There once was a land called Opportunity. It was an egalitarian place. There were 150 million households that lived there. They each earned $50,000 per year, spent $12,500 a year in rent, and lived in homes worth $150,000 each. One quarter of the citizens were landlords, and maintained 4 houses, earning the same $50,000 per year as the other citizens.
It was a mousetrap based economy. The capital city, New Califork, was located near the mines that contained the purest iron for their springs. So, 30 million families lived in the sprawling metropolis. It was such a vibrant place, full of ideas, that each year, New Califork's factories churned out mousetraps that could catch 10% more mice than the traps from the year before.
Opportunity had gone on like this for a while, with families across the land enjoying the abundance of more and more captured mice each year. But, then one day, a terrible cyclone hit New Califork and picked up 15 million homes, like the storm from the Wizard of Oz. When the storm had passed, 15 million homes had been scattered across the country. Cleaning up after the storm was a long process, and for some time they were too focused on recovering from the storm to think about rebuilding, and they put a moratorium on replacement homes in New Califork until things got back to normal.
For the most part, they made due. But, the largest problem was in New Califork. The city still possessed all of its high quality iron, so there was more iron than the remaining workers could use. Eventually, all the best scattered workers decided to try to move back to New Califork. They started to offer the landlords more rent to move into homes in New Califork, and sometimes landlords would agree, sending some other unfortunate family out to live in the countryside.
Eventually, they managed to realign all of their activities so that they managed to maintain their mousetrap output. But, the workers who had braved their way back to New Califork knew that they had made it because they were best mousetrap makers, so they demanded $100,000 annual salaries. Their bosses complied. Other mousetrap manufacturers were not able to move in to compete with them anymore, so the mousetrap factories that increased their wages to get the best workers could pass their costs on through higher prices. Of course, the workers had promised the landlords higher rents in order to get back to New Califork, so they now spent $25,000 on rent. The landlords didn't see any foreseeable end to this state of affairs, so the houses in New Califork now had a value of $450,000. Eventually New Califork was divided between the new $100,000 workers and the old $50,000 workers, though, of course, rents had risen for all of them.
With so many fewer workers and less competition in New Califork, the mousetraps started only improving by about 2% per year. And, what other changes did Opportunity see:
Opportunity after the storm is much like the US, and New Califork is a rough approximation in scale and levels of New York City, Los Angeles, San Francisco and San Jose. The largest effect of the storm, over time, will be the lower productivity caused by the lack of workers in New Califork - the loss of rising quality of life that Opportunists will never know they missed, like the robotic, self-setting mousetrap that was never invented because its creator ended up working in the cheese farms in Opportunity's countryside instead of moving to New Califork with her brilliant idea.
Among the immediate effects are an extra 6% of inflation due to rising incomes and rents in New Califork.*
But, the two most significant effects are, (1) a large jump in the incomes of the top earners and (2) a decent jump in the value of homes. The effect on high incomes is probably worse in the US, because New Califork has no income inequality, but, in the US, these cities tend to have the most positively skewed income distribution.
I could have added firms to the mix in Opportunity. The effect on firms would have been similar to the effect on workers. Firms located in New Califork would have tended to earn more income, so that there would be more variance in firm profits after the storm. Workers with higher wages would have worked for firms with higher profits. We also see this in the US.
The housing value may be unexpected. Housing demand tends to be somewhat inelastic. That is why rents in the constrained cities tend to represent a larger portion of incomes. Normally, this wouldn't matter much, because in the long run, housing supply should be very elastic. New homes will be built at roughly the same cost as existing homes, regardless of how much house people demand. But, the problem in New Califork, and in metropolitan US, is that locals prevent new housing from being built. This creates the odd result that by building those houses in less valuable locations all over the country instead of in our best cities, we actually raise the face value of the housing stock. When the supply of homes is reduced, the rise in prices (in terms of rent) is steeper than the fall in quantity, so total dollar value increases.
Opportunity held a vote. They were concerned about their newfound inequality and their lack of mousetrap growth. A lot of people said that the low growth was caused by the inequality itself, because regular families didn't have as much money to spend on mousetraps anymore. Should they allow new houses in New Califork again, or should they implement a tax and redistribution regime and an anti-inflation program? They voted overwhelmingly for the tax and redistribution regime. The backers made very good points. They said that with all of the new income inequality and high inflation, nobody would be able to afford the houses they might have built. Not only had inflation driven consumer prices up by more than 6%, but home prices, which the government of New Califork sneakily doesn't include in inflation figures, were up 20%. So, regular families couldn't afford much of anything, let alone houses. Maybe they would be able to after some income redistribution and a little less inflation. They also noticed that some firms were starting to capture persistently higher profits. Nobody was able to pin down the reason, but economists know that high profits can come from what is called "rent seeking" - a sort of unearned income that can come from government favors. It was a suspicious development, and confirmed for the Opportunists that the new taxes were being taken from people who didn't deserve it anyway. It was the only solution that made sense, if you think about it.
Of course, the New Califork landlords were all for building new homes. They were making money hand over fist, and they were all greedily thinking of all the additional rent they could make with more houses. But, with income inequality such a big problem already, obviously the last thing Opportunity needed was for the richest Opportunists to have even higher incomes. The fact that some landlords were vocal about their support for new homes in New Califork probably drove more support to redistribution, if anything. When people are suffering, it really is unseemly for those who have so much to be pushing their weight around for self-serving public policy. And those middle class $50,000 workers still hanging on in New Califork said, "You mean, those landlords who have been forcing all of my friends and neighbors out of town so they can rent their houses to these rich people moving in? They want to build more houses so they can move more rich people in and drive up rents even more? Uh. No."
I visited New Califork again, some time later. But, you know, after that storm, it just seemed like they were running to stand still. After that, it just seemed like when they did have some good times, all the income went to those high income workers, and everything - especially houses - would just get more expensive. The last I heard, they were so disturbed by the amount of money families were spending on housing that they put a stop to building across the entire country.
* The problem in the US is worse than this, because in New Califork, families are still staying in the original units. In the US, in 2005, the typical family moving to one of these cities not only raised their rent from about 25% to 33% of their income, but even to settle with that large cost increase, they have to downsize sharply. So, our rent inflation is higher than Opportunity's.