Tag Archives | government intervention

Rent Control in Mumbai

By Shubham Paliwal

Demand and supply mismatch created by price ceilings causes poor and reduced accommodation for the lower income people.

 The ‘Bombay Rents, Hotel and lodging House Rates Control Act, 1947’ served its purpose in the short term but in the longer term it led to reduced supply of houses for rents, dilapidated houses, black income and reduced taxes to the government. The rent control act should have been modified and the second generation rent controls should have been adopted as was done by many European countries.

The ‘Bombay Rents, Hotel and lodging House Rates Control Act’ was introduced because of the acute shortage of houses in Bombay due to the world war and partition of colonial India. The purpose of the act was to prevent exploitation of the tenants and to prevent speculation. The prices were kept low to provide relief to the city’s migrants after the partition. It was supposed to benefit the tenants.

Under it, the state put a cap on the amount of rent a tenant paid to a landlord, and this amount remained virtually frozen irrespective of inflation and the consistent rise in the market rates over time. Rents at about 19,000 buildings were set at 1940 levels to prevent owners from charging excessive rates during a time of distress.

Rent Control bombay

In its initial years, the system served the purpose of creating affordable housing at stable rents but it failed in its purpose in the long run. It did help the tenants but it led to market distortion and negatively affected the interests of the landlords. The prolonged continuation of first generation rent control law led to various unintended consequences.

It led to a consistent degradation of housing stock because builders and developers had no incentive to generate more rental housing (as the rents were much lower than the prevailing market rates). Thus, almost all new housing being built was for ownership purposes (most of it for the upper-middle classes and above). Rent controlled buildings were often unkempt and dilapidated because the nominal rents did not motivate landlords to spend on maintenance.

An amendment to the Rent Control Act in 1999 allowed flats to be rented out, without rent control, on a leave-and-license basis for one year at a time. This lead to surge in the prices of uncontrolled rental properties due to market distortion created by the shortage of housing stock being built for rental purposes.

Rent controls gave rise to the informal pagdi (or pugri) system, where tenancy is transferred from one tenant to another at property rates a little below prevailing market rates and the landlord and tenants both have a share in it. As tenants held capital in the form of black money (share in pagri) the central government could not levy wealth tax and capital gain tax on it. Moreover municipal taxes were linked with rent, therefore, along with freezing of rent, income of municipality also got frozen and fixed. In order to make up for increasing service expenses, the municipality levied a tax as high as 142%, repair tax 402% (residential) and 755% (non-residential) for buildings repaired by the repair board. The pagdi amount being in black money led to increased investments in illegal trades and business. Even though landlords got tax free black money income on every transfer of tenants, they shuddered away their responsibility of repairing buildings on the plea of meager rent income.

Thousands of rent-controlled tenants are becoming millionaires as developers tear down crumbling colonial mansions to build luxury towers for the rich and pay huge sums to the tenants to vacate the apartments. In suburban areas, where old chawls were demolished by builders for new houses, old tenants of chawls were given free flats worth lakhs in the new building as alternate accommodation. A large section of the tenants got premises for residence and business at ridiculously low rates.

Tenancy rights continued even after the collapse of a 100 year old building. Old houses started collapsing for want of proper maintenance and repair. Instead of amending the Act, repair cess act was introduced under which landlords were exempted from liability to repair buildings and tenants paid repair cess upto 400 to 700%.

With rent control in place, people are lined up for housing, and therefore, the landlord can discriminate on the basis of who will take the most meager accommodations.

Price ceilings set below the equilibrium price arrived at through supply and demand, increase the demand for apartments. Landlords decide to withdraw from the market as they do not receive the full amount that they would be able to charge in a free market, for example by selling apartments and investing elsewhere. The supply of accommodation is therefore reduced leading to queues and waiting lists for apartments caused by the increase in demand. Some landlords may impose certain criteria on the tenants they accept, causing discrimination against certain categories of tenant.

Rent Control Bombay1

Thus, overall the rent control act was beneficial only in the short term for the economy. In the long term it prevented modernization and led to increase in black money at the cost of taxes that the government could have collected and used for other purposes. It led to market distortion by creating a mismatch in the supply and demand of houses. The benefits accrued by the tenants were way more than was desired or necessary, the loss to the economy in terms of taxes was huge and thus it was not a wise move by the government. The government should have modified the rent control law much before by learning from the experiences of other economies.

Tenancy rent controls (also known as second-generation rent controls) are much more common in the contemporary world. One important feature is the “vacancy decontrol” provision which frees landlords to set rents freely once a rental unit becomes vacant. The amount of rent increase a landlord can impose on a sitting tenant is also limited. It also regulates or prohibits the practice of collecting nonrefundable deposits, limits the ability of landlords to evict sitting tenants, and restricts the use of fixed-term contracts.

Shubham Paliwal is a part of the GCPP’13 cohort at the Takshashila Institute.

[This and the other three essays on Price Controls was submitted as part of the Economic Reasoning coursework. Students were asked to identify instances of price controls in the world; who the intended beneficiaries were; and what were the unintended consequences of the price control. The 4 best answers were picked. The other three were on Price Control on Prescription Drugs in Europe and Price Control on Milk Products in Vietnam, Price Control on Gasoline in the US].

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Price Control on Milk Products in Vietnam

By Hiren Doshi

A price cap on milk products in Vietnam led to shortages, illegal production and distribution, distortions in the market and a dramatic drop in profitability of manufacturers. 

In 2014, The Ministry of Finance in Vietnam set ceiling prices on 25 milk products (which was later increased to cover almost 600 products) for children below the age of six in a move to contain constant price hikes on the dairy market. This move was in response to hyperinflation in price of milk powder in few years preceding 2014 and was aimed to help make the milk for children affordable for the citizens. Vietnam has around 10 million children below the age of 6 and was considered price sensitive to milk prices.

The price of powdered milk had approximately increased 30 times since 2008 until 2014, at between 3-20 percent at a time. The retail price of powdered milk in Vietnam was about 1.4 per litre USD and almost 1.5X as compared with Thailand and Malaysia making it among the highest in the world. Powder milk market in Vietnam was very competitive, with almost 800+ milk products catering for children under 6 years old, forcing the manufacturer to routinely spend far in excess of permitted advertising and marketing cost which then translated into higher cost for the consumers.

The regulation which was to be in effect for 12 months brought down the recommended wholesale price ceiling 15-20% below the prevailing wholesale prices. The price ceilings were based on three grounds: the results of inspection at five dairy firms, price developments of the dairy market and prices of similar products on regional markets. Retailers were also mandated to reduce their costs, be reasonable with their profit margins and charge retail prices which did not exceed 15% over the wholesale ceiling.

Milk Price Hiren

Some of the consequences in response of price ceiling were as below:

1.    Some milk suppliers in Vietnam pulled products whose prices was to be capped under the regulation from shelves and replaced them with new ones a week before the ceiling prices become effective. They worked around the regulation by launching new products with new labels but similar ingredients at much higher prices, and reducing weights of products.

2.    Even though the ceiling on advertising spend for milk products was abolished, spends on advertising and marketing by milk producers came down due to limited margin after the price ceiling.

3.    According to the research carried out by Nielsen in 2015 in Hanoi and HCM City, it indicated that milk products for children less than six years old were reduced 10 percent and 9 percent in terms of quantity and price, respectively against the previous year, after enacting the price ceiling. This means the consumption actually went down after the price ceiling was in force. This was counter intuitive to the very reason of putting the price ceiling in place.

4.    After price ceiling was extended for one more year after being in effect from June 2014, Nielsen noted that milk prices in Vietnam have been no higher than prices found in the middle group in Asia. Its statistics in July 2015 revealed that average milk prices in the high end segment in Vietnam were similar to those in other countries in the region, such as Malaysia, Thailand and Philippines.

5.    In April 2015, the European Union removed milk production quotas which existed for more than 30 years, leading to the worldwide drop in milk prices. In 1984, quotas were applied to limit the over-abundant supply in Europe, and milk farms that produced over their quotas were fined. This made the cost of importing powder milk cheaper than sourcing milk from local cow farmers.

6.    In early 2016, prices of milk sourced from cow farmers in Vietnam were about VND12,000-14,000 (US$0.54-0.63) per kilo, nearly double that of milk shipped from the U.S., Australia, New Zealand, and European countries, which sold for about VND7,000-9,000 ($0.3-0.4) per kilo.

7.    One interesting outcome of locally sourced milk becoming non-competitive was that local cow farmers sold record number of cattle in the last 12 months. For instance, in Cu Chi District, Ho Chi Minh City, nearly 10,000 cattle of 40,000 being reared were sold in the last 1 year.

Price ceiling on milk products for children under six was introduced in response to large and frequent price increase of milk, making milk prices in Vietnam one of the highest in the world. It was meant to increase the consumption of milk and help reorganize the milk industry ecosystem which keeps the low prices sustainable. In the end this move did not make any of the stakeholder happy – consumers continued to complain about high prices, manufacturer’s sale & profit dropped while the poor cattle suffered change of ownership during the worst crisis for local cow farmers.

Hiren Doshi is a GCPP-13 alumnus. 

[This and the other two essays on Price Controls was submitted as part of the Economic Reasoning coursework. The question asked students to identify instances of price controls in the world; who the intended beneficiaries were; and what were the unintended consequences of the price control. The 3 best answers were picked. The other two were on Price Control on Prescription Drugs in Europe and Price Control on Gasoline in the US in the 1970s].

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Allocative Efficiency vs. Social welfare

If perfect competition always leads to allocative efficiency, does it also lead to increased social welfare? If so, why does the government intervene in the markets in the first place and why does it have monopolies of its own?

By Anupam Manur (@anupammanur)

 

Source: Cox and Forkum

Source: Cox and Forkum

Perfect competition, by definition, will produce the truest price of goods and services. Due to existence of a large number of buyers and sellers and the competition among them, the market forces of demand and supply alone will determine the price levels in the economy. And it is through the price mechanism that resources are allocated most efficiently: all those who are willing to produce and sell at a given price point and all those who are willing to buy the goods at the given price point can do so.

One of the reasons that governments intervene is to increase competition in the economy. Remember, perfect competition in reality is a rarity. Very few instances of markets that can be described as being perfectly competitive. Competition in the markets can be seen on a continuum with perfect competition at one end and pure monopoly at the other, both of which are ideal types. In reality, most markets fall somewhere in between and it should be the collective effort of society (including government) to push markets towards greater competition. Many government interventions can actually be seen in this light. Liberalising reforms undertaken by the government are usually made with the intention to reduce concentration of market power and increase competition. Privatisation of certain sectors or allowing FDI limits are examples of such reforms. It should be noted that the reason for the concentration of market power could be the government itself. In India, we have seen how the MRTP Act, FERA, etc heavily distorted the markets, which were then reformed in 1991.

Government intervention in markets in the form of actually producing goods and services should be carefully analysed. In some cases, the government can enter a market as one player to provide competition. When it is just one player in the market, it can act as a balancing force to the private player and thereby, increase efficiency due to the added competition (provided, it is a fair market player). The existence of BSNL in the telecom sector is perhaps the best example for this. However, many other instances in history have proved the opposite: that government owned public sector units usually lead to distortions in the economy. Examples range from when the government is the only player (eg. electricity distribution companies) or when the government is part of many players, but fail to produce efficiently (Air India). Bank nationalisation is one of the better examples of how government intervention has resulted in considerable inefficiencies. The reasons for nationalisation was to have greater control over this sensitive sector, to force banks to lend to priority sectors and to the government.

The government can also intervene in markets to correct other forms of market imperfections. Apart from concentration of market power discussed above, market imperfections can take other forms: under production of public goods and merit goods (goods with positive externalities), overproduction of demerit goods, etc. Government intervention in these aspects can lead to higher social welfare. It must be noted, however, that any form of government intervention, if it does increase social welfare in the short run, should be of a temporary and least intrusive form. It should aim to correct the market imperfections and withdraw as soon as possible. If not, in the long run, the intervention will eventually lead to a reduction in welfare.

While these interventions tend to increase economic efficiency, other interventions will be detrimental to it.  When the government intervenes in the market in order to meet its social objectives or for certain political reasons, it will lead to a reduction in economic efficiency and even reduces social welfare in the long run. These interventions are undertaken when the government believes that the economically efficient outcomes may not lead to social welfare or that the aggregate social welfare might not accrue proportionately to targeted sections of society. For example, imagine if the railways were completely privatised, then, at equilibrium, the tickets would shoot up by 4-5 times at least and this could make it unaffordable to the poor. This prompts the government to run the Indian railways itself, such that it can have better control over the price mechanism.

When the government uses the price mechanism to achieve political and social objectives, it will lead to a reduction in economic efficiency. High ‘sin taxes’ are used in order to curb activities such as smoking and drinking. Taxes are also used as a tool for redistribution of wealth: high tax on ‘luxury’ items in order to fund welfare schemes.

The gray areas in government intervention occurs when there is a clash between economic efficiency and social welfare. Sometimes, economically efficient outcomes may lead to a reduction of social welfare. Imagine the market for essential drugs. An economically efficient solution might price a life-saving drug too high and out of reach of most citizens, thereby reducing social welfare. Else, imagine if there is a sudden drought this year with the failure of monsoons and the prices of essential commodities soar. The markets might not price in the extreme consequences of such events, which might even be death. In each of these cases, it might be justifiable for the government to intervene. The challenge is to find the least distortionary method to do so.

Anupam Manur is a Policy Analyst at the Takshashila Institution.

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Nudges – a Real Third Way

An influential book by Richard R. Thaler and Cass R Sunstein, “Nudge” looks into the science behind decision making and how it can be applied to policy formation.

By Narayan Sharalaya

Sometimes, even the best intended policies do not have the required effect. Why don’t people eat healthily, save wisely or become environment friendly even though incentives exist to do so? ‘Nudge’ provides answers to these questions using Behavioural Economics and proposes that the most simple and effective solution is the nudge. The book begins by explaining the rationale behind nudges and the authors’ guiding philosophy in using them. It then examines real life situations where nudges can or have helped.

Before going into further detail about nudges, it is important to look at some of the concepts used in the book.

  1. Libertarian Paternalism
    Coined by the authors, this term may seem somewhat oxymoronic but it is a guiding philosophy in this book. The authors wish to preserve the libertarian demand of the right to free choice but also advocate self-consciously guiding people towards a certain choice. It can be described as a kind of ‘soft’ paternalism. According to this concept, it must be cheap and easy to opt out of the nudges provided. For example, placing healthy food at eye level in supermarket displays would be following libertarian paternalism whereas banning all junk food would not.
  2. Choice architecture
    The way choices are presented to us influence the decisions we make.A choice architect organises the context in which people make decisions. The book shows how choice architecture can play a significant role in multiple scenarios ranging from organ donation to choosing an apartment. The authors also provide guidelines on how to select an effective choice architecture as this would ensure that people select the best choice available to them. For example, the Amsterdam airport managed to reduce spillage in its urinals by 80% by sticking a picture of a fly.

Urinal

  1. RECAP
    A frequent solution proposed by the book, RECAP stands for Record, Evaluate and Compare Alternative Prices. It is a mild form of government regulation where companies are required to post their prices publicly in an easy, readable form. While this imposes very little costs on the companies, it significantly helps in improving consumer decisions.

When do we need a nudge?

A nudge is needed when the decisions to be made are difficult (selecting the right mortgage), rare (buying a house), do not yield immediate benefits (eating healthy food) or are not fully understood (investing in retirement funds). A nudge in any of these situations helps improve decision-making drastically. The book also looks into the functioning of markets and whether they solve people’s problems. On this subject, the authors have a mixed view. Market competition ensures fair prices and welfare of the consumer but on the other hand, companies have a strong incentive to exploit human frailties and profit from them. In this case, the authors favour a nudge towards the favoured options.

Examples of Effective Nudges

  1. Savings
    The “Save More Tomorrow” campaign initiated by Tahler and Bernatzi in three private companies, successfully educated workers about saving for retirement. Participants were given an option of selecting between a default rate at which their salary increments would go towards their retirement fund or make their own savings decision. Workers that chose to enroll in this program showed much higher saving rates as shown in figure 2. The program followed libetarian paternalism by actively guiding workers towards a preferred option while retaining their freedom of choice.Save More Tomorrow
  1. Credit Markets
    The market for mortgages and credit cards are alike. They both involve making hard choices regarding fixed and variable interest rates, teaser rates, etc. They also tend to have dozens of hidden fees and charges most people are unaware of. The book proposes a form of RECAP, where companies will have to disclose the list of charges and fees they levy in an accessible format. This would help consumers make better choices while avoiding excessive regulation.
  2. Organ Donation
    Rather than have an ‘opt in’ option for organ donation, countries that have an ‘opt out’ policy for organ donation tend to have a higher number of donors than c. In other terms, a person’s consent to be an organ donor is presumed unless the person states otherwise. This is a good example of how choice architecture can have a direct bearing on subject behaviour. Another type of choice architecture that the authors suggest is a mandated choice. For example, where the grant of a license is dependent on people choosing between options.Organ Donation

The Real Third Way

Nudges can preserve freedom of choice while still guiding people to act in a certain way. The book emphasises the use of Nudges as a “third way” to influence behaviour which strikes a middle ground between the strict regulations favoured by the Left or the laissez faire approach championed by the Right. Furthermore, the scope of using a nudge is not limited to certain domains. With policy makers recognising the human frailties inherent in decision making, nudges are slowly finding their way into policy formulation.

Narayan Sharalaya is an intern at Takshashila Institution and is currently doing his Bachelors in Economics at NMIMS, Mumbai

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