Monday, January 8, 2018

Housing Supply and Demand: Some Basics

Teach a parrot the terms "supply and demand" and you've got an economist.  (Thomas Carlyle)

(Interesting digression: Carlyle is also usually cited as the first to apply the term “the dismal science” to economists.  This was in the context of a debate between the pro-slavery Carlyle and anti-slavery economists (notably John Stuart Mill) regarding the reintroduction of slavery to the West Indies.  See Persky (1990)).

Functions Give Rise to Curves

Supply and demand, the fundamental behavior of producers and consumers, are each multivariate concepts.  Demand for housing depends on income, housing prices, demographics (population, household formation, the age distribution), mortgage rates and availability, and certain taxes, among other fundamentals.  Some of these are relatively easy to measure, or at least they are conceptually straightforward; but there are other demand fundamentals that are a little “squishy,” at least to most economists – psychology, tastes, and expectations come to mind.  

Both the levels of variables and rates of change in those variables can be considered.  Furthermore, demand is forward-looking and will depend not just on today’s values of the variables, but on expectations about their future values.

On the producer side, supply is affected by housing prices, the prices of inputs, the technology of building and development, infrastructure availability, physical geography and topography, interest rates (especially short term, to builders), other taxes, and the regulatory environment, among other things.  Expectations and psychology, levels and changes, and psychology and so-called “animal spirits” matter hear, as well.

The familiar supply and demand curves pick a single variable (most often the price of housing) to analyze, while at least temporarily holding other things (income, prices of inputs, etc.) constant.  Exhibit 1 illustrates, presenting market-level supply and demand curves.

Even though the curves usually look similar when drawn, conceptually it’s important to distinguish between the demand function (and curves) for individual consumers, and the sum of these over all consumers in a market.  In this section we focus on market supply and demand.  Later we’ll examine supply and demand for individual producers and consumers, as well as for market aggregates.

Suppose, for simplicity, that all housing units are the same, so that we can measure quantity by simply counting houses; then rent per house is the same as the flow price per unit of housing services, and the value or asset price per house would also be a true price measure.  Holding for the moment the other variables that affect supply and demand fixed, we highlight the effect of prices on both supply and demand.  Demand slopes down – the higher the price, the less we demand.  Supply, using similar reasoning, slopes upwards.  If supply was fixed, the supply curve would be vertical.  If supply was horizontal, that would indicate that the market would supply any quantity demanded, at a constant market price.  As drawn, the supply curve is fairly flat – meant to convey fairly, but not perfectly, elastic supply.

Now let’s change one of the other variables, which we initially held fixed.  Suppose income in our city increases substantially; this would shift the demand curve out, i.e. the market would demand more housing, at any given price.  The intersection of supply and the new demand shows that some new houses would be built (Q1 – Q0 houses) and housing prices would increase from P0 to P1.  Notice that in a market with elastic supply, a lot of housing gets built – Q1 – Q0 is “large,” and P1 – P0 is “small.”

Contrast this with Exhibit 2, a heavily regulated market with fairly inelastic supply.  In this case, the same initial demand shock results in a “large” increase in prices, and a “small” quantity response.  We will return to this theme when examining some housing policies, in later posts.


Elasticity is economic jargon for "responsiveness."  It's the proportionate change in output given a proportionate change in price.  
Mathematically, we can represent the price elasticity of demand:

There are many elasticities, e.g. supply vs. demand elasticities; with respect to price, income, population…

No comments:

Post a Comment