Under inclusionary zoning (IZ), a local jurisdiction requires residential developers to set aside, among the homes they build and sell, a certain percentage classified as “affordable” and sold at a restricted price. [1] Although IZ has been in existence since the 1970s, interest in it has been gathering momentum over the past two years. Conventional explanations for this phenomenon include rising housing costs, resulting concerns about affordability, the federal government’s retreat from support for affordable housing programs, and perhaps the existence of local administrative infrastructures borne out of experience with exclusionary zoning (practices such as large lot requirements, which make it difficult or impossible to build lower-cost housing in certain neighborhoods and thereby exclude lower-income households.)

 

This goal of this article is to describe what IZ can be expected to accomplish and not accomplish, and under what circumstances, in light of economic theory. The article seeks to help readers attain a better understanding of IZ by leading them though the various economic implications.

 

In some jurisdictions, particularly in California, IZ literally mandates two prices for the same items. In other words, homes sold at the affordable price must be of the same size and quality as the homes sold at the market price in the same subdivisions.  In other cases, standards are relaxed for the affordable units so they can be produced at somewhat lower costs. The relaxation may involve density bonuses, an expedited permit approval process, or size/amenity reductions in the affordable units (although even in these cases detailed design and construction standards are often specified.)

Because many economic implications are similar under either scenario, we’ll start with the case of affordable homes and market rate homes that are similar in terms of size, quality, and development costs. This allows the market for new homes to be shown on one graph with a single supply curve. In addition, the analysis will initially focus on a competitive housing market, which economists regard as a reasonable working assumption in many local areas.

Under these conditions the local home building industry will charge a single price for its product, and the price that can be charged depends on how much various prospective buyers are willing to pay. By convention economists call the price/quantity combinations available to the industry a demand curve. In a competitive market, economists also define a supply curve (based on firms’ production costs), which shows how much the industry is willing to produce and sell at a given price.  An unregulated competitive industry in equilibrium operates at the intersection of demand and supply (Figure 1).

 

 

On top of this relatively simple picture, IZ imposes a partially non-market solution. IZ sets an affordable set aside (requiring, for example, that 15 percent of the new homes built be affordable) and a maximum price that can be charged for the affordable units. The remainder of the homes can then be sold for whatever the market will bear. In the case where the quality of the two types of homes is similar, this essentially establishes two prices for the same product, one of which is on neither a demand nor a supply curve (Figure 2). Households who are able acquire one of the new housing units at a below-market price are clear beneficiaries under the IZ ordinance.

 

 

But competition in the market implies that builders were breaking even before the IZ, in the sense of earning only a normal profit on the homes sold. [2] So the effect of IZ is to mandate that builders lose money on each affordable home built.The market forces that compensate for this are shown in Figure 2 as an upward movement along the demand curve. In English, builders pass the costs of IZ onto the buyers of new market rate homes by building fewer market rate units and selling them at a higher price.

 

If overall housing affordability is a concern, an important issue is whether the affordable housing units built under IZ partially, fully, or more than fully compensate for the reduced number of market rate units. Economic theory alone doesn’t provide an answer, as the outcome depends on whether builders are able to pass a high enough price on to new home buyers (on the graph this is determined by the slope of the demand curve over the relevant range). If they can’t, the burden shifts to the market for existing housing, where it adversely impacts overall affordability. [3] This possibility is shown in Figure 3. The households unable to buy new homes as the result of IZ (shown in the graph on the left) are pushed into the market for existing homes, where they drive up demand and prices for existing homes (in the graph on the right). 

 

 

Although the households who are made better off under IZ by being able to move into affordable units at restricted prices are likely to have relatively modest incomes, it’s interesting to note that some of the households made worse off in Figure 3 (especially renters and first-time buyers) could have similar income characteristics.

 

All else equal, lowering the affordable house price will exert more price pressure elsewhere in the local housing market. The further the affordable price drops below builders’ production costs, the higher the prices that will have to be passed on to buyers of new market rate homes in order to compensate, and the more difficult it will be to avoid an adverse impact to overall affordability like the one shown in Figure 3.

 

A slightly different scenario is shown in Figure 4, which graphs the case where an IZ ordinance allows affordable homes to be different from the market rate construction. The ordinance, for instance, may allow the affordable homes to be smaller or more densely clustered. Nevertheless, in this case IZ is still imposing a non-market solution, shown in the figure as an affordable price that lies below the supply curve.

 

 

Again, the market adjusts by transferring the cost of IZ onto the buyers of new market rate housing units in the form of fewer available units to buy and higher prices (illustrated in the figure by the supply curve for market rate units rotating upward above the affordable house price, reflecting the increased costs). The effect on overall housing production and existing house prices remains ambiguous, depending on how far the affordable house price is set below builders’ costs and how much of the loss can be passed on to buyers of new market rate homes.

 

What if, rather than the situation shown in Figure 4, costs are lowered enough so builders can produce affordable units at a normal profit? A jurisdiction may be able to accomplish this through the use of direct subsidies, effective density bonuses, other development concessions, or builder incentives. If costs can be lowered to a certain threshold this way, production and prices on both categories of new housing are the same as they would be in the unregulated market (unless the affordable set aside is so large that not all of the affordable units built can not be sold at the maximum allowable price). From a purely economic perspective, if costs are reduced far enough, the IZ ordinance becomes irrelevant (Figure 5).  From a political perspective, some municipal decision makers may feel they can only introduce strong cost reducing policies only the under cover of an IZ ordinance.

 

 

In a competitive market, the economic impacts of inclusionary zoning can thus be summarized as follows:

An important assumption underlying Figure 4 is that the markets for new market rate and affordable homes are separate, with distinct demand curves for each type of housing.  Anecdotal evidence suggests that this may be a reasonable assumption in practice, due to other restrictions often placed on the affordable units. In the typical case, IZ imposes restrictions on the incomes of households who can buy or rent the affordable units. IZ also typically restricts the price at which the affordable property can be sold for at least a decade (forever, in some jurisdictions). 

 

These restrictions may be useful if the goal of IZ is to force buyers of new market rate housing to pay the highest price possible, in order to avoid passing any of the costs on to renters and first-time buyers of existing units. The restrictions help prevent potential high-end buyers (those on the demand curve above price PM in Figure 2 and on the right-hand side of figure 4) from crossing over into market for affordable homes intended for less wealthy occupants.

 

Also keep in mind that, in both figures 2 and 4, affordable homes are sold at a non-market price that lies off the demand curve. This generally creates excess demand and raises the issue how affordable units should rationed among potential beneficiaries. Income restrictions (which reduce the number of eligible households) and resale price restrictions (which reduce the desirability of the product and the number of households who want to buy it at a given price) are one way to decide who goes to the top of the waiting list.

 

On the other hand, additional market restrictions introduce additional complications. If the  goal of an IZ ordinance is to make the low-income households who buy affordable units better off, it’s not obvious that resale price restrictions are desirable, as they deny the intended beneficiaries the obvious (and in practice probably quite substantial) benefit of immediate appreciation on an asset they purchase.

 

Moreover, mandated resale and income restrictions do not lead to a market outcome. They tend to reduce excess demand, but threaten to create excess supply. If the pool of eligible and willing buyers for affordable units is restricted too much, builders will find themselves unable to sell all the affordable homes at the maximum allowable price. Thus income and resale restrictions tend to have the same effect as lowering the affordable house price—additional downward pressure on new construction and higher costs passed on to buyers and renters of other (non-affordable) units.

 

An advantage sometimes attributed to IZ is that it enables local governments to create affordable housing without incurring additional costs. This is not strictly true, however.  Under IZ some local government resources are needed to enforce  the below-market price and income restrictions on buyers of the affordable units. If  IZ imposes resale restrictions, the enforcement on each affordable unit must be ongoing.

Proponents of IZ sometimes argue that housing markets are not competitive, so that the effect of IZ is to take monopoly profits away from builders in order to create affordable housing. The common counterargument is that substantial monopoly profits are not likely to exist for builders in many local housing markets, especially in the long run. In his 2003 paper on IZ, Kerry Vandell of the University of Wisconsin summarized this counterargument as follows:  “…virtually all analysts have concluded that the housing market in general approaches the characteristics of a competitive market…  on average, prices, rents, and profits tend to approach competitive conditions today in the U.S. urban housing market much more than they reflect ‘monopolistic’ or other deviant conditions.” [4]

 

Even if monopoly profits do exist in a particular local market, however, IZ is not a tool well designed to cope with them. IZ doesn’t make a housing market more competitive, as increasing the amount of land zoned for residential use or providing  builders incentives to operate in the local area might. In the absence of other measures, if local monopoly power were to exist before IZ, it would still exist after an IZ ordinance has been adopted. Thus, a jurisdiction proposing IZ as a solution to monopoly needs to undertake a detailed microeconomic analysis of the local market condition.

 

IZ is not a textbook example of a price control designed to regulate monopoly. In the textbook case, the price control forces the producer to sell output at a single price below the monopoly price but above the monopolist’s marginal cost. IZ instead mandates a system of two prices, only one of which is controlled.

 

What if monopoly pricing power were to exist in a housing market, and an IZ ordinance were adopted that set the affordable house price below marginal cost? In this case there is no important difference from a competitive housing market. The builder (who still has the power to charge monopoly prices on the market rate housing units under IZ) will pass the losses associated with selling some units below cost on to the buyers of new market rate units in the form or reduced output and higher prices. As under competition, the effect on prices and rents for existing housing units is ambiguous—depending on how far below marginal cost the affordable price is set, and the shape of the demand curve for new market rate homes.

 

Monopoly profits in home building allow another possibility, however: an IZ  ordinance with a price restriction below the current monopoly price but above the monopolist’s marginal cost.  If this could be done, it would unambiguously increase housing production, as the monopoly builder expands production of the affordable units until there are no more buyers for them or rising marginal costs finally make additional affordable units unprofitable. Moreover, in this scenario, the monopoly home building industry’s profits would increase. [5] A practical question in this hypothetical case is, “What was there to prevent the housing industry from behaving this way and earning the additional profit before the adoption of IZ?” One possibility is that other, pre-existing restrictions were in place that prevented the industry from building lower-priced homes. In that case, the effect of IZ is simply to allow builders to do what they would have done in the absence of regulation. 

The effect of income and resale price restrictions under monopoly are similar to their effect under competition. Resale price restrictions make buyers of affordable units less well off than would otherwise be under the ordinance, and both types of restrictions threaten to drive the effective price on affordable units below the maximum allowed and put downward pressure on the number of units produced. In the case of a market with monopoly power, this includes the possibility that additional restrictions act as a critical factor pushing the effective price on affordable units below marginal cost.

 

An interesting feature of IZ applied to a monopolistic market with an affordable housing price restriction set above marginal cost even after taking income and resale restrictions into account is that, were it to occur, it should be relatively easy to recognize. It’s one of the few scenarios under which the local home building industry is likely to support an IZ proposal.

If IZ is restricted to a small enough jurisdiction within a larger labor and housing market, it may have no impact on the larger market, as home builders will simply shift their constriction activities into neighboring jurisdictions.

 

In cases where IZ is able to impact a local housing market, it unambiguously makes the subset of households who acquire new affordable homes better off.  It does this  by passing higher costs onto buyers of new market rate homes and making these market-rate buyers worse off.

 

The implication for the broader housing market is ambiguous. IZ may drive up prices of existing housing units and benefit current property owners at the expense of reduced affordability for renters and first-time buyers.  Avoiding this outcome—which is possible even if builders in the area are earning monopoly profits—involves setting IZ parameters (the share of new homes set aside as affordable, and the price, income, and rent restrictions) in a way that satisfy a complex set of constraints based on local demand and cost conditions which are difficult to estimate. 

 

To the extent that subsidies, density bonuses, or other measures are able to increase the production of affordable housing by reducing the costs of development and construction, they would be just as effective—and easier to implement—without IZ. For these reasons, IZ is a less than ideal tool for improving overall housing affordability.

 

As a tool for achieving political objectives, it may prove more useful.  Consider for example a local governing body that is primarily seeking to maintain upward pressure on house prices (say, to satisfy its existing home-owning constituents) but is nevertheless facing political pressure from affordable housing advocates. IZ might be a logical policy choice if the local government in question cares little about  difficult-to-measure impacts on affordability, but instead simply wants to create a number of low-cost units as a showpiece it can use to appease advocacy groups.

 

To simplify the presentation for a web-based format, this article employed a fairly limited set of graphs to illustrate the economics of IZ. For readers interested in greater detail, additional graphs and underlying equations can be provided on request.

 

 

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