The homeowner cartel

    We’ve discussed how a developer would price his lots. Now let’s consider the incentive of the homeowners who have bought his lots. Fast forward a few years. Demand for the neighborhood has risen, partly because of a booming metropolitan economy, but also partly because the neighborhood is uniquely situated near downtown. We can also assume it’s developed a number of other attractive amenities. It has beautiful old trees, borders an especially popular park, and is in the attendance zone of a high-performing elementary school.

Our little neighborhood now consists of thirty-five homeowners who bought years ago. The thirty-five homes are worth between $475,000 and $500,000. The homeowners are sitting pretty.

But due to the surge in demand for the neighborhood, each owner is considering developing a part of his lot with new homes. We can treat each of the homeowners as a small developer and as in the case of the subdivision developer, consider their incentives to sell a portion of their lot for a new homes.

We will assume that the marginal cost of building a new house has increased substantially. The neighborhood was originally built out with modest starter homes. Now the demand is for fancier, larger homes with higher grade finishes which cost $225,000 a piece. The marginal cost, though, also includes the cost to each homeowner of giving up a portion of his  yard. Yards have their own intrinsic value because they are a place for a garden, for children to play, or simply as a buffer from neighbors. For simplicity’s sake, we assume all homeowners value their yards at $50,000 and that portion of the yard they are considering selling at $25,000. Hence the total marginal cost of each new unit is $250,000.

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If the neighbors could get together to agree on how many units can be built within the neighborhood, what will they agree to? If we make the (unrealistic) assumption that the neighbors don’t care who gets to build another house, the answer, again, would be determined by the marginal revenue. At between 45 and 50 units — say 47 — the neighbors’ marginal revenue would be equal to marginal cost. The 47 houses would be worth approximately $435,000 each. and the combined value of the homeowners’ land would be $8.75 and $9 million.  Again, as with the original developers, it is combined land value that the homeowners seek to maximize.

But suppose the neighbors cannot agree with each other how many houses to sell. In this case, the housing market in our little neighborhood will approximate a competitive housing market. Consider the incentive a single homeowner. Obviously, if he alone could develop his lot, he would fetch a large profit from selling 36th house, and would see only a relatively small decrease in value of his existing home. It is an easy call.

All of the homeowners face the same incentive, though. Once the homeowners are competing, the market for homes in the neighborhood stops functioning like a monopolistic market and begins to function like a competitive market. Each has an incentive to keep developing homes until the sales price is equal to the marginal cost of adding a new home.  Here that occurs after the sale of 85 homes or so. In a competitive market without zoning, homeowners will continue to develop until there are 85 homes in the neighborhood.

The homeowners are unambiguously worse off in this situation. Their total profit is now $0 — that is, the value of their land above the hedonic value they place on it (i.e., $50,000 per lot) — rather than $8.75 to $9 million! Stated differently, the ferocious competition has driven down the value of the land to next to nothing. The home sellers’ loss is great for the buyers who collectively pay millions less for the property. Moreover, a lot more buyers can buy into the neighborhood. The neighborhood houses 85 households rather than 35. Homeowners 36 – 85 who otherwise would have been shut out of the neighborhood, who would have been denied the enjoyment of the neighborhood’s amenities, can now find a place there.

Obviously, the 35 homeowners have a powerful incentive to prevent this sort of competition which, after all, will drive down the value of their land. Enter zoning. The homeowners can preserve the value of their land by demanding that the city limit the density of their neighborhood below the market-clearing quantity (85 homes). Zoning is not worth a little but a lot – it means the difference between $8.75 to $9 million in profits and none at all!

By acting in concert to reduce the quantity of housing and prop up housing, the home owners are functioning as a cartel. The chief problem with any cartel is defection by cartel members. The ideal arrangement for cartel members is for everyone else to observe the cartel’s quantity limits. Cartels are generally illegal in the United States and agreements to maintain quantity limits cannot be enforced in court. On the contrary, merely agreeing with others to set quantity limits may be a crime. Cartels are accordingly very difficult to hold together in practice.

Zoning is uncommonly good at overcoming the chief threat to the stability of any cartel, which is the defection by members of the cartel. In the absence of zoning, a competitive land market would drive home prices down to (or close to, at any rate) the cost of construction. Homes would be much cheaper, as would land. Naturally, the homeowners have a huge incentive to lobby vigorously against any rezoning that would reduce the lot minimum below one lot per acre. They might complain about the effect of their development on home prices — a perfectly accurate complaint, but perhaps not a sympathetic one in a neighborhood where home prices have more than doubled in just a few years. So perhaps they instead complain about traffic, noise, drainage or a host of other issues.

Fundamentally, exclusionary residential zoning is a tool for creating and maintaining a monopoly on housing. The monopoly is maintained, legally, by the city or county, whichever controls the zoning.  But the monopoly is controlled in fact, politically or socially, to one extent or another, by the residents who make up the jurisdiction’s neighborhoods. It is a monopoly should be taken seriously. In this chapter, we make the case that the central problem facing many cities today is the small groups of homeowners who behave indistinguishably from housing cartels.

We contend that some housing markets can best be described as a cartel of homeowners. The description of homeowners as a cartel doesn’t require all or even any homeowners to think of themselves as such. It’s enough that homeowners act as one. If homeowners work steadfastly to protect neighborhood character, or environment, or firefly habitat, or sightlines, or any of the myriad other reasons people (claim to) oppose development near to them, it has the same effect. As long as they work in concert to prevent any supplier from expanding the number of housing units on offer in the neighborhood, the effect is that of a cartel. Some anti-development homeowners perceive themselves as part of a cartel and some don’t; there is no difference in practice.

The indivisibility of housing

Let’s think a bit more carefully about the zoning our little cartel of homeowners would choose. In our example, allowing precisely 47 or 48 homes would maximize the collective value of the land beneath the homeowners’ homes.  At first blush, one might assume that the homeowners would support an increase in zoning to allow 47 or 48 homes. But this raises highly salient fact about housing. Homeowners cannot supply new housing in continuous quantities.  If all lots are to be treated the same, an increase in zoning for one homeowner must be accompanied by an increase in zoning for every other homeowner. Put differently, the minimum increase in density allowed by a uniform zoning is 35 units.

“Cheating” as cartel-buster

In housing, it’s hard to cheat, although it can happen with ADUs.