Wednesday, October 15, 2008

Election 08: Ballot Measure 63

So I shall finally take a breather from the national and international economics news of the day (it's bad) and at long last get to my economic analysis of the measures that shall grace our ballots this fall. Where to start? Well, I'll just piggyback on the main editorial in today's Oregonian and talk about measure 63. This measure proposes to exempt from the permitting process any home construction project with a total value that does not exceed $35,000.

I shall frame the question thusly: does government regulation of residential home improvement through building permits make good economic sense? The simple answer is yes: there are externalities involved making the cost of improper construction not strictly private and potentially quite significant.

Perhaps the best way to begin is to set something straight at the outset: free markets work their magic when the costs and benefits of the activity the market is involved in is purely private and accrue to only the participants in the market. Such a market probably doesn't exist and so the relevant questions are: what is the nature of the market failures; and, are they significant enough to intervene in a market, which almost assuredly guarantees a second-best outcome (compared to the ideal)? It is pretty clear from recent events, for example, that credit markets have significant spill-overs and the inefficiency that would result from increased regulation and oversight is probably worth it.

One could argue that the externailites associated with poor construction are minimal compared to the bureaucratic drag on investment that comes from building permits. For instance, the likelihood that if my house catches on fire thanks to an improperly installed gas stove and then catches your house on fire is pretty small. But the fact that there is a higher probability of houses catching on fire in an environment where there is no oversight does impose a cost on me through increased insurance premiums, increased cost of fire prevention and suppression, increased burden on public health for those whose house burned down with them in it, etc., etc. There are also the ancillary costs of lost home equity due to the fact that my neighbor's house is now a heap of charred remains. This is all part of the the public good aspect of home ownership: while houses are private property they do have external costs and benefits that accrue to the community in which they reside.

So the idea that there is enough private incentive to make sure work is done right is not accurate. The true cost of improper construction is quite a bit higher than the personal cost, and thus there is a clear incentive to cut corners. This is especially true for 'flippers' who, once the house is sold, have little fiduciary responsibility to the buyers. The incentive to cut corners would be that much greater.

This gets to another problem that arises in the resale market: asymmetric information. While it is true that there can be plenty of construction that happens illegally, the permitting process is a way to reduce the information asymmetries between buyers and sellers of houses. This asymmetry can be quite damaging to the efficiency of the market and, ironically, hurts the people who don't cut corners the most.

What about the cost of the bureaucratic intervention? Well, for starters, the building permitting process for all other projects will remain in place so the marginal cost savings are likely to be low in terms of the size of the bureaucracy. What about lost investment in building projects? This is impossible to say for sure, and I have no doubt that there is lost investment, but I can't imagine that it is anywhere near the magnitude of the social cost of unregulated construction. I stand ready to be corrected however.

People often mistake economics as being about free markets (and a lot of other things). Not at all. Economics makes clear both the efficiencies of the outcomes of free and complete markets, but more importantly economics studies the implications of imperfect markets and helps figure out appropriate policy responses. This one is a no-brainer.

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