The intuition is simple: We distinguish between two effects influencing the average rent. First, an equally distributed increase in processing costs leads to lower average rents because all landlords want to choose higher renter qualities on average. The second effect concerns the market power of landlords. Due to relatively low processing costs in the old steady state, landlords have chosen high rental prices and relatively low renter qualities. This translates into many vacant units of housing on the market and to low market power of landlords. Directly after the shock to processing costs, the low market power of landlords is not altered. In contrast, in the new steady state, the market power of landlords is relatively high due to few vacant units of housing on the market.
In sum, the shock to processing costs leads to a strongly reduced average rent. In the long run, this negative effect on rents is mitigated by the effect of increased market power of the landlord.
We will proceed as follows. In section 2, we describe some approaches that explain the structure and the consequences of the lessor-lessee relation in the rental market and compare them with our approach. The formal model is developed in section 3. The resulting equilibrium distributions of rental prices and qualities of renters are studied in section 4. In this section we also present the core part of this work: the dynamic short-time effects of an unanticipated shocks to processing costs. Finally, in the last part, we conclude.
monopoly power over tenants, which leads to a market rent above costs. Nevertheless, in this model free entry and exit leads to zero profits of landlords. The equilibrium is created by the mechanism of vacancies. Although this model features heterogeneity of vacant housing units, this approach shares an important feature with our model: a high vacancy rate is useful to potential renters, because they have better choice possibilities between vacant units. Therefore their market power is higher.
A paper which shares some intuitions with our work is Wasmer (2004). There the author makes use of search models usually applied in the theory of labor markets to explain some characteristics of the housing market. In a continuous time setting, a matching and screening mechanism is introduced. This model aims to study the effects of changes in the costs associated with legal eviction procedures to the market outcome. It is shown that higher legal costs lead to more selective landlords, higher rents and to lower vacancy rates.
Hubert (1995) studies the so-called tenure discount in rental housing markets. In this paper an adverse selection problem arises due to the asymmetric information in the market. It is explained why long-standing tenants pay lower rents than average tenants. This paper focuses on ”service costs”, which are the costs caused by the renter during his stay in the dwelling, such as maintenance costs and administrative costs. It is shown that landlords charge bad tenants strictly higher rents than good tenants in the case of a renewal of the rental contract.
Similarly, Basu and Emerson (2003) consider a model of tenancy rent control under asymmetric information. If there is any inflation in the economy, landlords tend to let their houses to short-staying tenants. Furthermore, they show that under certain circumstances it may be optimal for landlords not to increase the rent, even when housing demand exceeds supply, which they call efficiency pricing.
Deng, Gabriel and Nothaft (2002) study the duration of residence in rental hous-ing. They provide empirical evidence that this duration is dependent on structural characteristics and on renter characteristics. We use their results as a foundation of our assumption that the vacancy rate and the turnover per period are determined by the quality distribution of renters in the market. Furthermore, they show that
changes in the legal environment, e.g. the imposition of rent control mechanisms, have strong influence on the average duration of residence, which indicates a change in the distribution of renters.
Wheaton (1990) constructs a search model of the housing market which explains a strong negative relationship between market prices and vacancy rate. His approach serves as an explanation of structural vacancy in housing markets.
A further model which highlights the matching aspect in rental housing markets is Anas (1997). He shows that under certain circumstances, rent regulation and central matching mechanisms in the housing market can lead to welfare improvements. Inter-estingly, in his model the regulated rent is set above the market rent in order to create more supply of housing, which in turn improves the match.
Read (1991, 1993) studies the quality dispersion of houses and vacancies in the rental market characterized by imperfect information on the part of the tenants. In these models the rental price of houses is fixed and there are no asymmetries between landlords.
Read (1997) builds a stochastic search model of imperfect information where the vacancy rate is induced by free entry of landlords in the rental market. He examines the influence of exogenous parameters on the vacancy rate. In particular, he shows that the vacancy rate falls with increases in the cost of housing provision, which is in line with our results. In this model, potential tenants can be completely described by an exogenously given demand curve, a feature which we will adopt in similar form.
In a theoretical approach, Read (1988) shows that the vacancy rate in the rental housing market is dependent on the renter’s behavior when moving out and on the advertising by landlords. In this model a searching mechanism is introduced such that a natural vacancy rate occurs due to landlords who do not find an appropriate renter. The choice variable of landlords in the model is not the price, but the degree of advertising, which endogenously determines the vacancy rate.
All these approaches do either not consider double heterogeneity on both sides of the market or do not analyse the transitional dynamics of exogenous shocks to the landlord’s cost characteristics. With this work, we want to fill this gap in the
literature.