Equilibrium and the Law

[alex_tabarrok]

Originally posted on December 14, 2009.

To illustrate the importance of economics for the study of law I begin with a simple example due to David Friedman. There is in the law what is called “a nonwaivable warranty of habitability,” which is a fancy way of saying that a dwelling must have certain features such as heating, hot water, sometimes even air conditioning, whether or not such terms are in the lease and even if the lease explicitly excludes such terms. I ask my students who is made better off and who is made worse off by a legal doctrine that says tenants must have hot water? Invariably, the students answer that the doctrine makes tenants better off and landlords worse off. But is this so? Think about it and then read the extension for more.

If tenants benefit from a law that says apartments must have hot water then surely a law that says tenants must have hot water and a dishwasher benefits them even more, right? What about a law that says tenants must have hot water, a dishwasher and cable tv? By now the students have cottoned on to the idea that the rent will increase. Once you realize that the law causes the rent to increase it’s no longer obvious if tenants benefit or if landlords are harmed.

We can work out what happens with sone numbers. Let’s suppose that after much bargaining the tenant and landlord have agreed upon the rent and the amenities – each party to the contract is profit maximizing, doing as well as they can given market conditions and the interests of the other. Now suppose that tenants value the hot water benefit at $100 and that it costs the landlord $150 to provide the hot water. At these prices the tenant does not buy the hot water. The law is passed; by how much does the rent increase? By at least $100 but no more than $150. The landlord knows for certain that he can increase the rent by $100 because this will make the tenant just as well off as he was before, which by assumption was an equilibrium price. Similarly, if the landlord could profitably raise the rent by more than his cost he would have done so already – the fact that he did not indicates that an increase of more than $150 would not be profitable.

Thus the rent rises somewhere between $100 and $150, the precise amount to be determined by bargaining power. Suppose that the rent increases by $120. Then the tenant gets a benefit worth $100 at a price of $120 and is worse off by $20 and the landlord gets a benefit of $120 at a cost of $150 and so is worse off by $30. The law makes both the landlord and tenant worse off!

The lesson here is that a contract is multi-dimensional so if the government changes one dimension of a contract the other dimensions will adjust towards offsetting that change.

Bonus points: a) Suppose the tenant values the hot water at $150 and it cost the landlord $100. Does the regulation benefit the tenant and landlord now? If so, what is odd about this example? b) Explain why the loss to the tenant and the loss to the landlord must add up to $50. How does this further illustrate the principle?

The virtue of this thought experiment is that it brings home to students the importance of equilibrium.  To understand the effect of a law we have to think through what happens after all the economic actors have responded.   Although the thought experiment is the first step to clear thinking, it is not the last step.  Fire codes, to give just one example, may be justified on the basis of externalities even when they make both the apartment owner and the tenant worse off.