How The Housing Market Works

[Editors note: Sandy Ikeda was an original Market Urbanism writer and is now a regular columnist for the Foundation for Economic Education, or FEE.org. FEE has offered republishing rights, so Sandy’s past work will be appearing here every Tuesday at 10am eastern time]

People sometimes argue that we need substantial housing subsidies in some very expensive cities because “the cost of building new housing is greater than what most people can afford.”

It’s certainly true that families earning low or moderate incomes have a hard time buying or renting brand-new housing. But that’s not only the case today; it’s been true throughout the history of civilization, from Uruk to New York.

The ABCs of Housing

The housing market is subject to the same forces of supply and demand as any other market, although of course there are things that distinguish it from, say, the market for fast-food. For instance, unlike a hamburger, a house is durable: it’s not consumed all at once. It also depreciates: the average house in the United States, for example, has a useful life of about forty to sixty years before major renovations become necessary.

Let’s say there are 3 categories of housing – A, luxury housing; B, middle-income housing; and C, low-income housing – and that houses are continuously built, age, and wear down. In the real world there are of course many more than 3 categories but let’s assume for simplicity that there are only these three.

Now, this is very much like the market for automobiles, which are also durable. In the new-car market you have at the high-end the Mercedes S-Class Sedan, while at the low-end the Ford Fiesta, and in the middle there’s the Honda Accord. And within each category there’s an array of prices depending on initial quality, age, and condition. It’s the same in the housing market.

Filtering

A house depreciates because of wear-and-tear, competition from new supply, and changes in the demand for houses. It may then fall from category A to B or even C. Throughout history, as long as there is no government intervention, expensive, well-built residences sink over time within their original category or drop into a lower category – or “filter” – to families living on lower and lower incomes.

For instance, fancy apartment buildings built in the Bronx along the Grand Concourse a hundred years ago are now home to some of the poorest families in New York. Similarly, although I can’t afford a new Mercedes today, I might be able to buy that same car eight or ten years from now.

People currently living in houses in lower categories rarely buy new products in the higher categories. And the less-well-off families tend not to buy the newest, most expensive construction even within their own categories. So, to argue that the poorest people in a city cannot afford the most expensive housing currently being built is to state the obvious.

What if mostly luxury housing is being built?

This process would operate, though perhaps not as well, even if developers build mostly A-level housing. Instead of new housing filtering down within each category and then eventually dropping into the lower category, only new houses built in category A would filter down to B and C. That means that B and C housing would tend to be older and in greater need of repair and refurbishing than otherwise.

However, a family may buy a relatively run-down home and then renovate it gradually over time as they can afford to do so. Still, the less-well-off in each category could afford decent housing – especially if regulations allow old A and B housing to be divided into smaller units – in the same way that it’s possible for them to afford a decent used car.

On the other hand, a family who can afford A housing, other things equal, could also afford to buy B or even C housing. Sometimes a family will buy in a lower category because it may want to spend more of its budget on something else, say education, entertainment, or health care.

So if the government artificially constrains the supply of A housing – perhaps because of a misplaced concern that only “the rich” get new houses – high-income families have the option of buying or renting at the B level. That, in turn, increases the demand for and the prices of B houses. Middle-income families then, faced with higher prices, will now search more heavily than they would have among C houses, and that would increase the competition for and the prices of housing for the least well-off, who have the hardest time in any case affording a home.

The solution to high-housing prices is not to pass a law to force people to build B- and C-level housing, or to impose price-controls on housing. The result of all of these would again be less housing and higher prices overall. That’s because such regulations reduce the expected returns on investment for potential developers and landlords. Consequently, they may decide to invest less in housing altogether, which would hurt everyone, but especially those least-able to afford housing.

Costs don’t determine value

There also seems to be a basic economic confusion at work here. Let’s say I invest a lot of capital in a mansion on the coast of Newport, Rhode Island at a cost to me of $30 million. Will someone then pay me at least $30 million for that mansion because I spent so much to build it? Um, no.

On the other hand, if I strongly expect that someone would be willing to pay at least $30 million for a mansion at that location, that might give me an incentive to bear those costs. In other words, the expected demand for a product determines how much I’m willing to invest in it, but my costs will have no significant influence on the price people are willing to pay.

So to argue that new construction in A housing is driving up prices, is to confuse cause with effect. As with any other commodity, people in a market don’t increase their costs of production because they want to drive the price of that commodity up. On the contrary, people will spend on inputs only if they believe the demand for what they can produce with them will be high enough to cover those costs. If you don’t think the price of luxury housing will be high enough to cover your costs, you’ll find someplace else to invest.

In other words, it’s not the entrepreneurs, developers, architects, and construction companies that build very expensive housing in cities like New York that drives up housing prices! Indeed, those people are responding to what they believe buyers are willing to pay, and if they are prevented from building those units the result will be higher prices for everybody. And if you observe housing prices rise despite increasing supply, that probably indicates demand is currently increasing faster than supply. Prices, however, would have been even higher were the government to undertake policies that restricted supply.

Building new housing, even units that many could not conceivably afford to pay, takes pressure off the demand and keeps prices lower for all.

Sandy Ikeda

Sandy Ikeda is a professor of economics at Purchase College, SUNY, and the author of The Dynamics of the Mixed Economy: Toward a Theory of Interventionism. He is a member of the FEE Faculty Network.

This article was originally published on FEE.org. Read the original article.