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Housing Markets 101

Stephen Smith has a post about housing and gentrification that I think hits on some good points, but it only tells one piece of a bigger story about how housing markets works. He opens with this:
When libertarians (and liberals) argue that increasing the supply of urban housing will lower the price of urban housing, they’re drawing on some pretty basic and well-established economic concepts. And yet, the coexistence of gentrification and housing supply growth seem to put a lie to that theory – in cities across America, we see neighborhoods adding housing while still seeing rapid increases in the price of housing. From the point of view of the poor and often non-white residents who are being pushed out, the market remedy of increasing supply just doesn’t seem to be working.
Count the number of times the word "supply" appears. Now count the number of times "demand" is in the above paragraph. Herein lies a major problem with this discussion: it focuses way too heavily on the supply side of the equation. After all, the price of housing is measured as the equilibrium of supply and demand. If you ignore the demand-side, of course you're going to be perplexed when you see a boost in supply accompanied by a rise in price levels. It doesn't put a lie to the theory. In fact, it proves the theory.

(from M.V. Jantzen on Flickr)

I tackled this issue recently, arguing that we can't really talk about the "housing market" because housing isn't homogeneous. People are willing to pay more for high-quality housing than they are for low-quality housing. So if you change the type and quality of housing in a neighborhood, you alter the underlying structure of the market itself, and the price at which people are willing to pay to live there, all else equal.

But let's set that aside for a moment and assume, for argument's sake, that housing is a commodity. From a theoretical perspective, we can draw the housing market as a series of simple charts, similar to what you might remember from an intro to microeconomics course.

In a neighborhood housing market, the demand curve is downward sloping. There's nothing notable about this; and in the short-run, the supply curve is a vertical line. This is consistent with the reality that in most neighborhoods you can't start construction whenever you want to. In fact, it's often a huge hassle to construct new units, for a variety of reasons, NIMBYism being one of them. So in the short-run, the supply is fixed.

The theory continues that in order to meet the high or pent-up demand, as well as make housing more affordable, we ought to increase the supply of housing. Graphically, this is shown as a shift of the supply curve to the right. If all goes well, the resulting equilibrium will be a lower price and higher quantity of housing.

But it doesn't end there, because we haven't accounted for the demand curve, which very well may shift. This could be because new amenities have popped up in the neighborhood; but also because the neighborhood is getting safer, cleaner and generally becoming a more desirable place to live. It could even be for a completely exogenous reason. Whatever the case, let's imagine that the end result is a rightward shift in the demand curve.

If the shift in the demand curve is great enough, it can completely overwhelm the shift in the supply curve, leading to an equilibrium with higher prices.

Now, I'm not using this as an argument to say we shouldn't work to increase density in cities or metro areas. But I do want to show that the simplistic "increase supply to make housing affordable" argument doesn't always hold, for theoretical reasons, especially at the neighborhood-level, and in urban areas that are already relatively dense and desirable.

So if you want to bring down prices in a housing market, you need to boost supply, while keeping the demand curve from simultaneously shifting too far to the right. How do you accomplish this? It's a tough question to answer. Stephen Smith says build more in rich, already-developed areas. Ryan Avent says build more in low-density suburbs. The consensus seems to be that we need to build. The disagreement is about exactly where we need to do it.

I also want to note that we can't actually expect to witness falling rents, because rents, like the price of many things in the economy, are sticky. Imagine getting a call from your landlord at the end of your lease, during which she says, "hi, I know you're been paying a thousand dollars, but it looks like the market rent in the neighborhood has dropped, so how would you like to pay $900 for the next year?" It's not going to happen.

Landlords will almost never lower a rent, as we think of it. They might do so subtly, by offering "first month free" or "move-in incentives" that effectively lower the average price you pay per month, over the length of the lease; but the "contract price" won't actually go down over time.

For that reason, the best we can hope for is a sort of rent stabilization, where rents stop climbing in nominal dollars. A $1,000 lease five years from now is going to be a better deal than a $1,000 lease today. People hate thinking in terms of "real dollars," because we're bad at it - but it's what we've got to do to see how rents are changing.


DK said…
Landlords might genuinely lower rent if there's such an abundance of urban housing that supply actually surpasses demand. They'll lower rents if that's what they have to do to keep tenants from leaving for other apartments that offer more bang for the buck.

But I think one of the reasons for rental prices remaining high is that a lot of this urban housing being built is basically luxury apartments/condos. Often over 1,000 sq ft and in high rises, which are inherently more expensive to construct (and which minimum parking requirements certainly don't help).

What cities need to do is fill their empty blocks with low-to-mid rises containing lots of small, studio size apartments. Lots of people are willing to live with less personal space if in return they get access to so much great public space.

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