Inelasticity of Supply is Allowing Home Prices to Increase
I believe that one of the reasons why home values have gone up lately is that the supply of existing homes is what economists call inelastic. In lay terms, what is happening is that prices are rising because the supply of existing homes which would ordinarily be coming to market is constrained by the fact that so many homeowners are underwater. People don't want to have to pay $75,000 to sell their home. Ordinarily, as prices increase would-be sellers would see the opportunity to sell and list their property. Those would-be seller would be moving up to larger homes, moving down to smaller homes when the kids are gone, or become renters.
The implication is that prices will increase until such time as supply becomes elastic and, at that point, prices will flatten or even decrease slightly as those homes no longer underwater come to market.
The main economic effect of housing is in the building of new homes. While inelasticity induced by borrowers being underwater pertains to existing homes, those prices also set the level for new home prices. The latest rate of New Home Sales is 389,000 annualized. The latest rate of Existing Home Sales is 4,750,000 annualized. The recent increases in home values offer hope but also risk to home builders. As values increase, builders and the banks which back them will see profit potential and start building but they should be aware that as inelasticity dissipates values are likely to flatten. The good news here is that there will not be a housing bubble.
I think that this supply inelasticity
is highly unusual. There can be supply inelasticity of cartelized commodities
such as oil. There are not many instances where inelasticity exists because
the owners of a good simply refuse to sell it because they would lose rather
than make money. Companies can sell assets at a loss but it is a lot tougher
for families.
Below is an attempt to explain, in general terms, elasticity and inelasticity
as they refer to both supply and demand.
Demand, Supply, and Elasticity.
"Demand" is the amount of stuff that consumers are willing and able to buy at a given price.
The amount of a stuff demanded depends on:
- the price of the good
- the income of the would-be buyer
- whether the buyer likes it (consumer taste)
- the demand for alternative goods which could be used (substitutes). In the
case of housing this is the rental market.
Supply
Supply is the amount of a good producers are willing and able to sell at a given price. The amount of stuff supplied depends on:
- the market price of the good
- the cost of producing the good
- the supply of alternative goods the producer could make with the same raw
materials, plants, equipment and labor force
- the supply of goods produced at the same time (joint supply)
- unexpected events (i.e. "disasters") that affect supply.
The housing market has two sources of supply: new homes and existing homes. It is mainly existing home supply which I am addressing here but the prices of existing homes constrain the prices of new homes as well.
Elasticity
The price elasticity of demand measures how much the quantity demanded responds to a change in price. Reductions is selling in selling prices (sales) and supposed to spur gross revenue.
Elasticity is not a vague description but rather can be defined numerically as the change in demand divided by the change in price. (Since demand goes up as price goes down this number is actually negative and elasticity is more correctly mathematically defined as the absolute value of this number.)
Elasticity greater than one means demand is elastic. When the elasticity is greater than one, the percentage change in quantity demanded exceeds the percentage change in price. When the elasticity equals zero, demand is perfectly inelastic. There’s no change in quantity demanded when there’s a change in price.
Supply also has elasticity. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by percentage change in price. It measures how much the quantity supplied responds to changes in the price.
By the differences in nature between supply and demand (by that I mean that demand can change in a very short period of time) the price elasticity of supply is usually larger in the long run than it is in the short run. Over short periods of time, firms cannot easily change the size of their factories to make more or less of a good, so the quantity supplied is not very responsive to price. Over longer periods, firms can build new factories or close old ones, so the quantity supplied is more responsive to price - in the long run.
Elasticity vs. inelasticity is not a neutral proposition. Elasticity is better than inelasticity because it allows a means to stimulate production, GDP, jobs, taxes when the economy is languishing. Elasticity is good; inelasticity is bad.
Dick Lepre [email protected]
Web site: www.loanmine.com
Blog: economy.typepad.com
Phone: (415) 244-9383 | Fax: (866) 488-2051
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NMLS #9472. Equal Housing Opportunity.
Excellent discussion about inelasticity. I have some things to ad about my local situation- South Bay CA, Saratoga, Sunnyvale, Cupertino..
Yes, nothing is coming on the market. But foreclosure and underwater are not the issues. I live within a pistol shot of forty oldies, most of whom bought their homes when they were worth dirt and are holding on. Here are the reasons:
1) Prop 13 locks our real estate taxes at a nuisance rate. The guy who buys the house next door pays ten times what we pay.
2) Selling give a 500k exemption on taxes and a pay-through-the-nose rate on the rest. So: hold.
3) Real estate is rising at 10+ percent a year locally. All the homes are above their values before their collapse. Why sell? To invest in stocks which have done nothing over 12 years, CDs which pay nothing, bonds which pay 2% in the face of massive inflation?
4) Local banks hold foreclosures at full value on the books unless they close and sell or sell short. Then they have to write losses against earnings. So banks are holding bad notes that are appreciating at 10% given the run-up in prices.
So I have contributed to the mystery of inelasticity.
I think my facts are right; perhaps Dick can correct my errors in the next blog.
Dick, thank you. All is appreciated.
Posted by: John Rowe | November 16, 2012 at 03:24 PM
Increasing the price of home is normal yearly but i never thought that there is reason like this for increasing price of home.In Finland many of real estate are increasing their price of home it is because of the fact that home sales is also increasing and it is a sign of good real estate.
Posted by: Kaarle Lumme | December 03, 2012 at 03:51 AM