BackWhy real estate prices in Mumbai remain sky high
The economics of rent-seeking help explain the strident opposition to Mumbai's new development plan
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Since it was first proposed on 24 February, the new development plan of the Municipal Corporation of Greater Mumbai (MCGM), which intends to provide a roadmap for urban development until 2034, has aroused much commentary, largely negative. This stemmed from factual errors in the development plan, along with concerns about the proposed increases in the floor space index (FSI). The FSI governs how large and tall a structure may be built on any given plot of land. Because of the controversy, the Maharashtra government has returned the draft development plan to the MCGM, and asked it to revise the plan.
A key question is whether the revised plan will drop the proposed large increase in FSI, which was the centrepiece of a lively closed-door discussion at the IDFC Institute, a Mumbai think tank, of which I am a fellow. It became evident from the meeting that vested interests—including the builder lobby and officials tied to the current regime—strongly opposed liberalizing FSI norms and supported the status quo.
What is the economics behind this?
In a nutshell, as lucidly explained in a research note for IDFC Institute by architect and urban planner Bimal Patel, FSI rules have remained largely static since they were originally framed in 1964, while the property market has burgeoned. The result is scarcity (or an excess of demand over supply). In other words, FSI rules which have not kept pace with growth in the market effectively constrain how tall builders can build.
As a matter of textbook economics, a government can create scarcity in a given market by one of two mechanisms—it can either fix a price that is artificially low, or, alternatively, it can fix a quantity (that is, a quota), which, again, is artificially low—by “artificially low" I mean a level of economic activity which would be below what would prevail in a competitive market without government intervention.
In either case, by inducing scarcity, the government also creates something of economic value—the above-normal profits, or “rents" in economic jargon, associated with the restricted level of supply available in the market. In the case of the FSI in Mumbai, the economic rents show up in the form of inflated property prices, which is a rather obvious consequence, but also in subtler ways too—what one might call an entire political economy of “rent-seeking" that has arisen—a veritable nexus of municipal officials, builders, architects, brokers, fixers and so forth, all of whom benefit from their piece of the pie, thanks to the artificial scarcity in the market.
The term “rent-seeking" was originally coined by economist Anne Krueger in a landmark research paper published in 1974. Krueger’s paper, along with another classic research paper by economist, legal theorist and jurist Richard Posner, published the following year, have shaped the subsequent literature in economics, political science and public policy. Their work, in turn, was preceded by a path-breaking research article by economist Gordon Tullock, published in 1967, which anticipated some of their key insights.
Before Tullock, Krueger and Posner, economists generally assumed that the social waste arising out of government-induced scarcity—such as, for example, FSI limits set artificially low—was relatively small, and reflected the conventional economic inefficiency of output being too low compared to a competitive situation—what economists call “deadweight losses"—typically to the order of a few percentage points of the economic value of the activity. That was a loss, to be sure, but not one to worry about too much.
The conventional measure of losses was so small because conventional theory assumed that the rents themselves did not represent a loss to society at all, but rather merely a transfer from the rest of society to whoever captured the rent. (This is not to say that the transfer was ethically desirable, rather that there was no economic loss per se involved.)
What Krueger and Posner argued, contrary to the conventional view (which is still standard in first-year economics textbooks) was that the total value of rents created through government-induced scarcity should be accounted for as loss and not merely a cost-less transfer. This was because, they argued, these rents would be wastefully dissipated, by those seeking the rents, in the form of lobbying government authorities to capture those very same rents. The rents, in a sense, feed upon themselves, and end up being wasted. (Tullock had a different emphasis. He believed that rents captured by the government itself—say through revenues created by levying taxes or tariffs—would be wastefully spent, say on public works projects that no one wanted, or more simply merely pocketed by crooked officials.)
Subsequent research, including an important 1982 research paper by economist Jagdish Bhagwati refined these stark early findings, and suggested that it was unlikely that all of the rents would be wasted. To the extent that rent-seeking was “efficient", some of the rents might be captured and shared by rent seekers and rent creators alike, while the rest would be dissipated. As a consequence, the loss to society might not be 100% of the rents, as Krueger and Posner believed, but it was unlikely to be zero, as conventional theorizing would have it. Either way, the net effect would be that losses from rent-seeking would be considerably higher than economists were conventionally used to believing.
FSI-induced scarcity in Mumbai fits the rent-seeking paradigm strikingly well. The strongest opponents of reform are those who gain from the status quo—the builder lobby, in particular, but also architects and designers who have developed highly specialized skills to squeeze as much usable space out of a given quantum of FSI as the rules will allow. And where rules need to be bent rather than strictly adhered to, assorted fixers and middlemen may be able to help shepherd a project through the various regulatory hoops and grease the requisite palms.
As Patel writes, in the research note cited earlier, “This was a perverse way of designing and selling buildings but it was a very effective and a quasi-legal way of breaching FSI limits and expanding profits. Soon, wizard-like ‘FSI architects’ emerged. Using the above approach, they could design buildings so perversely that the floor space in their buildings was twice or even three times the allowable amount."
This is a classic case of resources being diverted to unproductive purposes, to get around an artificially induced scarcity; and, in the process, those rents which remain may be apportioned among the rent creators and the rent seekers. Consumers lose in such a set-up. So do builders and architects without insider connections, who find the FSI and other municipal rules so bewilderingly complex and opaque that they are almost impossible to comply with for an outsider. Another subtler sort of loss is that of good architecture. Architectural style in the city is distorted to maximize usable space, rather than to achieve functional, aesthetic or other architectural ends.
This confluence of vested interests—as the theory of rent-seeking would predict—has every interest in opposing reform to FSI rules. After all, if the artificial scarcity were to disappear, “FSI architects", insiders with knowledge of how to game the system, rent-seeking officials and the gaggle of intermediaries will lose their privileged position, and will need to face the pressures of a competitive market.
Such vested interests, as it happens, had a readymade argument to use against the development plan, which were the errors it contained. The unfortunate consequence has been to make the case for reform more difficult, since opponents of the development plan who oppose its liberalizing of FSI norms could shoot from the shoulders of those finding fault with its nugatory errors and omissions but who, in principle, would not object to the development plan’s reformist impulse.
Some three decades have passed since the pioneering work of Krueger, Posner and others, but their contribution to our understanding of the political economy of rent-seeking is as fresh as ever—and a vital clue to understanding the real meaning of the debate over Mumbai’s controversial development plan.
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