Econ 101: Are Housing Prices ‘Too High’?
Professor Gary Wolfram
explains the economics behind pricing and the housing “bubble.”
August 24, 2005
Â Â Â Â
Recent discussions about housing prices show confusion about what
makes for correct prices. The market sets prices that are “correct”
when the quantity that people demand of a good or service is equal
to the quantity supplied. The only time we can say that the price of
a good or service is “too high” is when there is a lot of it piling
up and no one is buying it.
Â Â Â Â If there is too little of the item available, so that
excess demand exists, prices will rise. As the prices rise, less
will be demanded while more will be supplied. If the market is then
flooded with the item, prices will fall. We can say that the price
is “too low” if there are lots of people trying to buy a good and
they can’t get it.
Â Â Â Â Otherwise, when arguing prices are too high or too low,
one is either stating his individual judgment of how much he values
the good or service, or he is speculating that there will be a shift
in demand conditions. In the latter case he is not really saying
prices are “too high” or “too low,” but that he thinks they are
going to change soon.
Â Â Â Â When looking at housing prices, it is important to
realize that prices are set at the margin – that is, by how much the
next buyer is willing to pay. Recent studies have found the price of
housing in certain cities much higher than could be sustained by the
income of the current residents. One example is the conclusion of
National City Corp.’s Richard DeKaser, as reported by USA Today on
August 17. DeKaser labeled 53 communities “extremely overvalued” and
declared that in 85 percent of the cities studied, “home-price gains
outpaced income gains during the past year.” Measuring prices
against incomes in this way, people tend to conclude that there is a
“housing bubble” and prices are due to drop; however, this needs to
be taken with a grain of salt.
Â Â Â Â If you look closely at such studies, you will find that
housing markets in cities that are becoming bedroom communities for
larger, wealthier cities, or are becoming a substitute location for
another high-priced housing market, will have prices that are higher
than you would expect from current residents. But this is simply a
reflection of the fact that higher-income people from nearby areas
are taking advantage of the low housing prices in the target city
and moving in, bidding up the price of the houses that are for sale.
Since the housing prices used in these studies would be the value of
the houses that are sold, but the incomes of the city will be the
incomes of the current residents, it will appear that housing prices
are very high relative to income.
Â Â Â Â An example should make this clear. Suppose there are
1,000 families in Suburbia. The average income of people in Suburbia
is $40,000, and the average house value is $100,000. Suburbia is
located 50 miles from Big City, which has 500,000 residents, an
average income of $250,000, and an average house value of $500,000.
Ten residents of Big City decide to take advantage of the low
housing prices in Suburbia and move in. Since there are only a few
houses for sale in Suburbia, they end up paying $150,000 for each of
the 10 houses. It will then appear that houses in Suburbia are now
Â Â Â Â The 10 new residents will only increase the average
income in Suburbia by a small fraction, but it will appear that
houses are now much more valuable there. Thus a study would show
housing prices are rising much more rapidly in Suburbia than incomes
are, and that a “housing bubble” exists.
Â Â Â Â At any point in time, the total amount of housing for
sale in a given city is small relative to the total housing stock,
and most residents will have purchased their houses in a prior year.
In a market where people are moving in and the demand for housing is
driven by people from outside, the sales of homes will reflect the
incomes of those moving in. The large majority of residents will
have already purchased their homes and will have mortgages
consistent with their incomes. It may be true that most residents
could not afford to purchase a new home in their community, but they
will not have to.
Â Â Â Â Is there a “housing bubble” and are housing prices set
to fall? That depends upon the particular city involved, but it is
only important if you are speculating – either by purchasing housing
in order to sell it at a higher price or spending the unrealized
equity in your current home. If you are like most of us, if the
price of housing fell, nothing would change for you other than a
decline in the potential you had to borrow on your house or to sell
it at a higher price. But if it is important for you to know, then
you must look for changes in the relevant demand for housing in that
city, which may well include demand from people from outside the
area who have greater incomes than the current residents.
Dr. Gary L. Wolfram is the George Munson Professor of political
economy at Hillsdale College in Hillsdale, Mich. He also serves as
an adviser to the Free Market Project.