Gentrification Dynamics

Summary

Gentrification is an engine for super-wealthy investors to extract income from the higher tiers of the professional upper middle class by displacing and exploiting the poor and working class. I conduct a thought experiment on the broad decisions faced by a business owner that finds herself in a suddenly more prosperous neighborhood and reflect on how these decisions, under certain assumptions in each scenario, impact workers and the neighborhood. Remember, this is a thought experiment—I’m not at all sure that I’m right, or that I’m not missing something huge.

Intro

To start, assume we have a locally owned service sector business (restaurant, barbershop, retailer, etc.) that exists in a particular urban neighborhood. Its sale prices are set at roughly what the neighborhood can afford. Some other line of work in the city takes off—something like the tech boom happens and suddenly many (but by no means all) people in the neighborhood have more money.

What happens to the business, its employees, and the neighborhood?

Scenario 1

Assume the owners pays wages that are reasonable enough for her employees to live in the neighborhood. As the incomes in the area increase, property values increase relatively little, with no speculative bubbles permitted to grow due to regulation or other institutional arrangements—perhaps huge piles of wealth are not permitted much liquidity but are instead restrained in some way. Income increases don’t go to property values (other than general home improvements), and there is only a small inflow of new, higher income residents. Prosperity is not tied heavily to land/housing value increases.

If the business owner maintains original prices, she may face some hardship due to slight increases in rent and taxes. If she raises prices she may alleviate this minor hardship. Since her customers are generally wealthier, she likely has some latitude to do so—but note that she is not compelled to do this here. However, if other businesses raise their prices as well, she is wise to follow the general trend to increase her profits, especially in anticipation of what comes next.

If she wishes to retain her local employees, she may choose to raise wages so they can afford to keep patronizing her business and other similar establishments. The local businesses that raise wages will be more likely to attract new and better employees, so her particular business has an incentive to do so. If she does not, the employees may go elsewhere for work, though again note that they still have a good chance of finding this new work in the neighborhood since other businesses are following this model. If there is not a terribly depressed neighborhood nearby, employees have leverage now to demand pay increases. If there is, owners may hire from the depressed area. Assume for now that there is NOT a depressed area to hire from.

To bring in additional income, the business may experiment and start offering modified or new services that are related to its old services. To keep costs down, it may also try changing its suppliers. If either of these strategies works then the business increases its capacity to raise employee wages, thus increasing its competitiveness on that front.

In this scenario, modest increases in income from an outside growth industry are translated first into higher prices (since that is what the traffic will bear) and then into higher wages (since it is to the advantage of each business to remain competitive and attract new talent, plus have their employees remain customers). Overall income has increased, as have costs, while services and neighborhood residents remain roughly the same—possibly with some expanded opportunities for new work or entirely new businesses, since people can afford to pay more overall, and possibly with some shuffling of suppliers to increase efficiency.

This is wage push inflation, where a wage increase in one sector leads to higher prices, which leads to more wage increases—sometimes in the sector that hosted the original increase (in which case it is directly iterative), other times in horizontally connected sectors. In the case of well structured and competitive markets, wage increases can happen relatively naturally through the incentives of business owners alone. When markets are not competitive, unions and other such organizations seem to be necessary to enforce the wage increase part of the cycle. When the labor market is slack (i.e. businesses don’t compete as much in it), wage increases are less likely to occur and this mechanism is more likely to break down.

If this mechanism works, the neighborhood is mostly preserved but undergoes some measured and stable evolution. There are increases in income, wages, and the diversity of economic activity, and there may be some decreases in non-labor business costs. Some new residents enter, some old residents leave, but the flow is manageable. Living, healthy cities contain many neighborhoods that repeatedly undergo this process and which keep the labor market from getting slack. If only one neighborhood did this in an otherwise depressed city, the slack labor market would very likely eliminate wage increases and you’re more likely to have a result like that of Scenario 2.

Scenario 2

Wages start out reasonable enough, but as incomes increase, property values enter a speculative bubble. People not in the golden industry are priced out of homes and rental units, or see that they have a lot to gain by selling and moving elsewhere. Lots of new people move into the neighborhood, lots of established resident leave.

If our business owner maintains original prices, the increased rent and taxes will probably drive her out. If she raises prices, she will be more likely to pay the rent but is now contributing to pricing others out of the neighborhood. Her own employees can no longer afford to patronize her business, and her customer base is narrower, though more affluent. Assuming there is some competition, she has an incentive to raise prices as little as possible to survive, but because she must make rent in a speculative market, she must strongly maximize the difference between income and costs. This is accomplished by not raising the wages of her employees, thus minimizing total price increases (which keeps the customer base wider and keeps the business competitive) and keeping costs down.

As in Scenario 1, there may be some possibility of changing suppliers to keep costs down. It also seems that there would be more risk and therefore less incentive to experiment with new services, and that the risk increases (and experimentation decreases) as the rental bubble’s growth rate increases.

Wages are now too low for employees to live in the neighborhood and must come from elsewhere in the city (somewhere more depressed), supplemented by the teenage children of the now-wealthier residents who will work part time for minimum wage and no benefits. If her business survives, it now caters to people who didn’t live in the neighborhood before the affluence hit and employs people who can’t afford to live in the neighborhood now—the introduction of bubble rent pushes this arrangement, makes it the most viable option. The bubble rent is an expanding cost that must be paid, stretching her business model to its limit.

I would guess that cities that host slack labor markets are more likely to fall into this trap, since the lower wage level surrounding the affluent neighborhood provides an extra shot in the arm for the investors/extractors. If the business doesn’t do this, it will perish. Its last-ditch option is to move to a more depressed part of the city where it can still operate. Its place will likely be taken by either a boutique that caters to the professional upper middle class and lower level wealthy or by some other business with low fixed costs and a greater ability to keep wages depressed—a franchise.

This is gentrification, and this is what we have come to believe development must be like. But it is a failure mode of development that ransacks neighborhoods by buying land cheap, inflating value, extracting as much of that inflated value as possible, and then moving on to the next juicy target. The neighborhood is left to fend for itself without the money that propped it up to such glorious heights.

It works especially well in already stagnant areas, since it rides off an income gradient—high prices in the target area, cheap labor within commute distance. I suspect you can even remove the original income increase and just advertise a certain neighborhood as trendy in order to attract existing wealth. Get the professional classes to move their wealth into a new fashionable spot for extraction rather than create genuinely new income streams. Keep the wealth moving, like a financial heat engine that extracts money instead of doing useful work.

Note especially that when compared to Scenario 1, the stagnation in wages in Scenario 2 is effectively theft from the worker’s wages to pay the landlords. The more benevolent the business owner, the more likely that she’ll try to raise workers wages, which means that she must raise prices higher or cut costs elsewhere (quality), which means she is more likely to go out of business. Massive rent increases further sharpen the divisions between business owners and workers.

Scenario 3

The business in Scenario 2, which includes a bubble, is now taken to be a franchise that may determine the wages it pays but which has additional fixed costs and is contractually obligated to use franchise suppliers. The only major change here is that the franchise model locks in supplier and certain administrative costs, while prohibiting most experimentation. The only two “outs” afforded in Scenario 2 are eliminated, which leaves wage stagnation and price increases as the only levers to maintain profitability. Franchises are an example of increased efficiency at the cost of lower flexibility. They can do quite well in gentrified areas, but only because they keep wages down and use their national brand names to charge higher prices. (In depressed areas, they likely do the former while not pushing the latter as much).

Closing Thoughts

Scenario 1 seems more likely when the distribution of wealth around a city or region is more equal and there are multiple loci of growth. There are more investment opportunities proportionate to the amount of wealth that investors have, and huge piles of hot money are not allowed to be used as weapons of extraction. There isn’t a strong preference to latch onto or create a very small number of “good” neighborhoods and ruin them.

Scenario 2 seems more likely when the distribution of wealth is very uneven and there are no regulatory mechanisms that prevent speculation. There are fewer investors and fewer investment opportunities, and those that do exist tend to attract tons of hot money and inevitably lead to speculation. This drives people out of their homes and drives out local businesses. By trying (and being allowed) to dump tons of money into a sure thing, that thing is destroyed and remade into something else—an engine of profit extraction that will only last as long as the investors decide to make it last, until there is another even better opportunity elsewhere. And then the money will leave, and the neighborhood will collapse. The people who once made it function are no longer there, the businesses that operated without all that speculative investment are gone. The props are removed and the neighborhood comes crashing down.

Scenario 3 is the same as 2, but explores the more restricted solution space of franchises. They are often more efficient than traditional businesses, which enables them to get a foothold in most places. But their lack of flexibility requires them to raise prices and depress wages in order to survive changes, further contributing to gentrification. They are also stagnant when it comes to generating new types of work. If I’m right about this, how much do franchises contribute to the collapse of gentrifying areas? If only so much price/wage disparity can be tolerated in a given area, franchises (especially upscale ones) may drive the area to this limit faster. Speculators would encourage this in order to increase their gains, then pull out even sooner. In this sense, the franchise owners are participating in the same behavior as the real estate speculators.

If I’m not too far off in my thinking above, many of today’s gentrified areas are likely to collapse into misery and stagnation in the future. We must develop tools to handle their inevitable breakdown and set them back on the path of slower, measured growth and vibrancy. We must halt the gentrification engine. I suspect that its only one symptom of what Stirling Newberry calls “The Red Queen’s Race,” so a solution to gentrification will likely be a sub-component of a much larger plan. I also very, very strongly recommend that you go and read that link several times until you absorb it all.

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