WARNING: THIS POST IS LONG AND DETAILED. BUT IF YOU STICK WITH IT, I THINK YOU WILL FIND IT WAS WORTH YOUR TIME.

San Francisco State Senator Scott Wiener, along with our own State Senator Nancy Skinner (in the news recently), have resubmitted their zoning bill SB 50, which was converted to a two-year bill at end of the last legislative session. The final version of the bill is not yet available, but the flaws in previous incarnations of this bill no doubt will remain.

The rhetoric from the bill’s supporters has been sloppy enough that I think it’s time to frame the issues the bill raises in the rigorous analytic framework of neoclassical economics. SB 50’s emphasis on housing supply recalls the supply-side economics of the Reagan administration. But neither supply-side economics nor SB 50 are based on mainstream economics. In what follows, I’ll lay out the groundwork my analysis, which will be familiar to any undergraduate economics major. I know because in the early 1990s, I taught economics at UC Berkeley as an graduate student instructor and as an acting instructor.

Here’s my first question, which is one that could have been drawn from a quiz early in an intro econ course: In a market with a standard downward sloping demand curve and upward sloping supply curve, in order to lower equilibrium price and raise equilibrium quantity, is it sufficient to shift the supply curve outward? If not, what other conditions must be assumed?

Figure 1 describes, in a standard intro econ graph, the question posed. In a housing market, assume a fixed demand curve (D), and an outward shift in supply from S₁ to S₂. The price of housing falls from P₁ to P₂, while the quantity of housing supplied rises from Q₁ to Q₂.

This is a result that proponents of SB 50 like to assume. But the result rests upon a very strong, and very unrealistic assumption–that the demand curve for housing is fixed. In the Bay Area, the demand for housing has shifted outward at a dramatic rate, driven by the growth of large monopolistic tech firms like Apple, Google and Facebook, and by the billions of dollars of venture capital being funneled to tech startups here. This growth requires more tech workers, more office buildings and ultimately more housing.

The choice of the expression “housing crisis” was a deliberate, misleading attempt on the part of SB 50 supporters and other pro-growth advocates to shape the debate. The state’s Office of Housing and Community Development (HCD) instead uses the term “housing shortage.” Statewide, the shortage is the result of both a physical shortage of housing and an income mismatch that HCD estimates requires the construction of 1.5 million units of affordable housing for the poorest of California’s residents.

If simple poverty is the major problem for the whole state of California, in the Bay Area the problem is mostly due to relative poverty–the influx of a highly paid cohort of tech workers crowding out lower-income residents. This is not a housing crisis–there was no hurricane or outbreak of mutant termites that destroyed thousands of apartments. What we have is a venture-capital driven influx of tech workers. It would be more accurate to call this a “housing demand shock.”

Here’s how we could graph a housing demand shock. For simplicity, in Figure 2 above, the supply curve of housing is held constant, while the housing demand shock shifts the demand curve from D₁ to D₂. While the assumption that the supply curve is constant is too simple, it is very realistic to assume that the demand for housing in California, and especially in the Bay Area, has been shifting outward. In this example, like the example in Figure 1, the equilibrium quantity of housing supplied rises from Q₁ to Q₂. However, unlike in Figure 1, the equilibrium price rises from P₁ to P₂.

The outward shifts in supply and demand both cause quantities to rise, while these outward shifts have contradictory affects on prices. To explore this more fully, let’s combine shifts in demand and supply together in one graph.

In this example, demand and supply curves both shift outward. Equilibrium quantities rise as before, and prices rise somewhat. The price response is moderated by the relatively small outward shift of the supply curve.

When both supply and demand curves are shifting out, it is the relative size of the shifts that matter. By now the reader can probably see that if the S₂ supply curve continued to shift out far enough, with its intersection point moving down the D₂ demand curve, the new price would be lower, not higher. The reader is encouraged to draw diagrams of their own, not only shifting the positions of the curves, but also drawing them steeper (more price-inelastic) or flatter (more price-elastic).

Three general points should be made here: 1) It is unreasonable to assume that housing supply can shift rapidly enough to accommodate a housing demand shock driven by volatile capital flows. This is especially true because builders of new affordable housing shared in very little of this largess. 2) It is generally faster to build office buildings than new communities. With respect to communities, office buildings require far less services like police and fire departments, schools, parks and libraries and utilities. 3) When they ignore the demand issues, SB 50 proponents violate one of the fundamental concepts of economics–that in a market, prices and quantities are set by the interaction of supply and demand, and not by supply conditions alone.

At least in San Francisco, SB 50 isn’t the only game in town. An initiative that explicitly links housing demand and supply will be on the ballot in March 2020. Sponsored by the community development organization Todco, Measure E will cap office construction unless the city meets its affordable housing goals (Links here and here).

While capping office construction to allow new housing to catch up is an idea worth supporting, restoring the jobs/housing balance could still take years–and without something like the Todco proposal it may never happen at all, since SB 50 makes no attempt to control housing demand.

An intriguing possibility to speed up that process is suggested by Figure 4. What if we could increase housing supply and simultaneously decrease housing demand by converting offices to apartments? In such a scenario, small office buildings could be completely retrofitted and converted to apartments, while whole floors of taller office buildings could be converted.

The advantages to this plan are many. Since building any new housing is very expensive, money would be saved by utilizing existing buildings. Downtown office workers could walk to work (or perhaps just take an elevator), and their presence in the neighborhood in the evenings would create a lively after-work social scene with new bars, restaurants and shops. If some of the new apartment units were affordable, inclusionary and affordable housing programs could be tapped for revenue to subsidize the retrofitting.

Of course, this would mean that some tech businesses would leave the city, a trend that is already beginning. But is this so bad? By moving to cities with lower housing costs, tech workers could afford houses instead of apartments, and move into neighborhoods with good schools and other amenities. And they might not have to move far. Oakland, Concord and Walnut Creek, Sacramento, Las Vegas, Phoenix and Austin all are possibilities. It makes sense to move jobs to where housing is more available.

In the story told in Figure 4, as offices start to close and workers move to other cities, the demand curve shift inward from D₁ to D₂. Housing quantities and prices both fall temporarily. But as the former office spaces are converted to housing, and the supply curve shifts from S₁ to S₂, housing prices continue to fall while musicians, artists, people of color, students, new immigrants and commuters are drawn back to the city. This is a story of the degentrification of San Francisco.

CONSTRAINED OPTIMIZATION AND THE LIMITS OF UPZONING

If SB 50’s advocates fail in part because they do not grasp the interaction of supply and demand, there remains a deeper failure. Upzoning will not effectively increase housing supply, at least not for many decades, if at all. Zoning is a constraint, although a complicated one. But in the current housing market in the Bay Area, zoning is mostly a non-binding constraint. That is why changing zoning laws will not be effective in the short run. By definition a “crisis” is something happening here and now and requires effective solutions in the short run. Zoning changes are not that solution.

To discuss this, I want to introduce the topic of constrained optimization in a form that is familiar–the model of consumer behavior in standard neoclassical economics.

Figure 5 presents a typical graph that could be found in many intro econ textbooks. A consumer is faced with choosing how many mangoes and avocados to purchase. The goal is to maximize utility subject to a budget constraint. To keep things simple, let’s just assume the consumer budgets six dollars per week on fruit, and they only like to eat mangoes and avocados. Mangos cost $1 each and avocados cost $2 each. If they spend their entire fruit budget of $6 per week, the consumer could buy six mangoes or three avocados, or some combination of the two. Their purchase decision will lie along the blue budget constraint line.

The graph also features a series of indifference curves which display the consumer’s preferences between mangoes and avocados. Along each curve, the consumer is equally satisfied with the options available. As we move to indifference curves further up and to the right, the consumer’s satisfaction, or utility, goes up. That’s another way of stating that more is better, a basic the assumption in these models. The consumer maximizes their utility by reaching the highest indifference curve possible without violating their budget constraint. In this example, our consumer will choose to buy two avocados and two mangoes.

Now let’s assume that due to the popularity of avocado toast, the local grocery where our consumer buys fruit limits customers to one avocado per day, or seven per week. We represent this new constraint on the graph as a dashed vertical blue line at the number seven on the horizontal avocado axis. Now the figure contains two constraints, one binding, one non-binding.

In this example, the budget constraint is the binding constraint, and the store’s limit is non-binding. But if our consumer was shopping for a family, their budget for fruit might be far larger and their budget constraint could lie much farther to the right. If, for example, our family shopper had a fruit budget of $60 per week and wanted to purchase 20 mangoes and 20 avocados, their choices would be constrained by the grocery store’s limits. In that case, the budget constraint would be non-binding, and the store’s limit would be binding.

Here is another example in a different context: Assume you are a very fast center fielder playing for a major league baseball team. The center field wall is short and you a facing a team with lots of power hitters. For you the outfield wall will be a constraint if the opposing team’s hitters are whacking balls into the grandstands. On the other hand, if you are playing a team that focuses on line drives and high batting averages, the outfield wall may not be a constraint because balls aren’t being hit that far.

The important point to remember is that removing non-binding constraints does not change the equilibrium outcome. Whether or not a constraint is binding or non-binding depends on the situation. In large, complex, multi-dimensional models, it is often not obvious which constraints are binding, and computer algorithms are used to determine the optimum outcome. In the real world, building housing is subject to many constraints. In the current Bay Area context, zoning rules are typically not the binding constraints for two reasons. First, there are many other constraints that are binding. Second, zoning rules don’t work quite in way that many SB 50 supporters seem think they do.

In an excellent letter date June 14, 2019 (here), the City Council of Rohnert Park sent to various legislators a list of the many constraints on building new housing. Excerpts from the letter appear in italics below:

As the letter describes, there are many binding constraints that prevent housing from being built, constraints which SB 50 does little or nothing to address. But even if all these constraints could be removed, there is still another problem. Upzoning–allowing multifamily and other large housing developments in neighborhoods in which they were previously restricted–requires homeowners to do nothing.

Let me give an example from my own neighborhood. I live in an R-1 neighborhood where only single-family homes can be built. My 1,100 sq. ft. house was built in the 1920s. If my neighborhood was upzoned to R-2 zoning (which allows for multifamily housing), what would I be required to do? Nothing. Upzoning removes a constraint–if my neighborhood became R-2, I could sell my house to someone who plans to build a duplex. But I’m not really interested in doing that. I think I’d rather sell to a family who wants to live in the perfectly adequate house that is already here, and until then I might add some plumbing to my backyard studio to convert it a legal accessory dwelling unit (ADU), which I would probably continue to use as an occasional guest house.

For me, R-1 zoning is a non-binding constraint. As in the examples above, if you remove a non-binding constraint, it doesn’t change the outcome. Some people seem to think that zoning is like eminent domain, where the state can condemn your house, force you to sell, and then demolish it to make room for a freeway (or an apartment building). That’s not how zoning works. Upzoning allows someone to build something bigger on my property, but it can’t require me to let them do it, or to sell to them. I still maintain my property rights.

Even if I wanted a duplex where my little house exists now, there is another problem. I might not be able to find a developer who would want to build it. The project very likely wouldn’t be profitable. Let’s just say because I live in a town with good schools within walking distance, with a charming walkable commercial district nearby, I could sell my house to a young family for $1 million. As an alternative, I could sell it to a developer who wanted to build a duplex.

First the developer would have to pay $1 million for the property. Then they would have to demolish the old house and build two new units. That’s expensive. Then they would have to find a buyer for the project. The problem is that privacy, space and aesthetics are all what economists call normal goods–as your income rises, you demand more of them. If you tear down a charming 1920s bungalow and replace it with a boxy duplex, you are destroying the very characteristics that made the property valuable in the first place.

Given how valuable single-family homes are in the Bay Area, and how expensive it is to build for all the reasons listed above, upzoning R-1 neighborhoods like mine might lead to very little building in the short run. In the long run it might lead to more, but as John Maynard Keynes famously said, “In the long run we are all dead.” If we really want to solve our “housing crisis,” solutions that take several decades are inadequate to the task.

However, the combination of upzoning and gentrifying low-income neighborhoods, typically occupied by families of color, could be profitable under SB 50. That’s why low-income community organizations tend to be among the most vociferous opponents of SB 50. Various versions of the bill in the past have attempted to mollify these critics, but the neighborhood groups are right to be extremely skeptical. They have been hesitant to abandon their positions on the bill (and possibly their positions in their old neighborhoods).

For a good example how and where such problems could emerge, consider Minneapolis. Advocates for upzoning consider the city a model. Minneapolis recently banned single-family zoning in favor of allowing residential triplexes “by right,” which means the city has very limited ability to block the projects. In an article that is both fascinating and disturbing, a Minneapolis planning commissioner, architect and resident of low-income North Minneapolis, dissects this policy (here).

To summarize, the arguments for SB 50 fail for two reasons. First, expanding supply will not bring down prices unless demand is constrained. Second, although zoning is a type of constraint, in the current situation, it is not a binding constraint. However, several other constraints are binding. Upzoning R-1 residential neighborhoods does not require a homeowner to move or prevent them from selling their house to a new owner who might live in it for decades.

If SB 50 is ineffective in bringing about its stated goals, what then is the real purpose of the proposed legislation? The real purpose of SB 50 is to destroy local control and small-homeowner property rights. Real democracy exists at the local level. But for corporate real estate developers and their sycophants (see here and here), local democracy is a nuisance. If democracy, at least on paper, must exist, they would prefer its decision-makers to be housed a compact space, like a state capital building, where they become easier targets for lobbyists and campaign-funding checks.

On the other hand, under local democracy, there are too many decision makers, and too many homeowners, to be bought off easily. Influencing local government officials is like herding cats, and homeowners are a group of independent and opinionated Jeffersonian free holders (at least after the mortgage is paid off). Local governance is messy. Some corporate real estate interests would prefer to do away with local governance and small homeowners altogether, and, judging from the legislation they support, require the little people to live in large, drab apartment blocks like those in the old East Berlin, or to house tech workers in Shenzhen-style worker barracks–quick to build, no design review required. SB 50, along with related bills like Skinner’s SB 330, take a giant step in that direction.

NEGATIVE EXTERNALITIES AND ANTITRUST

Since legislation like SB 50 and SB 330 are not the solution, it’s a good idea to step back and ask how we got into this mess. If we don’t understand how we got here, if we don’t understand the nature of the malady, we will keep on prescribing for ourselves the wrong remedies.

First, a note about rural California. In many respects, the problem there is not that the rich are getting richer, but that the poor are getting poorer (here and here). Although it is true that lack of affordable housing can exacerbate rural poverty, the opposite is also true–lack of effective demand due to poverty can reduce the amount of new housing. Poverty is both a cause and effect of the rural housing shortage.

Economic relationships in which cause and effect flow in both direction are difficult to disentangle. But in the real world, they are common. In his classic essay, “Politics and the English Language,” George Orwell stated this succinctly:

“But an effect can become a cause, reinforcing the original cause and producing the same effect in an intensified form, and so on indefinitely. A man may take to drink because he feels himself to be a failure, and then fail all the more completely because he drinks.”

In California, the combination of rural poverty and lack of housing are nothing new. Does anyone believe that in 1962, when Dolores Huerta and Cezar Chavez began organizing the United Farm Workers, those farm workers were better housed than they are today?

Here in urban coastal California, things have changed. As I mentioned earlier, the rise of demand for housing has been driven by the growth of large monopolistic tech firms like Apple, Google and Facebook, and by the billions of dollars of venture capital being funneled to tech startups here. The clustering of firms based on emerging technologies has been happening at least since the industrial revolution, and analyzing this new round of tech clustering is keeping economic geographers busy.

One of the new aspects of tech clustering in the United States is that it’s happening during an era of weak antitrust enforcement. Especially given the privacy issues engulfing Google and Facebook, is there any economic efficiency argument for Google Maps and Gmail to be run by the same company? How about Facebook and WhatsApp? The gigantism of tech firms is now drawing the attention of Congress.

New York University finance professor Thomas Philippon is the best known current thinker exploring the failures of U.S. antitrust policy. As he notes in an Atlantic magazine article, “In 1999, the United States had free and competitive markets in many industries that, in Europe, were dominated by oligopolies.Today the opposite is true.” A New York Times article about Philippon’s work on corporate concentration states, “Philippon’s biggest contribution is to explain that it isn’t some natural result of globalization and technological innovation. If it were, the trends would be similar around the world. But they’re not. What explains the difference? Politics.”

Facebook, Google, Apple and other tech firm are not immutable forces of nature. Our rules, or rather the lack of enforcement of them, have led to their growth. Bay Area citizens have every right to use the rule of law to restrain the behavior of, and the problems created by, these behemoths of the Bay.

Many of the problem big tech creates are what economists call negative externalities.The negative externality most often in the news today results from the burning of fossil fuels. The price of burning coal, oil and gas does not include the social and environmental damage caused by increasing levels of carbon dioxide in the Earth’s atmosphere, or their contribution to climate change. One partial solution would be to charge a carbon tax to increase the cost of burning fossil fuels and internalize those costs in the higher price.

Writing in the Jan. 18, 2018, edition of the New York Times, columnist E. Tammy Kim tied the logic of taxing negative externalities to the tech housing demand shock:

“A half-century ago, it seemed inconceivable that factories, smelters or power plants should have to account for the toxins they released into the air. But we have since accepted the idea that businesses should pay the public for the negative externalities they cause. Today, corporations must answer for increased rents and evictions, and for worsening traffic jams. Like air and water pollution, these costs are shared by all of us.”

Approximately 11 months later, in Dec. 2019, a report from the Brookings Institution mirrored the concerns of Kim:

“At the economic end of the equation, the costs of excessive tech concentration are creating serious negative externalities. These range from spiraling home prices and traffic gridlock in the superstar hubs to a problematic “sorting” of workers, with college-educated workers clustering in the star cities, leaving other metro areas to make do with thinner talent reservoirs.”

The Bookings report stresses subsidies to develop new regional growth centers. Their goal is to:

“Assemble a major package of federal innovation inputs and supports for innovation-sector scale-up in metropolitan areas distant from existing tech hubs. Central to this package will be a direct R&D funding surge worth up to $700 million a year in each metro area for 10 years. Beyond that will be significant inputs such as workforce development funding, tax and regulatory benefits, business financing, economic inclusion, urban placemaking, and federal land and infrastructure supports.“

The New York Times’s Kim endorses not the “corporate takeover of housing policy” (as the advocates of SB 50 suggest), but taxation of negative externalities in existing tech centers:

What is needed in Seattle — as well as San Francisco; Austin, Tex.; New York City; Boulder, Colo.; and other urban areas where the rapid influx of high-paid tech workers has made housing unaffordable for nearly everyone else — isn’t a corporate takeover of housing policy but, rather, a per-employee “head tax” that would fund real investments in affordable housing, which should be a public good.

These two policies are complimentary. In addition to taxing tech’s negative externalities to subsidize affordable housing, the tax revenue could fund the development of new regional growth centers–although if state taxing and funding mechanisms were used, the new regional grow centers would have to be in California.

SUMMARY

In this blog post I have attempted to explain how the advocates for SB 50 do not understand the basics of supply and demand. These advocates misunderstand or ignore the many constraints to building housing, and they do not have a clear understanding of zoning or the unintended consequences of upzoning. In their arguments they fail to recognize the broader economic context that includes antitrust and negative externalities.

SB 50 cannot fulfill its stated mission of reducing housing costs in the short run. However, if enacted, the bill could be effective in its intended, long run mission–removing local control of land use and encouraging the corporate takeover of housing policy.

NOTE: Jan. 14, 2019: I made changes to two paragraphs, at the suggestion of a reader. Typos continue to be corrected as I find them. Jan 15: I added link to Nancy Skinner news story in first paragraph.

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