The housing crisis, explained using game theory

post by Johnstone · 2023-07-15T20:27:07.679Z · LW · GW · 2 comments

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Crossposted from the blog The Hazy Path to which I contribute (thehazypath.substack.com).

In this article: the hidden effects of game theory, the power of incentives, and how to solve a problem that affects us all.

As I read countless headlines about Britain’s escalating housing crisis, I was perplexed by its apparent futility and absurdity.

After all, we have a deficit of 4 million homes, while a burgeoning construction sector is ready and willing to fill the demand. Even considering the barrier of planning permission, boosting construction ought to be a politically popular move. An increased housing supply will lower prices for everyone, and more people will be able to own their home, rather than being constrained by exorbitant rental contracts. Finally, it drives economic growth - Oxford Economics estimates that every 100,000 houses built raises GDP by 1%, a figure corroborated by ONS figures.

I could not understand why the housing crisis could exist in the face of these benefits to ramping up supply. I could not understand why planning permission remained so restrictive, despite the popularity of constructing homes. All I had to go on was the feeble explanations offered in print media.

This problem is often denounced as Nimbyism, which stands for “Not In My Backyard”. This refers to individuals being in favour of a project in general, such as building houses, but opposing it in their local area. It’s the influx of infuriated letters to the council offices. It’s the flyers and posters around town, presenting housing developments in a negative light. It’s the middle-aged residents chanting “We Are Not Amused”, without explaining what was supposed to be amusing about the plans in the first place.

It’s easy to decry these people as selfish, inconsiderate residents, prioritising their picture-perfect neighbourhoods over much-needed accommodation. But in fact, they are reacting to incentives in a completely rational way. To understand why, let’s examine a toy game with enduring appeal.

Imagine that 10 savvy investors are pooling together their cash to buy fine art. For their latest addition, they have each contributed £1 million to the fund, which is used to purchase a £10 million piece. Once bought, the masterful composition is hung in a jointly owned art gallery for their collective enjoyment, with the intention of eventually selling the painting for a handsome profit.

Now, imagine that one investor decides to sneak into the gallery in the dead of night, and swipe the valuable painting. (Bear with me, I’m getting to the point.) Having successfully pulled off the heist, he sells the piece to another avid collector for the original price of £10 million. All the investors are out by a million as a result of the iniquitous crime, but the perpetrator is up by £10 million. This nets him a cool £9 million. Can you blame him?

Probably, yes. We humans are morally averse to such behaviour, and with good reason: he cheated the group, acting in his own interest, to the detriment of everyone else. In the real world, this cheating carries harsh punishments in terms of social capital and reputation.

But now, let’s update our simulation to make it more similar to the housing market. Let’s expand the trust to millions of investors, managing hundreds of thousands of artworks. Now, if a single investor decides to steal a painting, he can’t be said to be cheating the group in any meaningful way, as they are only worse off by a negligible amount. The loss suffered by the group is minimal, and the thief’s gain is enormous by comparison. And yet of course, if all the investors did this, the losses would be so enormous as to bring the investment trust to a grinding halt. Do you see the comparison now? The fund represents the UK’s housing market, and the art thief represents a neighbourhood refusing construction.

One neighbourhood alone opposing construction won’t trigger a housing crisis. On the converse, one neighbourhood allowing it won’t cause it to end. Even if the benefits of adequate housing would outweigh the harms of construction, the benefits are shared among so many stakeholders that it seems impossible to achieve it.

Game theorists have a name for this dilemma: the collective action problem. And the housing market isn’t the only real-world example of it. Climate change is another fitting application. Your choice to get on a flight won’t single-handedly cause global ecological collapse. Meanwhile, your decision to forgo the flight in favour of more eco-friendly transport won’t put a dent in emissions. And yet, when everyone follows this perfectly rational logic, we find ourselves in trouble.

Believe it or not, political revolutions are yet another example of a collective action problem. To ensure the success of a revolution, a significant proportion of the population must rise up, overwhelming the incumbent government’s capacity to maintain law and order. No one wants to go it alone, for fear of being incarcerated or worse. Even if a revolution would be in the collective interest, each individual’s incentive to stay safe can often overwhelm the collective’s desire for justice.

A example of this phenomenon can be found close to home in the 2022 campaign “Don’t Pay UK”. Let’s set the scene: against the backdrop of the war in Ukraine, energy prices had soared. The UK government maintained that price increases were unavoidable, due to these global factors. But corporate balance sheets told another story. Oil and gas companies such as Shell, BP and ExxonMobil had seen their profits more than double from the previous year, from $89 billion in 2021 to almost $200 billion in 2022. From every household struggling under the weight of increased bills, significant funds were flowing to the fortunate oil giants. The Don’t Pay campaign, spurred on by this perceived injustice, implored UK citizens to simply refuse to pay their energy bills. If every household in the UK did this simultaneously, there would be no windfall profits to speak of, and energy providers would be forced to lower their prices. But no one wanted to participate in the campaign without the assurance that everyone else was doing it too. The consequences of participating without sufficient backup could be dire: disconnection of services, accumulation of debt, a reduced credit score and even legal action. The team running the campaign set a goal of 1 million signatories, to gauge whether the campaign would be successful. But even that was possibly too low: with an estimated 28 million households in the UK, even the planned enormous strike would be a tiny minority of customers. In the end, just 200,000 individuals signed up, and the strike was called off.

Based on this parable, you may assume that the collective action problem prevents revolutions from happening. And it can certainly act as a hindrance. But revolutions do happen. Why?

Charismatic leadership is certainly an important factor. Almost all successful civil disobedience campaigns have had a magnetic personality at the helm, capable of motivating large crowds to support their cause. Consider the actions of Mahatma Gandhi of the Indian independence campaign, Nelson Mandela of the anti-apartheid movement in South Africa, or Lech Wałęsa of the Solidarity movement in Poland, which brought about the end of communist rule. These leaders are effective at mobilising the populace to a clear action, especially when the benefits of mass action are clear and immediate.

But with issues such as the housing crisis or climate change, in which people feel disconnected from the endpoint of collective action, the effectiveness is reduced. With an incentive as clear as “immediate liberation from oppressive rule”, it doesn’t take much to reach a tipping point. But with more nebulous incentives, such as “protection from distant existential climate threat” or “more affordable housing”, a charismatic leader can’t achieve as much. There is no shortage of passionate climate activists, and yet emissions continue to tick up. There is no shortage of persuasive columnists condemning the Nimbies, but it doesn’t change the stubbornly dire housing market. And why would it? It’s all about incentives.

In the case of revolutions, the incentives quite clearly make sense, and the only thing holding people back is fear. But in the case of the housing crisis, people do have a genuine incentive to keep their neighbourhood how it is. So economists have proposed another solution: change the incentives.

Those of a mercantilist bent may suggest that a set amount of monetary benefit should be issued by the government, and competed for in the open market. Here’s how this might work in practice: the government creates a fund of £100 billion, say, to be invested in local communities. The fund will be allocated according to level of construction in the area. Suddenly, communities have a serious incentive to get to work on construction. However, detractors claim the government is creating “artificial incentives”, at great cost to themselves. So long as the incentives don’t make sense “organically”, it will be costly to fudge the numbers. Proponents will claim that the intervention pays for itself through the GDP-boosting effect of construction. Others remain less convinced, further claiming that these “selective incentives” could undermine voluntary cooperation.

And yet, this tool has seen a certain amount of success in the form of carbon pricing. Here’s how it works. There is an overall cap on the amount of CO2 that can be emitted in one year. This cap is then divided into “permits”, which each represent the right to emit a certain amount of CO2. These permits can be freely traded in the market. Any company that has successfully managed to cut down on CO2 emissions can sell their excess permits: this is an incentive to reduce emissions. Those companies that are failing to reduce their emissions will have to buy permits from other firms at a price set by the market: this is a disincentive to emitting CO2. Over time, the number of permits issued annually will be reduced, in accordance with climate targets. This policy is formally known as an emissions trading system, but is often abbreviated to “cap-and-trade”.

The cap-and-trade system first came to prominence in the United States during the 1990s, as part of the Clean Air Act. The Act’s goal was to reduce emissions of sulfur dioxide (SO2) in order to prevent acid rain. The scheme was greatly successful, reducing acid rainfall by 3 million tons in the year it was introduced. Nowadays, the largest cap-and-trade schemes can be found in China, the US state of California, and the European Union. Whether they will ultimately succeed in reducing CO2 emissions to a sustainable level remains to be seen.

Those who favour a more centralized approach might argue for increasing the disincentives to hindering progress, rather than increasing the incentives to promote it. In other words, the stick instead of the carrot. This policy has a few things going for it, such as the effect of loss aversion. People tend to respond more to the threat of losing current possessions than the prospect of gaining new possessions in the future. Losses are weighed much more heavily than gains. As a result, the threat of sanctions may be a more effective tool to stimulate action than the promise of rewards.

In the climate example, the means for such a system are clear. Harsh punishments would be exacted for failing to meet climate targets, such as fines and penalties, carbon taxes, or even litigation. Examples can be found across the world, such as in Australia, Norway and Uruguay. But in the housing market, it’s less clear how a community could be punished for failing to allow construction. Who would be responsible: the council? Community interests boards? The public? One cannot easily say.

For our final theory, let’s look back to the example of the art collector. In a small group, what stops would-be thieves from carrying out their nefarious plans? The answer is reputation: a powerful social system to reward those who contribute to the group, and punish those who take without limit. Loss of reputation means loss of trust and credibility, social exclusion and stigma, reduction of opportunities and financial repercussions. But once groups grow past a certain size - 150 to be exact - the effectiveness of reputation-based punishments drastically diminishes. The anomyninity afforded by a collective makes it difficult to punish free riders.

So, how about a mathematical solution? There are various examples of a reputation score being calculated by a mathematical formula, such as credit scores used by banks and lenders, or the somewhat more sinister social credit system being developed in China. Would it be possible to do the same for communities? Quite possibly: in the UK, every constituency could be allocated a score based on willingness for construction to take place. The score could be adjusted for different factors, such as quantity of ecological assets and risk of overpopulation. Constituencies with higher scores could be awarded additional government grants, given tax incentives to boost entrepreneurship in these areas, and even be top of the list for infrastructure developments.

Evidently, the housing market is a game that is rigged against the population, and the collective action problem only makes it more difficult to win. In order to restore stability and justice, we must change the rules of this game. Whether it’s through incentives to construction or disincentives to inaction, we must break down the barriers to home ownership. Hopefully you can see the obstacles to collective action more clearly, having dispelled the surface-level interpretations of gatekeeping and Nimbyism. The housing crisis may be a tough level to beat, but it’s vital to keep at it. With a dash of game theory, a pinch of economic insight, and a power-up of collective action, we can unlock a new world where everyone finds their own castle in the sky.

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