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The Cure for Costly Housing Is More Costly Housing

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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I was talking to a friend the other day, a San Francisco anti-eviction activist, and said that allowing more housing construction in the city would be a great way to lower rents. She looked at me in horror, blinked and asked “Market rate?” I nodded. She was speechless.

My experience was far from unusual. To my friend and many others, it has become an article of faith that building market-rate housing raises rents, rather than lowers them.  The logic of Econ 101 -- that an increase in supply lowers price -- is alien to many progressives, both in the Bay Area and around the country. Instead, the theory is that price is something set by the government. If the city government decrees that a new apartment block be affordable, the theory goes, it will be. But since rents for non-rent-controlled apartments are now very high, allowing new market-rate development will simply create more luxury units, whose prices will be out of reach for the average person. The only way to lower the cost of living, according to the progressive canon, is to have the government mandate lower prices.

Actually, the progressive theory isn't obviously crazy. There is a phenomenon called induced demand that can create precisely this effect. Economists have been astonished to discover that adding lanes to a highway -- an increase in supply -- often increases traffic rather than alleviating it. The reason is that the added capacity tends to cause people to shift away from public transit. The shift can be so big that it ends up outweighing the capacity increase.

The same could be true of housing development. If building more housing in a city causes more people to move there, the increase in demand will cancel out the increase in supply, leaving rents no lower -- or possibly even higher -- than they were before. In a small town, this would be a likely outcome -- if a new city is built where none stood before, you would expect rents to be higher. But in a big established city, this is unlikely. A few people and businesses might move in to San Francisco or Manhattan from the surrounding areas if housing development restrictions were lifted, but these are already such dense urban centers that most of the people who have the money to be able to choose where to locate are already there.

But still, the induced demand theory can’t be dismissed out of hand. So this is really an empirical question. Faced with two competing theories -- the basic Econ 101 theory of supply and demand versus the theory of induced demand -- we have to turn to the evidence. It’s well known that urban land has been getting more expensive, but how would denser development change the picture?

In the 1987, economists Lawrence Katz and Kenneth Rosen looked at San Francisco communities that put development restrictions in place. They found that housing prices were higher in these places than in communities that let developers build.

In the 2005, Edward Glaeser, Joseph Gyourko and Raven Saks looked across a large number of cities. Finding it hard to quantify the amount of development restrictions in each city (since laws differ from place to place), they reasoned that cities where developers build shorter buildings even when taller buildings would be profitable are places where regulation is more restrictive. Using that assumption, they find that cities with more restrictions tend to have higher prices.

So the supply-and-demand theory looks like it’s winning. But can it be used to actually predict changes in rents? According to blogger Eric Fischer, it most certainly can. Fischer collected more than 30 years of data on San Francisco rents. He modeled them as a function of supply -- based on the number of available housing units -- and demand, measured by total employment and average wages. His model fit the historical curve quite nicely.

Recent experience fits right in with this prediction. In response to the housing crisis, San Francisco recently allowed a small increase in market-rate housing. Lo and behold, rents in the city dropped slightly

So all the evidence points toward development restrictions being a big reason for high rents. Allowing more market-rate housing in large established cities is a good way to bring down the cost of living, not just for high earners, but for the poor and working class as well. Progressives should support higher density, not more restrictions, if they want to help the most economically vulnerable city-dwellers.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net