13.4 The benefits of exchange and market power

Invitation Homes is the largest single-family rental company in the United States, owning roughly 85,000 houses across the country. While Invitation Homes owns less than 1% of all rental houses in the United States, it owns close to 15% of all rental houses in South Florida, and even larger concentrations in certain neighborhoods and communities.

It is not uncommon for a single rental company to own almost all the houses on one street, suggesting that rental companies such as Invitation Homes may exhibit their greatest market share at the neighborhood level.

In this section we explore the implications for buyers when firms have significant market power. Before we begin, we need to understand how buyers and sellers gain from exchanging with each other.

Gains from exchange

Suppose you are renting a house from a rental company named Step Right In. You are the buyer/renter (or tenant) and Step Right In is the firm/landlord. Figure 13.8 shows the demand, marginal costs, and marginal revenue curves for Step Right In. The figure looks similar to what we saw for CORE Brewing Co. Figure 13.8 shows that Step Right In will rent 30 of the houses it owns in the neighborhood and charge a rental price of $2,000 per month. We will assume that the homes that are rented are pretty similar in size and features. Step Right In determines the price and quantity of rental houses by comparing the additional revenue it would gain from renting another house (that is, marginal revenue) with the additional cost of providing another house rental (that is, marginal cost). Step Right In will want to rent an additional house as long as the additional costs of renting the house do not exceed the additional revenue. This strategy will allow Step Right In to earn as much profit as possible.

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-8

Quantity of houses that Step Right In rents per month.

Figure 13.8 Quantity of houses that Step Right In rents per month. Like CORE Brewing, Step Right In compares the additional costs of renting a house with the additional revenue of renting a house. Step Right In will want to rent an additional house as long as the marginal costs do not exceed the marginal revenue.

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-8a

Step Right In’s demand curve

Let’s start by plotting the demand for rental homes in the neighborhood. The law of demand dictates that an increase in price results in a decrease in quantity demanded. As a result, the demand curve is downward sloping. Step Right In is the landlord for the entire neighborhood; the firm’s demand curve is equal to the market demand curve.

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-8b

Adding the marginal revenue curve

Because the firm faces a downward-sloping demand curve, it must lower its price to rent out an additional property. But this lower price applies not just to the extra unit, but to all units rented. As a result, the additional revenue gained from renting one more property (marginal revenue) is less than the price charged, causing the marginal revenue curve to be steeper than the demand curve.

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-8c

Adding the marginal cost curve

Let’s assume that the additional cost to rent out these homes is $500 (including utilities, insurance for an additional unit, and so on). We can add the MC curve to the figure with a horizontal line at $500 corresponding to the $500 per unit constant marginal costs of renting out an additional house.

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-8d

Finding the profit-maximizing price and quantity

Now that we have all the relevant curves in our figure, let’s label the price and quantity that Step Right In will charge if it wants to maximize profits. We saw earlier that firms can maximize their profits by setting the MR = MC and charging the highest price on the demand curve at that level of output. MR = MC at 30 houses is shown by point I. The price that Step Right In will charge is $2,000 a month in rent, shown by finding the price that corresponds to the quantity of 30 houses on the demand curve (shown by point H).

Once Step Right In determines how many houses to rent and the price it will charge, renters decide how many houses to rent. We can assume that the rules of the game, which determine how rental houses are allocated to renters, are as follows:

• The firm decides how many rental houses to rent out and sets a single price.
• Individual renters then decide how many houses to rent.

consumer surplus

Each consumer who buys a good receives a surplus equal to their willingness to pay minus the price. The term “consumer surplus” normally refers to the sum of these surpluses across all consumers.

producer surplus

The producer of a good receives a surplus on each unit, equal to the price minus the marginal cost of producing it. The term “producer surplus” normally refers to the sum of these surpluses across all units sold.

Figure 13.9 shows how both buyers (the renters) and Step Right In (the firm or landlord) could benefit from a transaction. We saw in Chapter 12 that the demand curve reveals buyers’ willingness to pay for quantities of a good or service. Buyers are represented all along the demand curve. For example, some buyers are willing to pay $2,500 or $2,800 to rent one of Step Right In’s houses, a price above the $2,000 that Step Right In charges. Other buyers are willing to pay only $1,000 or $800, prices below what Step Right In charges. The difference between what renters are willing to pay and what they pay is their consumer surplus, which is a benefit to renters.

Step Right In also benefits from exchanges with renters. It has a constant marginal cost of $500 to rent a house, and it rents its houses for $2,000 per month. The difference between the rent that the firm charges and the marginal cost to rent a house represents a surplus for Step Right In. This producer surplus is a benefit to Step Right In.

The shaded yellow area represents the surplus to renters because it is the difference between what buyers are willing to pay to rent a single-family house and the rent they have to pay. The green area represents the surplus for Step Right In because it is the difference between its marginal cost of providing a rental house and the rent that it receives.

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-9

Gains from exchange

Figure 13.9 Gains from exchange The figure represents the gains from exchange between renters (buyers) and corporate landlords (firms). Renters gain the yellow-shaded area, which represents the difference between renters’ willingness to pay and what they actually pay for rent. Step Right In gains the green-shaded area, which represents the difference between its marginal costs of providing an additional rental house and the rent it receives for each rental house.

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-9a

Step Right In’s original profit-maximizing price and level of output

Let’s start by redrawing Figure 13.8. The firm chooses an output of 30 units (where MR = MC at point I) and charges a price per unit of $2,000 (the price when output is 30 at point H).

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-9b

Identifying consumer surplus

We want to shade in the area that represents the gain to the buyers, or in this case, renters. Renters gain the yellow-shaded area, which represents the difference between renters’ willingness to pay and what they actually pay for rent. We call this gain to buyers the consumer surplus. You can calculate the area of the triangle by multiplying ½ times the base of the triangle (30) times the height of the triangle (1,500). Consumer surplus, therefore, equals $22,500.

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-9c

Identifying producer surplus

We also want to shade in the area that represents the gain to the producer, or in this case, the landlord, Step Right In. Step Right In gains the green-shaded area, which represents the difference between its marginal costs of providing an additional rental home and the rent it receives for each rental home. We call this gain to the producer the producer surplus. You can calculate the area of the rectangle by multiplying the height of the rectangle (1,500) times the base of the rectangle (30). Producer surplus is $45,000.

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-9d

Identifying total surplus

Now that we have identified the consumer and producer surplus, we can think about total surplus. Total surplus represents the total benefits to society. Total surplus is equal to the consumer surplus plus the producer surplus, or the yellow- and green-shaded areas combined.

The landlord’s surplus for each house it rents is the difference between the price and the marginal cost of providing and renting the house. To see Step Right In’s profit, we need to bring in its average total costs, which we introduced in Chapter 12. Let’s redraw our demand, marginal costs, and marginal revenue curves again and include the average total costs in Figure 13.10. We will assume that average total costs are $700. Profit corresponds to the firm’s total revenues (the price it charges per unit multiplied by the units sold) minus its total costs (the fixed costs plus the variable costs). Follow the steps in Figure 13.10 to ensure you can see how to find these values.

Producer surplus tells us the firm’s surplus relative to the outside option of not renting houses but still incurring the fixed costs. In contrast, profit tells us how much surplus the firm receives relative to the outside option of leaving the market altogether.

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Profit for Step Right In

Figure 13.10 Profit for Step Right In This figure shows how much Step Right In earns in profits when it charges rent of $2,000 and rents 30 houses per month.

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Step Right In’s consumer surplus

Let’s start by redrawing Figure 13.8 and labeling the consumer surplus we identified in Figure 13.9.

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-10b

Identifying total revenue on the graph

To calculate the firm’s profit, we need to find its revenue. Step Right In’s total revenue is calculated by multiplying the price it charges by the number of units it rents for that price. The price is $2,000 per unit and the quantity it rents is 30, which means we can show the total revenues as the area \(\$2000 \times 30 = \$60,000\) shown in purple. CORE query: the final instance of ‘price’ in this caption had some alternate font formatting on it in the manuscript, should it be italicised or was that an error?

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-10c

Identifying total variable cost and total fixed cost to the graph

We saw in Figure 13.9 that the landlord’s surplus for each house it rents is the difference between the price and the marginal cost of providing and renting the house. To see Step Right In’s profit, we need to bring in its average total costs (ATC), which we introduced in Chapter 12. Let’s suppose the average total costs for Step Right In are $700. Remember that a firm’s total costs are its fixed costs plus its variable costs. The fixed costs (FC) are $6,000 or \(\text{FC}=(\$700-\$500) \times 30\) (the purple area). The variable costs (VC) are the marginal costs multiplied by the number of units, or \(\$500 \times 30 = \$15,000\) (the blue area). They sum to the total costs. The firm’s total costs are therefore \(\$6,000 + \$15,000 = \$21,000\).

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-10d

Identifying Step Right In’s profit

We know from Chapter 12 that profit equals total revenue minus total cost. We calculated total revenue in step 2 and total cost in step 3. We can subtract the costs from step 3 (\(\text{TC} = \$21,000\)) from the revenue in step 2 (\(\text{TR} = \$60,000\)) to find Step Right In’s total profit: \(\$60,000 - \$21,000 = \$39,000\). The economic profit is shown by the area shaded in green.

Let’s take another look at Figure 13.10. Quite a few possible renters are willing to pay more than Step Right In’s marginal cost. For example, some potential renters are willing to pay $1,300 or even $1,600 for monthly rent. It seems Step Right In would benefit from exchanging with these renters because its marginal costs are only $500. Why does Step Right In rent only 30 houses when both the firm and renters could be better off if it rented more houses?

price discrimination

A selling strategy in which different prices are set for different buyers or groups of buyers based on the buyers’ differing willingness to pay.

deadweight loss

Deadweight loss is a measure of the total loss of surplus (that is, potential gains from trade) relative to the maximum available in the market.

principle of individual and societal interests

Individuals doing the best they can often does not lead to the best outcomes for all people or for the environment.

The answer lies in our assumption that Step Right In charges a single rent to all tenants. This is a simplification, as many real-world companies practice price discrimination, which is charging different prices to different customers (seen, for example, in student discounts or airline fares). If Step Right In could charge some renters $1,600 and others $1,300, it could increase its profit and make these additional renters better off.

At the single rent Step Right In charges, some renters who value a house above the company’s marginal cost are priced out of the market. The value these renters place on housing, along with the potential profit Step Right In could earn from them, is lost to both sides. The loss is called deadweight loss because it cannot be captured by either renters or the landlord under the single-price assumption. The potential gains from trade that are not realized are represented by the blue-shaded area in Figure 13.11.

Figure 13.11 illustrates the individual and societal interests principle. When individuals or firms act to maximize their own benefit, the result is not always the best outcome for everyone. Step Right In is doing the best it can by setting the single rent that maximizes its profit. However, that choice leaves some potential renters, who value a house more than it costs to provide it, without housing. Those missed transactions represent gains from trade that society as a whole loses.

In other words, Step Right In’s interest in maximizing profit conflicts with the broader social interest of making sure all mutually beneficial trades occur. You can think of the deadweight loss as the gap between what is privately optimal for Step Right In and what is socially optimal.

deadweight loss

Deadweight loss is a measure of the total loss of surplus (that is, potential gains from trade) relative to the maximum available in the market.

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-11

Deadweight loss

Figure 13.11 Deadweight loss Deadweight loss is a measure of the total loss of surplus (that is, potential gains from trade) relative to the maximum available in the market. In this figure, the deadweight loss is the area shaded in blue. This area represents transactions that do not take place even though some buyers are willing to pay a price greater than the marginal cost (MC) of $500.

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-11a

Step Right In’s consumer and producer surplus

Let’s start by redrawing Figure 13.9, which labels the consumer surplus and producer surplus.

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-11b

Identifying the deadweight loss

Deadweight loss is a measure of the total loss of surplus (that is, potential gains from trade) relative to the maximum available in the market. At the single rent Step Right In charges, some renters who value a home above the company’s marginal cost are priced out of the market. The value these renters place on housing, along with the potential profit Step Right In could earn from them, is lost to both sides. The loss is called deadweight loss because it cannot be captured by either renters or the landlord under the single-price assumption. In this figure, the deadweight loss is the area shaded in blue. This area represents transactions that do not take place even though some buyers are willing to pay a price greater than the MC of $700.

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https://books.core-econ.org/uoe-101/13-04.html#figure-13-11c

Consumer surplus, producer surplus, and deadweight loss

We can combine the areas to show them all on the same axes, showing the consumer surplus, producer surplus, and the deadweight loss for the firm charging a price above its marginal costs.

We have seen that both buyers (renters) and sellers (landlords) gain from exchanging with each other. Now we want to think about how the gains from exchange are distributed.

Bargaining power

bargaining power

The extent of a person or firm’s advantage in securing a larger share of the economic rents made possible by an interaction.

market power

A firm has market power if it can sell its product at a range of feasible prices without losing many potential buyers to competing firms.

The division of gains from economic interactions depends on the relative bargaining power of the participants: that is, their ability to influence the price in their own favor. The owners of Step Right In have bargaining power—a type of market power⁠—as the only seller or one of a few sellers of rental houses in a particular neighborhood. They can charge a high price for rent, knowing that buyers who value a rental house highly will pay it. An individual renter has little power to bargain for a better deal because the firm has many other potential renters. Step Right In’s market power and ability to set a high price increases its producer surplus and reduces the consumer surplus for buyers. In other words, Step Right In benefits from extracting the maximum willingness to pay from renters.

Step Right In can even attempt to steepen the demand curve for its rental houses by engaging in one of the strategies we mentioned earlier, such as restricting competition. One way to restrict competition is to purchase many of the houses for sale in a particular community so that other corporate landlords (or anyone else) can’t buy houses there. If a corporate landlord is able to buy nearly all the houses in one community, people who want to rent in that community have no choice but to pay the rent that Step Right In charges.

Corporate landlords also benefit from economies of scale. For example, small-scale landlords who own one or two properties often have to hire maintenance companies to service their properties, and property managers to manage their properties. In contrast, corporate landlords have in-house legal teams and maintenance workers, which lowers the costs of acquiring and maintaining properties. These economies of scale make it more challenging for smaller-scale landlords to enter the rental housing market.

Finally, corporate landlords have merged with other landlords to allow them to acquire a larger number of properties, thus increasing the market power of the firms providing rental housing.

As Figure 13.11 shows, the surplus that accrues to the buyer or renter is not always the same as the surplus that accrues to the seller or landlord. When the price of rent is high and the number of houses provided is lower, corporate landlords receive more rent. When the price of rent is lower and the number of houses provided is greater, then renters have greater surplus.

In the end, when corporate landlords are successful in restricting competition and increasing their market power, they can set higher rents and reduce consumer surplus. For some renters, the reduction in surplus might have little impact because they were already willing to pay a high rent. For others, especially those with lower incomes, the loss of surplus can create real hardships. For example, if a renter’s willingness to pay is closer to the market rent, they may have little or no consumer surplus left. With no extra value from their housing transaction, they have less income available to spend on other goods and services.