25 May 2014

Supply, Demand and the Housing "Market"

For many reasons the conventional story of supply and demand does not fit the housing market. It is a market only in the sense that there are some people selling and some people buying. otherwise talking about a market in housing is likely to mislead.

Nonetheless we can use the old theory to gain insights. I tried to suggest on Twitter a way of looking at the interaction of supply and demand which better fits the facts than the textbook model. I made a mess of it so here is an explanation in more than 140 characters.

My target here is the belief that house prices are rising because demand outstrips supply.

Firstly, the textbook story looks like figure 1.
Figure 1
Here we see that supply is lower than demand. Theory says that in these conditions the price should rise to the equilibrium. So far so good. the problem is that this model explains high prices not rising prices. at best it explains why prices have risen but not why they continue to rise.

To deal with continually rising prices we need to assume that the demand curve is moving rightward faster than the supply curve. This is where the second problem comes in: house-building is stronger when prices are rising.  During the last boom, new housing units were added faster than new household formation. Increasing supply, in this model, means shifting the supply curve to the right, which should lower prices; the opposite happened.

A more realistic model would recognise that the supply curve is nearly vertical, at least in the short run. However for an increase in supply to coincide with higher prices we need an upward sloping demand curve. That gives a model like figure 2.
Figure 2
Notice that supply is still lower than demand at the assumed current price. In the conventional model when this occurs some buyers are willing to pay more to secure their purchase. Thus prices rise until they reach the market clearing equilibrium. In this model too prices rise, but they are rising away from the equilibrium. They just keep going.

To understand why, we need to find a reason why rising prices attract buyers into the market. perhaps people feel the need to buy now before prices rise further. Perhaps they believe that rising prices are making house owners richer and they want to join in. A combination of anxiety at missing the chance to own and the desire to own an appreciating asset are enough. Fear and greed are powerful incentives.

The gap between supply and demand can explain high prices, but the shape of the demand curve explains the dynamic of increasing prices.