The Cartel Theory of Everything; Housing
Competition is for losers.
That is what Peter Thiel argued in Zero to One, and at least on the underlying economic logic, few would disagree.
To illustrate, imagine you are the owner of United Widgets. The widget industry is almost perfectly competitive - you and each of your nine rivals sells million widgets a year at $10 apiece, for $10 million in sales.
Widgets cost you $9 to make, giving you a profit margin of 10%, for a total profit of $1 million a year.
You are sick and tired of the price wars cutting into your profits, so you call a meeting of your competitors and propose a merger. “Competition is for losers,” you begin, “so let us combine our companies and put an end to it.”
You have a slide deck ready to go.
“There are ten of us, each selling a million widgets each for $10.
“If we combine forces, we will have a widget monopoly. My analysis shows that we can raise our prices 30%, to $13, and the result is that we will sell 30% fewer widgets - 700,000 each.
“Our sales will actually go down - 700,000 times $13 is $9.1 million in sales, which is less than the $10 million in sales we were making before.
“But this is ok - instead of making $1 per widget, now we will be making $4 per widget. $1 times 1 million is $1 million, and $4 times 700,000 is $2.8 million.
“We will triple our profits if we just stop undercutting each other.”
So far, so good. This is a typical example you might encounter in an introductory economics class, with realistic numbers. A monopoly is almost always great for profits, even if it doesn’t grow revenue and actually reduces the volume of product sold. Going from a tiny per unit profit to a large per unit profit outweighs all of that.
The owner of General Widgets speaks up. “This is a great idea, except that this is obviously illegal. If we tried this, the government would sue us. Also, this doesn’t stop new widget companies from springing up and undercutting us.”
This is true - if it was 1870, maybe you could get away with merging every producer into the Standard Widget Trust, but in the U.S., the Clayton Act of 1914 explicitly prohibits this.
You have another idea. “What if instead of merging into one big company, we form a cartel and agree to collude? We each agree to a quota of 700,000 widgets each, and fix our prices at $13, and we would get the exact same monopoly profits as we would have gotten if we had merged?”
The owner of General Widgets has another objection. “That is even more illegal than combining into one big company! The Sherman Antitrust Act of 1890 specifically says that this form of restraint of trade is illegal.”
We have talked a bit in past editions about Bob Crandall, the legendary former CEO of American Airlines. For all of his success as an aviation innovator, one indelible piece of his legacy is this recorded 1982 conversation with Howard Putnam, the chairman of rival airline Braniff:1
Crandall: “I think it’s dumb as hell, for Christ’s sake, all right, to sit here and pound the shit out of each other and neither one of us making a f—ing dime.”
Crandall: “I mean, you know, goddam, what the f—is the point of it? . . .”
Crandall: “I have a suggestion for you. Raise your goddam fares twenty percent. I’ll raise mine the next morning.”
Putnam: “Robert, we—”
Crandall: “You’ll make more money, and I will too.”
Putnam: “We can’t talk about pricing.”
Crandall: “Oh, bullshit, Howard. We can talk about any goddam thing we want to talk about.”
The United States Department of Justice did not agree that they could “talk about any goddam thing we want to talk about”, and they were forced to agree to a legal settlement.
So here is your puzzle. You want monopoly profits, but the obvious routes to monopoly profits violate federal law. What should you do?
Monopoly profits are the holy grail of business.
In Zero to One, Peter Thiel advocates gaining a monopoly by building something that is 10x better than anything else that exists, and that cannot be easily replicated. For example, people are willing to pay a premium for Apple products, giving them some degree of monopoly power; Apple reported an operating margin of 27% last year, compared to the 11% average for the broader market and 5% averaged by consumer electronics companies.
Monopoly profits achieved in this way are legal, and somewhat tolerated by the public, although there is some debate on how much one should be able to exploit a competitive advantage.
Monopoly profits are less legal and less tolerated if achieved through less natural means, such as through collusion. Monopoly profits are good for shareholders, but bad for everyone else; they result in a transfer of wealth from consumers to capitalists, and lower the overall output of goods.
In our widget example, widget consumers suffer the consequences of shifting from a competitive price to a monopolistic price. There are three million consumers who are sad because they can no longer buy widgets, and the seven million remaining consumers are sad because they have to pay a $3 surcharge per widget, a transfer of wealth that goes straight to you, the undeserving widget manufacturer.
Because shareholders are typically wealthier than consumers, monopoly profits typically end up transferring wealth from the poor to the rich. Competition may be for losers, but competition does play a role in maximizing economic output, spurring innovation, and creating a more equal distribution of wealth.
Businesses are always going to be highly incentivized to seek monopoly profits, and they have no reason to be picky about how they arrive at that goal. Inventing a new vaccine or developing commercialized nuclear fusion would be great, but that is probably out of reach for most. Any method of avoiding competition will do.
One view of cartels is that they are more of a historical curiosity than anything else. More often than not, an introductory economics textbook will discuss cartels only in passing.
Although it is theoretically possible for a group of firms to obtain monopoly profits by forming a cartel, one learns in an introductory economics class that this is difficult in practice because cartels are inherently unstable. There is a high temptation for any cartel member to cheat. By exceeding your quota, you can take advantage of high prices and unmet demand to make a lot of money.
In our widget example, perhaps instead of selling 700,000 widgets at $13, you sell the full million at $12.75. You would make $3.75 times one million instead of $4 times 700,000, that is $3.75 million instead of $2.8 million. The problem is, everyone will also realize that they should cheat and they will end up driving everything back to the competitive price of $10 and everyone will lose their monopoly profits. This tends to happen in real life, too; OPEC sets production quotas that smaller members sometimes violate.
There is an added complication, which we discussed above - in most situations, cartels are very illegal. It is fine for OPEC, which is an organization of sovereign nations that do not have to follow American law, but most firms do not have that luxury.
In summary, by this view, cartels are illegal and unstable, therefore they are rare and not worthy of study.
There is another view, articulated recently by critics such as New York Times columnist David Brooks and venture capitalist Marc Andreessen. These critics see cartels as perhaps the single biggest culprit behind the major challenges facing the American economy today. This is what one might call The Cartel Theory of Everything.2
Brooks makes the case, citing Brookings economist Jonathan Rothwell, that the top one percent of earners in America are disproportionately composed of members of professions that have convinced legislators to allow them to collude to restrict supply and pass laws that shield existing members from competition. In other words, legalized cartels.
His chief example is the medical profession. In America, the number of medical school and residency slots is capped, and other medical professionals such as nurse practitioners are legally limited in what they can do. As a result, doctors and surgeons in the US get paid over double what doctors and surgeons get paid in Western Europe even relative to the average worker in their countries.
He also points out that there are eight times as many software developers as there are dentists in America, but there are about as many dentists as there are software developers in the top one percent of earners, the result of restricted entry to the dental profession, as well as laws that limit the kind of work that dental hygienists can do.
Andreessen argues that this issue extends to higher education, that there is a college cartel that controls accreditation and thus controls access to critical federal student loan funds, so that no innovative alternative can ever break through.
Both Brooks and Andreessen identify housing as possibly the biggest cartel of them all. We have covered the housing cartel at length here in prior editions, where existing homeowners in a city frequently enact policies to restrict or prohibit the construction of new housing, resulting in artificially high rents and housing prices.
The above chart was originally created by AEI economist Mark Perry, showing the prices of major categories of goods and services over time. Perry observes that there are several potential interpretations, all of which are intertwined. The blue categories are mostly manufactured goods, where there is a lot more innovation that holds prices down relative to the red categories, which are mostly services. Manufactured goods also are mostly globally tradeable, which exposes them to foreign competition that the red categories are generally protected from. Finally, the blue categories have a lot less government involvement and regulation than the red categories.
We can add one more potential explanation to the mix: the red categories - higher education, medical care, and housing - are also where we have identified the involvement of cartels that conspire to keep supply artificially restricted and prices high.
In the case of housing, we can test this hypothesis by comparing markets where new constriction is restricted by law to markets where construction is more open. If local cartels are a major factor, we would expect price growth to be concentrated in restricted markets, all things being equal.
Below we can compare San Francisco and Boston, two markets that restrict building, to Chicago and Atlanta, major cities which are economically healthy but also allow construction. Housing prices in the former have tripled since the turn of the century, while housing prices have not even doubled in the latter, evidence of the impact of barriers to entry erected by cartels.
Housing, medical care, and education combine to make up almost 40% of GDP (depending on how you measure it), but that actually understates their importance to the standard of living for the average American. These are all necessities, and therefore they are goods that poorer households are forced to spend a much larger share of their income on than richer households. For example, in California, 56% of low-income households spend more than half their income on housing. By comparison, only 2% of high-income households in California end up spending over 50% of their income on shelter.
Cost-burdened low-income renters are only part of the story when it comes to housing scarcity. As we found in an earlier edition, one is lucky to find a home in a high-wage region at all. Many of the lowest-income households are forced to live and work in low-wage regions, or live in low-cost regions and commute for hours to high-wage regions, or suffer overcrowded conditions in high-wage regions, or in some cases even end up living on the street.
As we saw in our widget example, the price increase captured by a cartel functions as a tax, except that tax proceeds get transferred to cartel members rather than to the government. Any cartel that exists in the production of an essential good will transfer wealth from the poorest households to the richest households.
A cartel will also leave what economists call a “deadweight loss”. In our widget example, it is the three million widget buyers who are sad and widget-less because they are not willing or able to meet the higher price set by the cartel. In the case of housing, the impact is more serious, because high productivity and therefore high wages depend on being close to other highly productive workers. A worker in Oklahoma City will usually end up getting paid less than a worker in San Francisco for doing the exact same job. Most American households avoid inflated housing costs by living in less-restricted markets, but still end up bearing the hidden cost of lower wages.
Economists Chang-Hai Hsieh and Enrico Moretti estimate that housing supply restrictions have reduced economic growth by 36% since the 1960s. If that is accurate, restrictions in the housing sector indirectly actually end up costing the economy over $7 trillion a year, a burden that is disproportionately borne by the lowest income households.
Returning to our original puzzle, it is clear that the secret to a successful cartel is to recruit the government to your side. The government can make anything legal. The government also will solve the other typical cartel problem, the temptation for members to cheat and undermine the whole enterprise. If violating a quota is actually illegal, enforcing compliance becomes much easier.
How do you convince the government that a widget cartel is actually in the public interest? You have to be a little bit clever in your PR campaign; you can’t simply come out and admit that you wish to gouge widget consumers for your own profit.
One semi-legitimate argument that you can deploy is that cartels are simply more stable. Firms that are insulated from competition are unlikely to go out of business. In the decades following the Depression, banks benefited from strict limits on competition, limits imposed with the intent of curbing bank failures.3 We have also looked at the case study of the airline industry before deregulation in 1978; the airline industry of that era was very stable, even if fares were sky-high.
These may not be satisfying examples, as these cartels (and others of the era) came to a sudden end when the government eventually decided that the American public would be better off with much lower airfares and easier access to credit, even if it came at the cost of a few firms going out of business. Even after airlines and banks went under in droves, there seems to be little popular appetite to return to an era when a cross-country flight cost $1,500 and credit was hard to come by. It is hard to put the toothpaste back in the tube.
Another argument you can deploy is that your cartel is somehow in the public interest; perhaps you can argue that it is necessary for public safety. This was a tactic the airlines tried (although air travel is now safer than it ever was), and that doctors and dentists and even lawyers employ today.
You can also argue that the cartel is necessary to maintain the integrity of the product; homeowners argue that residents prefer to live in places with limited density (even though the highest rents are frequently found in the densest parts of the densest cities, like San Francisco and New York), and the NCAA argues that fans will not watch college athletes if they get paid (even though athletes have been paid under the table by boosters since the dawn of college sports).4 Any plausible sounding argument is usually enough to at least distract people from the real issue.
One potential strategy is to quietly migrate from legitimate cooperation to rules that limit competition and increase member profits. Firms are allowed to cooperate to set industry standards and to lobby for the interests of their members, but they are not allowed to collude to raise prices. Sometimes they cross the line; for example, last year, the National Association of Realtors was forced by the Department of Justice to change their rules to make it harder for buyers’ agents to steer their clients to homes where they would earn a larger commission.
The most successful cartels do not look like cartels at all. When you think of a cartel, you think of fat-cat corporate executives in a smoke-filled room. The cartels we have identified so far look nothing like that. Professional associations of doctors and dentists and lawyers are groups of white-collar workers that look just like you and me. Homeowners in coastal cities look no different from normal homeowners, they are just far wealthier. Most cartel members today are scarcely aware they are part of a cartel at all.
Official organizations can pull off cartels as well. Your odds are better if you are part of a non-profit organization, where people are more likely to believe that you are acting in the public interest. (Don’t worry about the non-profit designation; every organization is run for someone’s profit, and non-profit status means no taxes!)
A disproportionate number of antitrust cases seem to involve non-profits. The Blue Cross Blue Shield association of health insurers reached a $2.7 billion antitrust settlement last year over practices that raised prices for consumers. In 1993, the Ivy League schools and MIT agreed to a settlement with the Justice Department whereby they were forced to stop colluding on financial aid packages and faculty salaries.
One of the most successful cartels of all is the NCAA, the non-profit organization which oversees all major collegiate athletics programs. The NCAA has managed to maintain rules that prevent their members from compensating the players that produce their product, even as men’s basketball and football programs now bring in tens or even hundreds of millions of dollars for their schools.
It is crucial for a cartel to maintain the right framing for public consumption. In the NCAA’s language, the players who spend the majority of their days training to compete are not regular employees but “student-athletes”. The NCAA publicly denies that it is in any way a cartel, despite all evidence to the contrary, perhaps just another example of Peter Thiel’s rule that real monopolies are easily identified because they are the only ones that vigorously deny any suggestion that they are a monopoly.
Another tactic is to allocate a portion of your monopoly profits to public relations and advertising to improve public opinion toward your cartel. The NCAA and NFL are good examples of this.
A smart cartel will also lobby and buy off key special interest groups whose support they will need. We saw previously that one of the biggest missteps the airline industry made when fighting deregulation was not convincing the airline unions that the cartel was crucial to maintaining wages. The airline unions supported deregulation in exchange for increased bargaining power, which was of little use when deregulation destroyed monopoly revenues, which in turn resulted in lower employee compensation.
It is a good idea to also publicly support strategic exemptions to cartel pricing for those who cannot afford it, if it is at all possible. You can only make money off of the people who can afford the monopoly price, so you are happy to allow people who cannot afford the monopoly to buy at a lower price, if you can keep it from undermining your monopoly. In our widget example, you can still make money selling at $10, so if you can separate those who can only afford $10 from those who are able to pay $13 by making them apply for a discount and supplying proof they cannot pay, you will still come out ahead. Pharmaceutical companies call such programs “patient assistance” and colleges call it “financial aid”, but all of these programs share the same intent: to allow monopoly sellers to extract the maximum revenue from each consumer.
If people are upset about inflated prices resulting from the cartel, adamantly deny that cartel behavior has anything to do with high prices. As a bonus, convince the public that the government should try to rectify the situation by offering subsidies to consumers. This will do nothing for affordability as long as it is not coupled with price controls, as the cartel has enough market power to raise prices to capture the subsidy. The net result is a new direct transfer of wealth from the government to cartel members, which is exactly what you want. This is a standard tactic you see in higher education, healthcare and housing.
The housing market provides an example of many of these strategies in action. Existing homeowners have a lot to lose from new development, which in addition to changing the neighborhood they bought into (which they must have liked the way it was, to have moved there in the first place), provides competition for existing homes and depresses rents and housing prices.
Existing homeowners therefore should naturally support anything that acts as a tax on new development. They do not want to be seen as directly gouging renters and buyers, so they are happy to ally with any group that wants to make new construction more expensive, from construction unions to environmental groups.
They will also support taxes on new development. One popular tax on new development (which is less bad) is the affordable housing mandate, which is merely a tax on new development whose proceeds are allocated by lottery to people that can prove they cannot afford the monopoly price (another example of means-tested financial aid).
It also makes sense for existing homeowners to support rent control in exchange for political support of restrictions on new construction. The key is that the form of rent control most commonly implemented only applies to the few property owners that rent out their properties on a monthly basis. Rent control does not generally affect existing homeowners, as they have a workaround; they rent to themselves, and then will sell at an unrestricted price when they move.
The sale of a home, of course, is just rent by another name; a home buyer is paying a lump sum up front for rent in perpetuity, bundled with the cost of future maintenance and taxes. Homeowners should come out ahead from this type of rent control; developers are dissuaded from building new rentals and homeowners preserve the ability to gouge future residents.
Existing homeowners will also support government subsidies for homebuyers and renters intended to make housing more affordable, as it will inevitably mostly end up in their own pockets. Most studies show that programs like tax deductions for mortgage interest and tax breaks for imputed rental income and capital gains are giveaways to existing homeowners that end up forcing future buyers to pay more homes, and have no real impact on affordability.
Let’s say you are a member of a cartel. You want to know how to evaluate cartel membership as an asset, and how to think about the risk of impairment.
The value of membership in a cartel is the difference between the future profit you expect as a cartel member and the future profit you would obtain in a competitive market. To maintain the cartel, members typically have production quotas that restrict supply. Your quota has value as long as the cartel remains in place and demand exceeds the combined quota.
We saw that when the airline industry was regulated, airlines owned government-issued route certificates that entitled them to operate with certain frequencies on certain routes. Route certificates were scarce and as long as the route was profitable, the certificate had value. After deregulation, route certificates were unnecessary and became worthless.
We also looked at the history of taxi medallions. In that particular case, the value of medallions grew over the years but then suddenly plummeted as demand for taxis shrank following the entrance of ride-sharing services such as Uber. If the total supply quota exceeds demand, your medallion will have no value.
Conversely, if demand grows unexpectedly, prices will increase sharply since supply cannot respond. This is what has happened to housing in many coastal cities over the last two decades where demand grew while supply was restricted.5
Interestingly, perhaps the biggest risk to a cartel is not opposition from its direct victims (suppliers and consumers), who are diffuse and frequently unaware of the existence of the cartel, but rather discontent from some of its own members. Even if the whole cartel prospers, members only care about their own individual outcome, and cartels frequently also redistribute income between members in such a way that manages to leave some members worse off than they were before.
In our airline case study from the 1970s, deregulation ended up passing with the assistance of United Airlines, which effectively vetoed the efforts of the airline industry to block it. United felt that they were a strong enough operator that they would capture enough increased market share from deregulation to outweigh the drawbacks of lower per unit profitability.
Another interesting case study involves the NCAA. Until the early 1980s, the NCAA only allowed one college football game to be televised per week; the restricted supply drove up the cost of television rights.6 This policy was not challenged by college football viewers, who could rarely watch their favorite team, nor was it challenged by the television networks that paid the inflated rights fees.
It actually was some of the NCAA’s own members who successfully challenged it, in a landmark 1984 Supreme Court case, NCAA v. Board of Regents of the University of Oklahoma. Rewards from the existing contract were spread fairly evenly throughout the entire membership of the NCAA, even though a small minority of major football programs (like Oklahoma) contributed most of the viewer demand.
Those major programs wanted to keep the revenue for themselves rather than allow it to be redistributed to the hundreds of smaller NCAA members. In the wake of the ruling, total broadcast revenues initially fell as more games became available to broadcasters, but they eventually recovered, and today dozens of college football games are televised each week, and the major programs are awash in money.
There is a housing proposal that would seem to have the benefit (or drawback, depending on your perspective) of targeting this particular cartel weakness, and brings together some of the concepts we have touched on so far.
First, recall that we can think of the value of a property as some combination of the value of the land, the building, and the development rights attached to the property. We called these development rights “medallions” in an earlier edition, and we will stick with that terminology - they can be a function of zoning rules or specific development rights that can be granted or even bought and sold, as in the case of transferable development rights (often referred to as “air rights”) in New York City and other jurisdictions.
The value of an asset is a function of its cash flows from now until eternity, so a good way to think about a property is to work backwards from what it will be in the future, rather than what it is today.
A residential property has value because it provides shelter in a place where people want to live. An empty piece of land in a good location should be valued as the difference between the value of the best finished property that can be built on it and the cost of construction. (This is why an existing building can lower the value of a piece of land - the cost of construction includes the cost of tearing down what is already there, if necessary.)
We can go one step further and say that the value of land is the combination of what the value of the land would be if there were no limitations on construction, and the value of the development rights attached to it, what we are calling medallions.7
We can check this theory by looking at the market for land in New York City, which appears to be quoted as a price per “buildable square foot”. That is, you are expected to pay a price that is a function of the floor space of the largest building you can legally develop on the plot of land, regardless of the actual amount of land you are buying.8 This conforms with our theory that it is the medallion value that predominates when you are buying a property in a high-demand, supply-constrained city.9
It is no coincidence that this housing example parallels our widget example, because wherever you have a successful cartel, most of the value of a business operating under that cartel is likely to be mostly attributable to the monopoly economics created by the cartel. There is usually a huge gap between monopoly profitability and competitive profitability. In the middle of the country, where housing production is less constrained, a homeowner would expect any increase in demand to be offset by new construction, keeping housing prices in check as long as construction costs stay in line.
The more valuable medallions become, the more property owners will want to be granted new medallions. This will be particularly acute for property owners who are land-rich but medallion-poor; perhaps they have an underdeveloped parcel of land in a central location, like a single family home on a large piece of land near mass transit.
New medallions will of course reduce the value of existing medallions, since they will soon result in new construction, so they are not in the interest of existing property owners as a whole. They are especially not in the interest of property owners who have already maximized the development potential of their land, like for example the owner of a high-rise condominium.10
The owner of an underdeveloped parcel of land should want the total supply of medallions to stay in check while being personally granted new medallions for free (free medallions being effectively equivalent to free money). This is indeed what developers sometimes lobby for; development restrictions for thee but not for me.
We have the same situation with our housing cartel as we had with the airline cartel and the college football cartel. The cartel benefits the interests of the members as a whole, but the spoils are currently divided in a way that some of the individual members are allocated such low quotas that they would be better off with an unconstrained market and will oppose the cartel, given the opportunity. The owners of undeveloped or underdeveloped land in prime locations are like Southwest Airlines in the 1970s or the University of Oklahoma in the 1980s.11
I call this idea “street by street zoning,” and it has been outlined in a recent paper by John Myers, co-founder of London YIMBY. The basic idea is simple: Let each street decide on its own how it wants to zone commercial activity, including construction. Of course, in some contexts the deciding entity won’t be a street but rather a block or some other very small neighborhood area.
The upside is that street-by-street zoning would allow so much room for experimentation. Some zoning reforms might increase home values; a street might decide to allow for multiple dwellings on a lot (an in-law apartment in a backyard barn?), or make it easier to “upzone” by making it easier to rebuild.
There is no commonly known example of street-by-street zoning, but some partial instantiations of the idea can be found. In New Zealand, individual homeowners can waive some rules governing neighboring properties, and the English system of neighborhood planning allows for some use of local development plans, backed by local referenda.
Street-by-street zoning would allow neighborhoods to defect from the city-wide cartel and vote to mint medallions for themselves. Landowners in the most underdeveloped prime locations would almost certainly wish to do so; for example, at Manhattan prices, the owner of a modest 8,000 square foot parcel of land might be entitled to a grant of 80,000 square feet of air rights (using a floor-to-area ratio of 10), which at $350 per square foot, would be worth $28 million.
Such a proposal would naturally split homeowners in the same way similar proposals split airlines and college football programs decades ago, and therefore some form of this proposal stands a better chance of political approval.
Street-by-street zoning also partially negates the stated rationale for allowing cities a free hand to restrict building, which usually invokes the importance of local control. If local control at the city level is better than local control at the state level, then certainly local control at the neighborhood level is even better?
A proposal of this nature is by no means a sure thing. For one, some homeowners may still prefer the status quo over receiving a lot of money and being forced to move, or staying in a changed neighborhood. Also, at least in the U.S., taxes might make redevelopment a less attractive option for homeowners in many cases. However, this type of creative proposal has a higher chance of success than most.
It is now fashionable to be concerned about the monopoly power of Big Tech, and to have an opinion about Amazon’s private label efforts or Apple’s App Store policies. Big Tech is very visible, perhaps so much so that it is overrated as a threat. Big organizations like Amazon are easy to track and regulate. We are already predisposed to think of big corporations as an evil menace.
Cartels are effective precisely because they do not look like evil monopolies at all. The coastal homeowner campaigning against new development looks like your mother, and very well might actually be your mother. Doctors and schoolteachers are the healers and educators of society, not the enemy. None of them believe that they are advocating for policies that take from the poor and give to the rich; they are certain that the true problem with housing must lie with developers and investors, or that the true problem with health care must lie with administrators and CEOs.
This is what makes cartels more dangerous. The tech sector is actually quite small compared to housing and health care; none of the major tech companies have revenue much greater than $200 billion globally, while housing and health care reach into the multiple trillions of dollars per year in the U.S. alone.
Cartels only persist because voters and legislators support them and exempt them from some of the laws that govern most businesses. Cartel members make up a very small subset of voters; even in the case of housing, although the majority of American households are homeowners, only a tiny fraction are in markets that benefit from restricted supply. They rely on the support of other voters to maintain the status quo.
Properly recognizing and understanding cartels is crucial to understanding economic policy today. We have to decide: Is competition for losers, or should competition apply to everyone?
In the last two weeks, workers at Kellogg’s and John Deere have gone on strike, and the main sticking point is the two-tier wage system those companies seek to extend. We previously examined the drawbacks of two-tier systems, which are a way for current employees to achieve higher wages and benefits at the expense of future employees (who have no say) by creating a lower “b-scale” for new employees. Inevitably, the new employees resent the old employees for selling them out and tear down the two-tier system as soon as they gain sufficient numbers to do so. Ultimately, this also causes trust to break down; the new employees don’t trust the old employees, and neither of them trust management, who proposed the two-tier system in the first place.
We looked at some ways that we succumb to the temptation for incumbents to build b-scales into different aspects of society, specifically in housing policy, which also tends to end up freezing out the next generation. What is most remarkable (and depressing) is that companies and unions continue to propose and pass two-tier wage systems even after seeing them backfire everywhere else.
Bloomberg published another look at unfair property tax assessments, this time focused on New York. We covered an earlier entry in this series that was focused on Detroit. Once again, they find that the richest homeowners pay the lowest rates, while working class homeowners pay much higher rates. One consistent theme we have covered here is that regressive tax policy compounds our housing issues; while we debate the taxation of unrealized capital gains for the builders of productive capital, we don’t even tax most realized income and capital gains for the wealthiest housing owners, who are merely capturing cartel profits while actually blocking the deployment of productive capital.
This has become a classic example of attempted price-fixing; it is cited in Gregory Mankiw’s popular economics textbook, for example. However, there are more interesting stories from the genre. One hilarious essay from John Brooks’s Business Adventures covers GE’s involvement in a 1950s price-fixing scandal that resulted in Congressional hearings, and Kurt Eichenwald’s The Informant (later a movie starring Matt Damon) is about a whistleblower at Archer-Daniels-Midland (ADM) in the 1990s who cooperates with the FBI in unraveling an international price-fixing conspiracy, and then goes to jail himself for embezzling millions from his employer.
I am naming this after The Housing Theory of Everything, an excellent essay published last month by Sam Bowman, John Myers, and Ben Southwood, comprehensively documenting the deleterious consequences of housing restrictions on everything in society. Since the housing cartel is merely one of many cartels in America (albeit probably the biggest), it seems appropriate.
The tradeoff did not go unnoticed at the time. According to the FDIC: In a speech marking the dedication of the headquarters building of the FDIC in 1963, Wright Patman, then-Chairman of the House Banking and Currency Committee, declared: . . .” I think we should have more bank failures. The record of the last several years of almost no bank failures and, finally last year, no bank failure at all, is to me a danger signal that we have gone too far in the direction of bank safety.”
The full story of the NCAA is told by Taylor Branch in this classic 2011 article in the Atlantic; in it, he documents that player compensation was so deeply ingrained in early college sports that in 1939, players at the University of Pittsburgh actually went on strike over unfair pay.
As a cartel member, this is not necessarily a good thing - remember that you are interested in the long term sustainability of your cartel, and volatile prices create a lot of unwanted bad press that can evolve into unfavorable legislation. Even OPEC continually talks about price stability as a goal.
It might seem a bit abstract to divide a property between the land, development rights, and physical structure, but it is useful from an analytical standpoint. One example: Why do people claim that housing prices are interest rate sensitive? Interest rates don’t usually affect the price of durable goods very much; you don’t expect Boeing and Airbus to be able to charge more for airplanes when interest rates go down, you expect competition to hold down airplane prices and airlines will end up buying more planes because lower interest rates lower their total cost of ownership. It does make sense that scarce intangible assets like land and development rights will be interest rate sensitive, since they can’t be manufactured in the same way houses can. Therefore you would expect lower interest rates to have the biggest impact on home prices in supply-constrained areas, since that is where the housing bundle is heavily weighted toward development rights, which is about what we actually observe.
This can’t exactly be true, since a tall building is much more expensive to construct than a short one on a per square foot basis, but directionally it seems to be correct.
This article has additional evidence for this theory, indicating that development sites in Manhattan cost $684 per buildable square foot while construction costs average only $362 per square foot. Also, there is a limited market for air rights (which are just transferrable building permits) in New York City, which can be sold only to adjoining property owners; one recent major high-profile transaction cleared at $350 per square foot.
There are clearly some second order effects here we are ignoring for now; the value of a property is a function of all of the other buildings and infrastructure it is connected to, so there are a lot of other forces that will affect the value of nearby properties following new development. We are just looking at what is likely to be the primary impact.
As an aside, you might hear some people claim that making it easier to build would actually benefit current homeowners, while others claim that it would harm them. A framework like this makes it clear that less-restricted development would definitely be to the economic benefit of some homeowners (single-family homeowners in prime locations) and definitely economically harm others (condo owners in marginal locations), with the remainder being somewhere in between. As a whole, homeowners would lose out from more development, but the effect on any individual homeowner is ambiguous and depends on their situation.