmacies and wholesalers take their cut).  Gross profit for branded manufacturers was 76% of their revenue, or about $205 billion, with $71B of that invested in research and development, $30B spent on marketing, and about $15B on capital equipment. Taking the 2017 industry return on capital of about 11%, and assuming that the rate of return on R&D is the same as that on marketing, we come up with a ballpark range for the industry’s return on R&D around 85%. Some argue that the industry actually spends considerably more than $30B on marketing, which might reduce the return to R&D to about 50%.  But either way, that’s a high rate of return, and they receive an equal return on their marketing investment.

All in all, rapidly climbing drug prices; the essential goods nature of the market, with it’s propensity for supra-normal prices and profits; the regulatory evasion we observe; plus a 50-85% return on R&D and an equal return on marketing, all point to there being plenty of room to more closely regulate this industry to protect consumers, while still providing healthy returns to investors.

More evidence that raising the minimum wage — even doubling it — won’t hurt jobs.

Another study analyzing the effect of raising the minimum wage on employment levels is out, and it projects that raising the minimum wage to $15/hour by 2024 would reduce inequality and lift families out of poverty, and would not have any negative effect on jobs.

I have described why that’s what we should expect in a previous blog post and in a paper, Working Poverty: Low Skills or Low Wages?  Wages at the low end are as low as they are because of the market (or “monopsony”) power these employers have, accounting for as much as half of their profits, and the money to fund the increase simply comes from those “supranormal” profits.

While previous studies have examined the minimum wage – employment connection and shown no job losses for small increases to the minimum, this most recent paper from the Institute for Research on Labor and Employment at Berkeley analyzes the effect of the doubling of the minimum to $15, and similarly finds no employment losses.  For the millions of low-wage workers, this offers a fair and economically sound path out of poverty, and for all of us, a significant reduction in inequality.

Good News for Low Income Workers

Good News: this headline from Politico this week contains good news for low-wage workers — “McDonald’s halts lobbying against minimum wage hikes“. As the largest fast food provider and one of the largest low-wage employers in the country, McDonald’s withdrawal from this lobbying effort is expected to have a significant impact in the struggle over raising the minimum wage. A struggle which, historically, workers have been on the losing side of: the current minimum of $7.25/hr was set 10 years ago, and in inflation-adjusted dollars, is just 61% of its peak value, in 1968.

Really good news: raising the minimum wage is fair, AND does not hurt employment. This may sound contrary to our conventional wisdom, in which we assume that people get paid what their skills are worth, and that increasing the cost of labor will reduce the number of jobs. But those views are based on the assumption that our labor markets are highly competitive markets, with lots of vendors offering similar jobs for competing wages. In reality, our low-wage markets tend to be quite concentrated: in both food service and retail trade, the two largest low-wage industries, the top five companies control approximately half the market. Combining this concentration with the low labor supply elasticities measured in these industries, I found that the competitive market wage in these industries would be at least $12/hour in my recent paper, Working Poverty: Low Skills or Low Wages?, a wage rate that brings a worker supporting a family of three out of poverty.

Furthermore, with labor markets this concentrated, economic theory actually predicts that raising the minimum wage would maintain or even increase employment, something that numerous empirical studies have shown. In other words, concentrated markets behave almost oppositely from what we tend to expect: wages don’t reflect skill or contribution to the company, they reflect the firm’s maret power, and correcting such a market failure increases employment, not reduces it. In fact, correcting this market failure simply returns money from windfall profits to the workers from whom it was annexed via market power, eliminating half of family poverty at the same time.

Sad news: one of the best champions for raising the minimum wage, Princeton professor Alan Krueger, sadly passed two weeks ago, at the age of 58. He co-authored in 1994 one of the most influential studies on the minimum wage, showing that hikes in the minimum did not reduce employment, and continued work in the area for decades (see, for example, Theory and Evidence on Employer Collusion in the Franchise Sector). His work inspired numerous others (self included) to examine labor through a market
power lens, and that will continue to make a difference for years to come. RIP Dr. Krueger.

What will it mean if the billionaires win the tax rate debate?

The recent proposal by Alexandria Ocasio-Cortez to raise the top marginal tax rate is generating lots of discussion. For the most part, debate centers on two questions about the proposal: is it a good idea, and if it is, could it get enacted? The first question, the economics of the issue, is certainly of top importance, and it ought to affect the second question, the likelihood that a top rate hike could be enacted. But do we feel confident that Congress will legislate in support of policies that a majority of people want and economics may say will optimize benefit to our society?

We may have an opportunity to test that question in a close to ideal setting over the next months. Unless the economic consensus becomes clear that raising taxes on the rich would be harmful to the economy, the test of whether society will get what it wants in this case has arguably already begun.  For the sizable majority (70%) of people in this country already favor increasing taxes on the rich, including a majority (54%) of Republicans. Given that the people most opposed to such a change constitute less than 0.1% of the people in this country, and that they are the wealthiest portion of the electorate by definition, we could hardly have a better example with which to test Gilens’ and Page’s assertion that the average citizen only gets what they want from government when that is also what the rich want government to do. Their influential study found that “average citizens and mass-based interest groups have little or no independent influence [on U.S. government policy]”. In this case, the policy choice is between what 70% of Americans want, and what the wealthiest 0.1% want.

And there are plenty of reasons the economics may favor raising marginal taxes on the highest brackets. Top tax rates are near historic lows, economic growth has tended to be higher under higher top rates, and top economists have stated their support, some estimating the ideal top tax rate to be 73%. Corporate profits per GDP are at historically high levels, significant fractions of which can be attributed to the exertion of market power, asymmetric globalization, or the exploitation of environmental externalities. Each of these market distortions increases profits but reduces overall societal benefit (the sum of consumer, producer and worker benefit), potentially providing the best economic justification for increasing tax rates: high marginal taxes in the highest income brackets may remove much of the incentive to initiate such market distortions.

One way or another, we will see how this plays out in the next few months, and possibly into the 2020 election cycle. For other “test cases” to keep an eye on, check out this list comparing elite vs general public interest in various policies. As we watch the progress of these various policy proposals, let’s keep Gilens’ and Page’s question in mind: “Who governs? Who really rules?”


Affordable Housing & Economics

Affordable housing is an important issue across the country, and one that’s easy to think of here in high-growth Austin, Texas. House prices and rents have risen dramatically, especially in central Austin, causing families to move further out, and many musicians (who are so integral to our culture, here in the “Live Music Capital”) to flee the city entirely. For many low-wage workers it can mean even tighter times, less money for everything from groceries to gas to saving for their child’s college education.

Solutions for the affordability issue tend to fall into two different categories: some are economic solutions that attempt to address the root causes of unaffordable housing prices, and others are solutions that focus on direct provision of affordable housing. I’ll talk about this second category in an upcoming blog post, as there is a lot of excellent work being done; but in today’s post I want to focus on root causes and some examples of policy attempts to address the issue at that level.

Let’s kick off the discussion with an example from New Zealand that may seem extreme here in the U.S.: they recently banned most foreigners from buying a home in New Zealand. Housing prices have almost doubled since 2007 in Auckland, the country’s largest city, and foreign ownership in central Auckland has risen to 22%. The associate minister of finance put the rationale this way: “We believe it’s the birthright of New Zealanders to buy homes in New Zealand, in a market that is shaped by New Zealand buyers, not by international price pressures.”

For many Americans, that may sound like draconian government intervention and a violation of market principles. But is it really? First, the common belief that “free (i.e. unregulated) markets are good for society” is not accurate. Rather, economics says that competitive markets with no significant externalities are good for society, as they maximize output and growth, minimize consumer costs, and provide competitive wages. Many real estate markets do have several of the attributes of competitive markets: in large markets there are generally a lot of sellers and a lot of buyers, and there is a lot of information available to consumers about prices (through MLS systems) and about property condition (due to legislated requirements that sellers disclose all information they have about property condition).

But most real estate markets are also influenced, often heavily, by government action, some of which is consciously taken in order to influence the market. Interest rates, determined to a large degree by the Fed’s rate, make an enormous difference in the price a buyer can afford. A buyer who can afford a $200,000 mortgage when the rate is 6% (a typical pre-Great Recession rate), can afford a 25% bigger loan when the rate is 3.75% (a rate common for many recent years), thus boosting prices. Lending requirements also have a large effect, as we all observed in the runup to the Great Recession, when loosened restrictions, combined with opaque financing tools (e.g. CDOs), boosted prices by shifting risk from lenders to investors and the public.

City and regional governments play a big role as well. A decision to build a highway from an urban area to outlying areas will increase property values in those outlying areas. Municipal incentives to bring more employers (and thus more people) to town will have a similar effect, especially when the engendered growth happens more quickly than the housing supply can adjust. And the motivations and needs these goverment entities must balance are often skewed against affordability: buyers immediately become future sellers, and those that can afford rising property taxes thus have an incentive for prices to increase.

Finally, we must not forget that housing is an essential good for everyone. This provides both an obvious political reason to keep prices in check, and also another strong economic reason to do so: necessity goods intrinsically have low price elasticity, meaning they are the most susceptible to abuses of market power that increase prices beyond competitive-market rates.

Going back to the example of New Zealand banning foreign real estate ownership — it is not clear at this point whether that policy will have the desired effects on affordability. But recognizing the myriad ways that policy already impacts housing prices makes a compelling case for trying ideas like this. Foreign ownership of real estate is increasing in the United States as well, with Texas near the top of the pack, where foreign purchases as a percent of the total leapt from just 2% to 15% in the years between 2008 and 2016. Just how much this factors into the rising cost of housing we don’t yet know, but we may find ourselves at some point dusting off examples like New Zealand’s as we search for new answers.