# Unit 11 Rent-seeking, price-setting, and market dynamics

Rent-seeking explains why prices change (and why sometimes they don’t), and how markets work (sometimes for better, sometimes for worse)

• Prices are messages about conditions in the economy, and provide motivation for acting on this information.
• People take advantage of rent-seeking opportunities when competitive markets are not in equilibrium, often profiting by setting a price different from what others are setting.
• This rent-seeking process may eventually equate supply to demand.
• Prices in financial markets are determined through trading mechanisms and can change from minute to minute in response to new information and changing beliefs.
• Price bubbles can occur, for example in markets for financial assets.
• Governments and firms sometimes set prices and adopt other policies such that markets do not clear.
• Economic rents help explain how markets work.

Fish and fishing are a major part of the life of the people of Kerala in India. Most eat fish at least once a day, and more than a million people are involved in the fishing industry. But before 1997, prices were high and fishing profits were limited due to a combination of waste and the bargaining power of fish merchants, who purchased the fishermen’s catch and sold it to consumers.

When returning to port to sell their daily catch of sardines to the fish merchants, many fishermen found that the merchants already had as many fish as they needed that day. They would be forced to dump their worthless catch back into the sea. A lucky few returned to the right port at the right time when demand exceeded supply, and they were rewarded by extraordinarily high prices.

On 14 January 1997, for example, 11 boatloads of fish brought to the market at the town of Badagara found the market oversupplied, and jettisoned their catch. There was excess supply of 11 boatloads. But at fish markets within 15 km of Badagara there was excess demand: 15 buyers left the Chombala market unable to purchase fish at any price. The luck, or lack of it, of fishermen returning to the ports along the Kerala coast is illustrated in Figure 11.1.

law of one price
Holds when a good is traded at the same price across all buyers and sellers. If a good were sold at different prices in different places, a trader could buy it cheaply in one place and sell it at a higher price in another. See also: arbitrage.

Only seven of the 15 markets did not suffer either from over- or under-supply. In these seven villages (on the vertical line) prices ranged from Rs. 4 per kg to more than Rs. 7 per kg. This is an example of how the law of one price—a characteristic of a competitive market equilibrium—is sometimes a poor guide to how actual markets function.

When the fishermen have bargaining power because there is excess demand, they get much higher prices. In markets with neither excess demand nor excess supply, the average price was Rs. 5.9 per kg, shown by the horizontal dashed line. In markets with excess demand, the average was Rs. 9.3 per kg. The fishermen fortunate enough to put in at these markets obtained extraordinary profits, if we assume that the price in markets with neither excess demand nor supply was high enough to yield economic profits. Of course, on the following day they may have been the unlucky ones who found no buyers at all, and so would dump their catch into the sea.

This all changed when the fishermen got mobile phones. While still at sea, the returning fishermen would phone the beach fish markets and pick the one at which the prices that day were highest. If they returned to a high-priced market they would earn an economic rent (that is, income in excess of their next best alternative, which would be returning to a market with no excess demand or even one with excess supply).

By gaining access to real-time market information on relative prices for fish, the fishermen could adjust their pattern of production (fishing) and distribution (the market they visit) to secure the highest returns.

A study of 15 beach markets along 225 km of the northern Kerala coast found that, once the fishermen used mobile phones, differences in daily prices among the beach markets were cut to a quarter of their previous levels. No boats jettisoned their catches. Reduced waste and the elimination of the dealers’ bargaining power raised the profits of fishermen by 8% at the same time as consumer prices fell by 4%.

Mobile phones allowed the fishermen to become very effective rent-seekers, and their rent-seeking activities changed how Kerala’s fish markets worked: they came close to implementing the law of one price, virtually eliminating the periodic excess demand and supply, to the benefit of fisher­men and consumers (but not of the fish dealers who had acted as middlemen).

This happened because the Kerala sardine fishermen could respond to the information given by the prices at different beaches. It is another example of the idea we introduced in Unit 8 to explain the effect of the American Civil War on markets for cotton: that prices can be messages. For the economist Friedrich Hayek, this was the key to understanding markets.

### Great economists Friedrich Hayek

The Great Depression of the 1930s ravaged the capitalist economies of Europe and North America, throwing a quarter of the workforce out of work in the US. During the same period, the centrally planned economy of the Soviet Union continued to grow rapidly under a succession of five-year plans. Even the arch-opponent of socialism, Joseph Schumpeter, had conceded:

‘Can socialism work? Of course it can … There is nothing wrong with the pure theory of socialism.’

Friedrich Hayek (1899–1992) disagreed. Born in Vienna, he was an Austrian (later British) economist and philosopher who believed that the government should play a minimal role in the running of society. He was against any efforts to redistribute income in the name of social justice. He was also an opponent of the policies advocated by John Maynard Keynes designed to moderate the instability of the economy and the insecurity of employment.

Hayek’s book The Road to Serfdom was written against the backdrop of the Second World War, when economic planning was being used both by German and Japanese fascist governments, by the Soviet communist authorities, and by the British and American governments. He argued that well-intentioned planning would inevitably lead to a totalitarian outcome.1

His key idea about economics revolutionized how economists think about markets. It was that prices are messages. They convey valuable information about how scarce a good is, but information that is available only if prices are free to be determined by supply and demand, rather than by the decisions of planners. Hayek even wrote a comic book, which was distributed by General Motors, to explain how this mechanism was superior to planning.

But Hayek did not think much of the theory of competitive equilibrium that we explained in Unit 8, in which all buyers and sellers are price-takers. ‘The modern theory of competitive equilibrium,’ he wrote, ‘assumes the situation to exist which a true explanation ought to account for as the effect of the competitive process.’

In Hayek’s view, assuming a state of equilibrium (as Walras had done in developing general equilibrium theory) prevents us from analysing competition seriously. He defined competition as ‘the action of endeavouring to gain what another endeavours to gain at the same time.’ Hayek explained:

Now, how many of the devices adopted in ordinary life to that end would still be open to a seller in a market in which so-called ‘perfect competition’ prevails? I believe that the answer is exactly none. Advertising, undercutting, and improving (‘differentiating’) the goods or services produced are all excluded by definition—’perfect’ competition means indeed the absence of all competitive activities. (The Meaning of Competition, 1946)

The advantage of capitalism, to Hayek, is that it provides the right information to the right people. In 1945, he wrote:

Which of these systems [central planning or competition] is likely to be more efficient depends mainly on the question under which of them we can expect [to make fuller use] of the existing knowledge. This, in turn, depends on whether we are more likely to succeed in putting at the disposal of a single central authority all the knowledge which ought to be used but which is initially dispersed among many different individuals, or in conveying to the individuals such additional knowledge as they need in order to enable them to dovetail their plans with those of others. (The Use of Knowledge in Society, 1945)

Hayek’s challenging ideas, and their application, are still fiercely debated today.2

exogenous
Coming from outside the model rather than being produced by the workings of the model itself. See also: endogenous.
endogenous
Produced by the workings of a model rather than coming from outside the model. See also: exogenous.

Unit 8 introduced the concept of competitive market equilibrium, a situation in which the actions of the buyers and sellers of a good have no tendency to change its price, or the quantity traded, and the market clears. We saw that changes from the outside called exogenous shocks, like an increase in the demand for bread or a new tax, will alter the equilibrium price and quantity.

The opposite of exogenous is endogenous, meaning ‘coming from the inside’ and resulting from the workings of the model itself. In this unit, we will study how prices and quantities change through endogenous responses to exogenous shocks and the real-world competition that Hayek complained was absent from the model of competitive equilibrium. We will see that rent-seeking behaviour by market participants can bring about market clearing, move markets to different equilibria in the long run, cause bubbles and crashes, or lead to the development of secondary markets in response to price controls.

### Question 11.1 Choose the correct answer(s)

Figure 11.1 shows how bargaining power affected prices in Kerala beach markets on 14 January 1997. Based on this information, what can we conclude?

• The higher the excess supply, the lower the price of fish.
• The price of fish in all markets with excess demand is 9.3.
• The data satisfy the law of one price.
• The data demonstrate that buyers have bargaining power when there is excess supply.
• The price of fish is zero in all markets with excess supply.
• The average price in the markets with excess demand is 9.3, but the higher the excess demand, the higher the price.
• The law of one price is not satisfied because fish are sold at different prices in different places.
• When there is excess supply, the price is zero. The buyers have all the bargaining power while sellers have none.

## 11.1 How people changing prices to gain rents can lead to a market equilibrium

When Lincoln’s decision to blockade the southern ports led to a drastic shortage of cotton on the world market (Unit 8), people saw the opportunity to benefit by changing the price. In turn, these price changes sent a message to producers and consumers around the world to change their behaviour.

The blockade was an exogenous shock that changed the market equilibrium. In a competitive equilibrium, all trades take place at the same price (the market-clearing price), and buyers and sellers are price-takers. An exogenous shift in supply or demand means that the price has to change if the market is to reach the new equilibrium. The following example shows how this can happen.

Figure 11.2 shows the competitive equilibrium in a market for mangoes. At point A, the equilibrium price equalizes the number of mangoes demanded by consumers to the number produced and sold by mango-sellers. At this point, no one can benefit by offering or charging a different price, given the price everyone else is offering or charging—it is a Nash equilibrium. Follow the steps in Figure 11.2 to see how an increase in the demand for mangoes gives mango-sellers an opportunity to benefit.

Figure 11.2 An increase in demand in a competitive market: Opportunities for rent-seeking.

Equilibrium

At point A, the market is in equilibrium at a price of Rs. 8. The supply curve is the marginal cost curve, so the marginal cost of producing a mango is Rs. 8.

An exogenous demand shock

The shock shifts the demand curve to the right.

Excess demand

At the going price, the number of mangoes demanded exceeds the number supplied (point D).

Raising the price

When demand has increased, a mango-seller who observes more customers will realize that she can make higher profits by raising the price. She could sell as many mangoes at any price between A and B.

Increasing quantity

If she sells the same quantity as before at a higher price, the price exceeds the marginal cost of a mango. She earns an economic rent. But she could do even better by increasing the quantity as well.

A new equilibrium

As a result of the rent-seeking behaviour of mango-sellers, the mango industry adjusts. Prices and quantities increase until a new equilibrium emerges at point C.

At the original point of competitive equilibrium (A) the price was Rs. 8, and all buyers and sellers were acting as price-takers. When demand increases, the buyers or sellers do not immediately know that the equilibrium price has risen to Rs. 10. If everyone were to remain a price-taker, the price would not change. But when demand shifts, some of the buyers or sellers will realize that they can benefit by being a price-maker, and decide to charge a different price from the others.

For example, when a mango-seller notices that every day there are customers wishing to buy mangoes, but none left on the shelf, she realizes that some customers would have been happy to pay more than the going price, and that some who paid the going price for their mango would have been willing to pay more. So the mango-seller will raise her price the next day—price-taking is no longer her best strategy, and she becomes a price-maker. She does not know exactly where the new demand curve is, but she cannot fail to see the people who want to buy mangoes go home disappointed.

By raising the price she raises her profit rate, and earns an economic rent (at least temporarily)—that is, she makes higher profits than are necessary to keep her mango business going. Moreover, because her price now exceeds her marginal cost, she will produce and sell more mangoes. The same is true of other mango-sellers who will experiment with higher prices and increased outputs.

As a result of the rent-seeking behaviour of mango-sellers, the market adjusts to the new equilibrium at point C in Figure 11.2. At this point the market again clears, supply is equal to demand, and none of the sellers or buyers can benefit from charging a price different from Rs. 10. They all return to being price-takers, until the next change in supply or demand comes along.

When a market is not in equilibrium, both buyers and sellers can act as price-makers, transacting at a price different from the previous equilibrium price. If we start from the original equilibrium and take the opposite case of a fall in demand for mangoes, there will be excess supply at the going price of Rs. 8. A customer at the mango shop might say to the mango-seller: ‘I see you have quite a few unsold mangoes piling up on your shelf. I’d be happy to buy one of those for Rs. 7.’ To the buyer this would be a bargain. But it’s also a good deal for the seller, because at the reduced level of sales, Rs. 7 is still greater than the mango-seller’s marginal cost of producing/procuring the mango.

### Market equilibration through rent-seeking

disequilibrium rent
The economic rent that arises when a market is not in equilibrium, for example when there is excess demand or excess supply in a market for some good or service. In contrast, rents that arise in equilibrium are called equilibrium rents.

The mangoes example illustrates how markets adjust to equilibrium through the pursuit of disequilibrium economic rents:

• When a market is in competitive equilibrium: If there is an exogenous change in demand or supply, there will be either excess demand or excess supply at the original price.
• Then, there are potential rents: Some buyers are willing to pay prices that are different from the original price, but above the marginal cost for the seller.
• While the market is in disequilibrium: Buyers and sellers can gain these rents by transacting at different prices. They become price-makers.
• This process continues until there is a new competitive equilibrium: At this point there is no excess demand or supply, and buyers and sellers are price-takers again.
innovation rents
Profits in excess of the opportunity cost of capital that an innovator gets by introducing a new technology, organizational form, or marketing strategy. Also known as: Schumpeterian rents.

Notice how market equilibration through rent-seeking resembles the process of technological improvement through rent-seeking modelled in Unit 2. There the exogenous change was the possibility of adopting a new technology. The first firm to do so gained innovation rents: profits in excess of the normal profit rate. This process went on until the innovation was widely diffused in the industry and prices had adjusted so that there were no further innovation rents to be had.

### Einstein Equilibration through rent-seeking in an experimental market

Economists have studied the behaviour of buyers and sellers in laboratory experiments to assess whether prices do adjust to equalize supply and demand. In the first such experiment, done in 1948, Edward Chamberlin gave each member of a group of Harvard students a card designating them as ‘buyers’ or ‘sellers’ and stating their willingness to pay or reservation price in dollars. They could then bargain amongst themselves, and he recorded the trades that took place. He found that prices tended to be lower, and the number of trades higher, than the equilibrium levels. Chamberlin would repeat the experiment every year. One of the students who took part in 1952, Vernon Smith, later conduc­ted his own experiments and won a Nobel Prize in economics as a result.

He modified the rules of the game so that participants had more information about what was happening: buyers and sellers called out prices that they were willing to offer or accept. When anyone agreed to a proposed deal, a trade took place and the two participants dropped out of the market. His second modification was to repeat the game several times, with the participants keeping the same card in each round.

### Exercise 11.5 What is the fundamental value of a Bitcoin?

A bubble may have occurred in the market for the virtual currency called Bitcoin. Bitcoin was introduced by a group of software developers in 2009. Where it is accepted, it can be transferred from one person to another as payment for goods and services.

Unlike other currencies it is not controlled by a single entity such as a central bank. Instead it is ‘mined’ by individuals who lend their computing power to verify and record Bitcoin transactions in the public ledger. At the start of 2013, a Bitcoin could be purchased for about $13. On 4 December 2013 it was trading at$1,147. It then lost more than half its value in two weeks. These and subsequent price swings are shown in Figure 11.16.

Use the models in this section, and the arguments for and against the existence of bubbles, to provide an account of the data in Figure 11.16.

### Exercise 11.6 The big ten asset price bubbles of the last 400 years

According to Charles Kindleberger, an economic historian, asset price bubbles have occurred across a wide variety of countries and time periods. The bubbles of the last 100 years have predominantly been focused on real estate, stocks, and foreign investment.10

• 1636: The Dutch tulip bubble
• 1720: The South Sea Company
• 1720: The Mississippi Scheme
• 1927–29: The 1920s stock price bubble
• 1970s: The surge in loans to Mexico and other developing economies
• 1985–89: The Japanese bubble in real estate and stocks
• 1985–89: The bubble in real estate and stocks in Finland, Norway and Sweden
• 1990s: The bubble in real estate and stocks in Thailand, Malaysia, Indonesia and several other Asian countries between 1992 and 1997, and the surge in foreign investment in Mexico 1990–99
• 1995–2000: The bubble in over-the-counter stocks in the US
• 2002–07: The bubble in real estate in the US, Britain, Spain, Ireland, and Iceland

Pick one of these asset price bubbles, find out more about it, and then:

1. Tell the story of this bubble using the models in this section.
2. Explain the relevance to your story, if any, of the arguments in the ‘Do bubbles exist?’ box in Section 11.6 about the existence of bubbles.

### Question 11.7 Choose the correct answer(s)

Which of the following statements about asset prices are correct?

• A bubble occurs when beliefs about future prices amplify a price rise.
• When positive feedback occurs, the market is quickly restored to equilibrium.
• Negative feedback is when prices give traders the wrong information about the fundamental value.
• When beliefs dampen price rises, the market equilibrium is stable.
• When beliefs amplify a price rise, the price moves further away from the fundamental value, causing a bubble.
• Positive feedback is when an initial price change sets in motion a process that magnifies the initial change, so the market moves further away from equilibrium.
• Negative feedback is when an initial price change is dampened by other market participants selling the asset, in the belief that the price is now above the fundamental value.
• If beliefs about the fundamental value dampen a price rise, the market moves back to equilibrium.

### Question 11.8 Choose the correct answer(s)

Which of the following statements about short selling (shorting) is correct?

• Shorting is used to benefit from a price fall.
• Shorting involves selling shares that you currently own.
• The maximum loss a trader can incur by shorting is the price he receives from the sale of the shares.
• Shorting is a sure way of profiting from a suspected bubble.
• Shorting allows a trader to benefit by selling borrowed shares while the price is high, and buying them back (to return to the owner) when the price has fallen.
• Shorting involves selling shares that you have borrowed.
• Once you have sold the shares at a certain price, there is no limit to the amount of loss you can incur, as the price can keep rising.
• Shorting works only if your timing is correct (just as the bubble bursts). Otherwise the strategy can result in a large loss.

## 11.8 Non-clearing markets: Rationing, queuing, and secondary markets

Tickets for Beyoncé’s 2013 world tour sold out in 15 minutes for the Auckland show in New Zealand, in 12 minutes for three UK venues, and in less than a minute for Washington DC in the US. Similarly, the tickets for the Avengers: Endgame movie sold out within minutes of the tickets going online in the Indian box office. In both cases it’s safe to say that there were many disappointed buyers who would have paid well above the ticket price. At the price chosen by the concert organizers, demand exceeded supply.

We see excess demand for tickets for sporting events, too. The London organizing committee for the 2012 Olympic games received 22 million applications for 7 million tickets. Figure 11.17 is a stylized representation of the situation for one Olympic event.

The number of available tickets, 40,000, is fixed by the capacity of the stadium. The ticket price at which supply and demand are equal is £225. The organizing committee do not choose this price, but a lower price of £100; at this price 70,000 tickets are demanded. There is excess demand of 30,000 tickets.

Figure 11.17 Excess demand for tickets.

Some of those who obtain tickets for a popular event may be tempted to sell them rather than use them. In Figure 11.17, anyone who buys a ticket for £100 with the intention of reselling could sell it for at least £225, receiving a rent of £125 (compared with the next best alternative of not buying a ticket).

The potential for rents may create a parallel or secondary market. In the case of tickets for concerts and sporting events, part of the initial demand comes from scalpers: people who plan to resell at a profit. Tickets appear almost instantly on peer-to-peer trading platforms such as StubHub or Ticketmaster, listed at prices that may be multiples of what was originally paid. For the 2011 Cricket World Cup final, tickets originally priced at Rs. 37,500 were sold at as much as Rs. 125,000. The popularity of the game was such that some fans were willing to pay 10 times the base price for some tickets!

Prices in the secondary market equate demand and supply, and allocations are accordingly made to those with the greatest willingness to pay. The assumption that this market-clearing price will be much higher than the listed price is responsible, in part, for the initial frenzied demand for tickets. Nevertheless, some individuals who buy at the lower prices hold on to their tickets, and attend an event that they would otherwise be unable to afford.

Event organizers may try to prevent scalping. In the World Cup final, the security officers were supposed to intervene. But prevention is increasingly difficult, as online sales provide new opportunities for scalping on a large scale using ‘ticket-bots’: software that automatically buys tickets within moments of their release. The New York Times estimated that scalpers made $15.5 million from just 100 performances of the Broadway musical Hamilton in the summer of 2016. rationed goods Goods that are allocated to buyers by a process other than price (such as queueing, or a lottery). In the case of the London Olympics, the organizing committee set the price, and the tickets were allocated by lottery. This is an example of goods being rationed rather than allocated by price. The organizers could have chosen a much higher price (£225 for the event in Figure 11.17), which would have cleared the market. But that would have meant that people willing to pay less than £225 would not have seen the event. By allocating the tickets through a lottery, some people with a lesser willingness to pay (perhaps because they had limited incomes) would also get to see the Games. There was much public debate about the process, and some anger, but IOC President Jacques Rogge defended it as ‘open, transparent and fair’. Another example of rationing is the online reservation system for the Indian Railways. As a hugely popular mode of transport, a number of people are unable to get confirmed seats through the general online booking system. To address this, the Indian Railways introduced a system called ‘Tatkal’ (meaning instant). A select number of seats (ranging from 40 to 300, depending on trains and the route), are opened up for sale one day before the journey, at a slightly higher price. The time window is very narrow, with tickets only available for purchase for an hour. This facility allows many passengers to book tickets, especially in cases of emergencies, when tickets have to be booked at very short notice. There are other cases where the producer of a good chooses to operate with persistent excess demand. The New York restaurant Momofuku Ko offers a 16-course tasting menu at lunch for$175, and has just 12 seats. Online reservations may be made one week in advance, open at 10 a.m. daily, and typically sell out in three seconds. In 2008, the proprietor David Chang sold a reservation at a charity auction for \$2,870. Even taking into account the willingness of individuals to pay more for an item when the proceeds go to charity, this suggests substantial excess demand for reservations—but he has not raised the price.

### Exercise 11.7 IOC policy

1. Do you think the IOC policy of using a lottery is fair?
2. Is it Pareto efficient? Explain why or why not.
3. Using the criteria of fairness and Pareto efficiency, how would you judge the widely criticized practice of ‘scalping’ tickets.
4. Can you think of any other arguments for or against scalping?

### Exercise 11.8 The price of a ticket

Explain why the seller of a good in fixed supply (such as concert tickets or restaurant reservations) might set a price that the seller knows to be too low to clear the market.

### Question 11.9 Choose the correct answer(s)

Figure 11.17 is a stylized representation of the market for an event at the 2012 London Olympic Games. 40,000 tickets were allocated by lottery, at £100 each.

Assume that buyers could resell their tickets in the secondary market. Which of the following statements is correct?

• The market cleared at £100.
• The probability of obtaining a ticket was 4/7.
• The economic rent earned by those selling in the secondary market was £100.
• The lottery organizers should have chosen a price of £225.
• The market would have cleared at £225 for the supply of 40,000 tickets.
• 70,000 people wanted tickets, but only 40,000 were allocated, randomly.
• In the secondary market the ticket could be sold at £225, making the economic rent earned £125.
• With supply limited to 40,000, selling them all at £225 would have increased the organizers’ profit. But they preferred to set a price that was affordable for more people.

## 11.9 Markets with controlled prices

In December 2013, on an unusually cold and snowy Saturday in New York City, demand for taxi services rose appreciably. The familiar metered yellow and green cabs, which operate at a fixed rate (subject to minor adjustments for peak and night-time hours), were hard to find. Those looking for taxis were accordingly rationed, or faced long waiting times.

But there was an alternative available—another example of a secondary market: the on-demand, app-based taxi service called Uber, which by March 2017 would be operating in 81 countries. This recent entrant in the local transportation market uses a secret algorithm that responds rapidly to changing demand and supply conditions.

Standard cab fares do not change with the weather, but Uber’s prices can change substantially. On this December night, Uber’s surge-pricing algorithm resulted in fares that were more than seven times Uber’s standard rate. This spike in pricing choked off some demand and also led to some increased supply, as drivers who would have clocked off remained on the road and were joined by others.

City authorities often regulate taxi fares as part of their transport policy, for example to maintain safety standards, and minimize congestion. In some countries, local or national government also controls housing rents. Sometimes this is to protect tenants, who may have little bargaining power in their relationships with landlords, or sometimes because urban rents would be too high for key groups of workers.

Figure 11.18 shows a situation in which local government might decide to control the housing rent in a city (note that here we mean rent in the everyday sense of a payment from tenant to landlord for use of the accom­modation). Initially the market is in equilibrium, with 8,000 tenancies at a rent of Rs. 5,000—the market clears. Now suppose that there is an increase in demand for tenancies. Rents will rise, because the supply of rental housing is inelastic, at least in the short run: it would take time to build new houses, so more tenancies can only be supplied immediately if some owner-occupiers decide to become landlords and live elsewhere themselves.

rent ceiling
The maximum legal price a landlord can charge for a rent.

Suppose that the city authorities are concerned that this rise would be unaffordable for many families, so they impose a rent ceiling at Rs. 5,000. Follow the steps in Figure 11.18 to see what happens.

Figure 11.18 Housing rents and economic rents.

The market clears

Initially the market clears with 8,000 tenancies at rent of Rs. 5,000.

An increase in demand

Now suppose that there is an increase in demand for tenancies.

Rent increases

The supply of housing for rent is inelastic, at least in the short run. The new market-clearing rent, Rs. 8,300, is much higher.

A rent ceiling?

Suppose the city authorities impose a rent ceiling at Rs. 5,000. Landlords will continue to supply 8,000 tenancies, so there is excess demand.

The short side of the market

When the price is below the market-clearing level, the suppliers are on the short side of the market. They, not the demanders, determine the number of tenancies.

Some people would pay much more

There are 12,000 people on the long side of the market. Only 8,000 obtain tenancies. There are 8,000 people willing to pay Rs. 11,100 or more, but tenancies are not necessarily allocated to the people with highest willingness to pay.

A secondary market

If it were legal, some tenants could sublet their accommodation at Rs. 11,000, obtaining an economic rent of Rs. 6,000 (the difference between Rs. 11,000 and the controlled rent of Rs. 5,000).

The long-run equilibrium

The long-run solution for making more tenancies available at a reasonable rent is for the city authorities to encourage house-building so as to shift out the supply curve.

short side (of a market)
The side (either supply or demand) on which the number of desired transactions is least (for example, employers are on the short side of the labour market, because typically there are more workers seeking work than there are jobs being offered). The opposite of short side is the long side. See also: supply side, demand side.

With a controlled price of Rs. 5,000 there is excess demand. In general a controlled price will not clear the market, and trade will then take place on the short side of the market: that is, the quantity traded will be whichever is lower of the quantities supplied and demanded. In Figure 11.18, the price is low and suppliers are on the short side. If the price were high (above the market-clearing price), demanders would be on the short side.

When the rent is Rs. 5,000, the number of tenancies will be 8,000. Of the 12,000 people on the long side of the market, 8,000 would pay Rs. 11,000 or more, but tenancies are not allocated to those with highest willingness to pay. Those lucky enough to obtain tenancies may be anywhere on the new demand curve above Rs. 5,000.

This brief economic analysis of rent controls in Paris points out the counter-productive effects: Jean Bosvieux and Oliver Waine. 2012. ‘Rent Control: A Miracle Solution to the Housing Crisis?’. Metropolitics. Updated 21 November 2012.

Richard Arnott, on the other hand, argues that economists should rethink their traditional opposition to rent control: Richard Arnott. 1995. ‘Time for Revisionism on Rent Control?’. Journal of Economic Perspectives 9 (1) (February): pp. 99–120.

The rent control policy puts more weight on maintaining a rent that is seen to be fair, and affordable by existing tenants who might otherwise be forced to move out, than it does on Pareto efficiency. The scarcity of rental accommodation gives rise to a potential economic rent: if it were legal (it usually isn’t), some tenants could sublet their accommodation, obtaining an economic rent of Rs. 6,000 (the difference between Rs. 11,000 and Rs. 5,000).

If the increase in demand proves to be permanent, the long-run solution for the city authorities may be policies that encourage house-building, shifting out the supply curve so that more tenancies are available at a reasonable rent.

### Exercise 11.9 Why not raise the price?

Discuss the following statement: ‘The sharp increase in cab fares on a snowy day in New York led to severe criticism of Uber on social media, but a sharp increase in the price of gold has no such effect.’

### Question 11.10 Choose the correct answer(s)

Figure 11.18 illustrates the rental housing market. Initially, the market clears at Rs. 5000 with 8,000 tenancies. Then, there is an outward shift in the demand curve, as shown in the diagram. In response, the city authority imposes a rent ceiling of Rs. 5000 and prohibits subletting. Based on this information, which of the following statements are correct?

• There are 4,000 potential tenants who are left unhoused.
• The market would clear at Rs. 11,000.
• If subletting was possible, then those renting could earn an economic rent of Rs. 3,300.
• Excess demand could be eliminated in the long run by building more houses.
• At Rs. 5,000, 12,000 people want tenancies, but there are only 8,000 available.
• The market would clear at Rs. 8,300.
• Those subletting would be able to charge a rent of Rs. 11,000 under the new demand curve, obtaining economic rent of Rs. 6,000.
• If enough houses were built the supply curve would shift outwards and the market would again clear at Rs. 5,000.

## 11.10 The role of economic rents

An economic rent is a payment or other benefit that someone receives that is superior to his or her next best alternative. Throughout this unit, we have seen how economic rents play a role in the changes that take place in the economy.

• In the real case of the Kerala fisherman, and the hypothetical market for mangoes, rent-seeking by buyers or sellers in response to a situation of excess supply or demand brought about a market-clearing equilibrium.
• In the model of the bread market, rents (economic profits) can arise in a short-run equilibrium in which the number of firms is fixed. In the long run, other bakeries enter the market in pursuit of these rents.
• In asset markets, rents arise when the price deviates from the fundamental value of the asset, providing opportunities for speculation and creating the potential for bubbles.
• In markets that do not clear because prices are controlled, excess demand gives rise to a potential economic rent, which leads (unless prevented by regulation) to the development of a clearing secondary market.
• Another example, from Unit 2, is the innovation rent obtained by early innovators, which provides the incentive to adopt a new technology.
disequilibrium rent
The economic rent that arises when a market is not in equilibrium, for example when there is excess demand or excess supply in a market for some good or service. In contrast, rents that arise in equilibrium are called equilibrium rents.

In each of these examples, rents arise because of some kind of disequilibrium, or short-run constraint—we call them dynamic or disequilibrium rents. They set in motion a process—rent-seeking—that ultimately creates an equilibrium in which these kinds of rents no longer exist. In contrast, we have also seen examples of persistent or stationary rents. The main examples are shown in the table in Figure 11.19.

Type Description Unit
Bargaining In a bargaining situation, how much the outcome exceeds the reservation option (next best alternative) 4.5
Employment Wages and conditions above an employee’s reservation option providing an incentive to work hard 6.9
Monopoly Profits above economic profits made possible by limited competition 7
Government-induced Payments above the actor’s next best alternative not competed away because of government regulation (for example rent control, intellectual property rights) 9

Figure 11.19 Examples of stationary rents.

equilibrium rent
Rent in a market that is in equilibrium. Also known as: stationary or persistent rents.

In the models studied in this unit, we have seen that if markets do not clear, there are disequilibrium rents that give incentives for people to change the prices or quantities at which they transact, and so bring about market clearing. The labour market (see Unit 9) is different: it does not clear in equilibrium. Employees therefore receive a rent—the difference between the wage and their reservation option. But in this case it is a persistent or equilibrium rent: because a contract to work hard is unenforceable there is no way any buyer (the employer) or seller (the worker) can benefit by changing his or her price or quantity.

Economic rents and rent-seekers often have a bad name in economics. People disapprove because they think about rents as those arising from government-created monopolies (taxi licenses, intellectual property rights) or privately created monopolies. These rents indicate that the good or service will be sold at a price exceeding its marginal cost, and so the markets for these goods are not Pareto efficient.

But we have now seen the usefulness of some economic rents. They encourage innovation, provide incentives for employees to work hard, encourage new entrants to a market and thereby lower prices for consumers, and can bring an out-of-equilibrium market to a Pareto-efficient equilibrium.

### Question 11.11 Choose the correct answer(s)

Which of the following are stationary rents?

• Innovation rent where firms make positive economic profits from a new invention.
• Employment rent where the wage is set high to induce workers to work hard.
• Monopoly rent where firms make excess profits due to limited competition.
• Speculative rent where profits are made by correctly betting on the price changes in a bubble.
• Innovation rent is only temporary until other firms catch up—it is a dynamic rent.
• Employers will continue to pay wages above the reservation wage, because otherwise employees would reduce their work effort.
• When competition is limited, firms will continue to produce where price is greater than marginal cost.
• This is clearly not permanent!

## 11.11 Conclusion

Prices are messages about the conditions in a market economy. In situations of market disequilibrium, or short-run equilibrium arising from temporary constraints, people act on price messages if they are able to do so, in pursuit of economic rents. In markets for goods this often leads in the long run to market clearing and the eventual disappearance of the rents.

Assets are purchased partly for their resale value. In markets for financial assets, supply and demand shift rapidly as traders receive new information. The price adjusts in a continuous double auction to reconcile supply and demand. Prices in asset markets send messages to traders about future prices, which can cause the price to deviate from the fundamental asset value; in this case rent-seeking may create a bubble or a crash.

Sometimes suppliers or regulators choose to override price messages, leading to excess supply or demand, for example for concert tickets, taxi cabs, or housing tenancies. Economic rents can then persist—unless a secondary market is allowed to develop.

### Concepts introduced in Unit 11

Before you move on, review these definitions:

## 11.12 References

1. Friedrich A. Hayek. 1994. The Road to Serfdom. Chicago, Il: University of Chicago Press.

2. ‘Keynes and Hayek: Prophets for Today’. The Economist. Updated 14 March 2014.

3. Eugene Fama, quoted in ‘Interview with Eugene Fama’, The New Yorker. (2010).

4. Tim Harford. 2012. ‘Still Think You Can Beat the Market?’The Undercover Economist. Updated 24 November 2012.

5. If the efficient market hypothesis is accurate, how could the 2008 financial crisis happen? Robert Lucas on Fama’s efficient market hypothesis: Robert Lucas. 2009. ‘In Defence of the Dismal Science’. The Economist. Updated 6 August 2009.

6. Brunnermeier argues Lucas was right to emphasize that financial market frictions are a counter-argument to the efficient market hypothesis: Markus Brunnermeier. 2009. ‘Lucas Roundtable: Mind the Frictions’. The Economist. Updated 6 August 2009.

Robert J. Shiller. 2003. ‘From Efficient Markets Theory to Behavioral Finance’. Journal of Economic Perspectives 17 (1) (March): pp. 83–104.

Burton G. Malkiel. 2003. ‘The Efficient Market Hypothesis and Its Critics’. Journal of Economic Perspectives 17 (1) (March): pp. 59–82.

7. The classic examination of bubbles was made by John Maynard Keynes in Chapter 12 of his General Theory. John Maynard Keynes. 1936. The General Theory of Employment, Interest and Money. London: Palgrave Macmillan.

8. John Cassidy. 2010. ‘Interview with Eugene Fama’. The New Yorker. Updated 13 January 2010.

9. Robert J. Shiller. 2015. Irrational Exuberance, Chapter 1. Princeton, NJ: Princeton University Press.

10. Charles P. Kindleberger. 2005. Manias, Panics, and Crashes: A History of Financial Crises (Wiley Investment Classics). Hoboken, NJ: Wiley, John & Sons.