What if new housing does not reduce housing prices?
Almost all economists believe that a policy change that encourages the building of more housing will tend to reduce housing prices. That’s what the laws of supply and demand seem to predict. There are empirical studies supporting this claim. And yet, according to Bloomberg many people do not seem to accept the obvious:
In a working paper released in November, three scholars from three different University of California campuses reported public-opinion-survey results showing that “about 30%-40% of Americans believe, contrary to basic economic theory and robust empirical evidence, that a large, exogenous increase in their region’s housing stock would cause rents and home prices to rise.” (Italics theirs.) A similar percentage believed that such an increase would cause rents and prices to fall, with the balance predicting no change.
Another study by political scientists Clayton Nall of UC Santa Barbara and Stan Oklobdzija of UC Riverside and law professor Chris Elmendorf of UC Davis found that this skepticism does not carry over to other commodities:
We show that the public understands the implications of supply and demand in markets for agricultural commodities, for labor, and even for cars, a durable consumer good that, like housing, trades in new and second-hand markets.
The confusion may be due to endogeniety—builders prefer to build new units in booming areas where prices are rising. But it is theoretically possible that new construction might actually cause housing prices to rise. For instance, suppose new construction made a formerly run down neighborhood more attractive. In that case, it might create such strong positive externalities that the price of existing homes in the area actually rose, despite the increase in supply. In other words, it might boost demand by more than it boosted supply.
In practice, this sort of spillover argument is unlikely to apply over any significant geographical range. But what if it were true? What would be the policy implications?
Standard economic theory suggests that if an activity produces positive externalities, then the argument for encouraging that activity becomes stronger, not weaker. Thus if building new housing causes housing prices to fall, that’s great news. The free market is at work providing more homes for more people. And if building new housing causes housing prices to rise, that’s really, really good news. The free market is at work providing more homes for more people, and the quality of nearby neighborhoods is also rising due to positive externalities.
Ironically, in the debate over housing construction, rising prices are widely seen as a sign that the policy causing a supply increase has not been successful, that it has failed to achieve its goal. In fact, economic theory suggests just the opposite. If new construction causes rising prices as a spillover effect then the benefits are so strong that governments might want to actually subsidize new construction.
Why are people confused on this point? Because they focus on prices, whereas they should be focused on the quantity and quality of housing. More quantity means higher living standards, and more quantity plus more quality means much higher living standards, regardless of what happens to prices.
It’s analogous to the way that almost everyone misunderstands taxes. People focus on who writes a check to the federal government, not how a person’s flow of consumption is altered by the tax system. If taxes are not reducing your consumption, now or in the future, then you aren’t paying any taxes. (Perhaps your children or grandchildren are paying the tax, or it’s paid by the workers in the business you don’t create because your capital was confiscated by the government. Or those who would have received your charity.)
Economics is not about money, it’s about how resources are allocated. Don’t follow the money—follow the goods and services.
PS. I did a recent post discussing the construction of new residential skyscrapers in Austin. This tweet caught my eye:
Jan 31 2023 at 12:03am
“The free market is at work providing more homes for more people, and the quality of nearby neighborhoods is also rising due to positive externalities.”
I think the argument of anti-gentrification NIMBYs is that the higher quality and desirability of the neighborhood “prices out” long time residents. I don’t agree with it and think it’s flawed, but that’s a common sentiment. I think the anti-gentrification argument against building more high quality housing must be flawed because that same argument could also be used against reducing crime, picking up the garbage, improving schools, indeed improving the neighborhood in any way. Anything that improves quality of life could increase demand to live in the neighborhood and the resulting gentrification would increase rents…unless, of course, enough new housing was built to meet the demand.
Anti-gentrification folks seem to view upscale professionals the way some xenophobes view immigrants. They just don’t like them but, instead of just saying so, they come up with all sorts of code phrases to describe even things that are usually positive: “driving up rents” to describe rising property values, “changing the neighborhood’s character” to describe falling crime, less blight, and more amenities. In fact, new folks moving into the neighborhood are a kind of immigrant.
Jan 31 2023 at 12:49pm
BC, Good comment. By their logic NYC should turn Central Park into a toxic waste dump. It would make housing more “affordable”.
Jan 31 2023 at 3:25pm
NYC should turn Central Park into a toxic waste dump
This was tried in the 1970s.
Jan 31 2023 at 4:17am
Well, induced demand (I hate the term and prefer “pent-up demand”) may make prices plateau for a while as most large NIMBYfied urban areas work through their backlog, but the problem is best seen as a generational conflict between older people defending their rising property valuations against new entrants, literally rent-seeking.
Jan 31 2023 at 6:50am
I like the idea of looking at real outcomes instead of focussing on prices – at least when stepping away from business cycles! I think if the boost to demand in an area due to the positive externalities associated with development led to the same people being willing to pay more to live in the area, some progressive advocates may be okay with the higher prices. The issue seems to be distributional – neighborhoods experiencing development become nicer, and outsiders willing to pay for the increased amenity come in and displace the original poorer folk. Gentrification, in other words. Of course, holding population constant and taking a real perspective, overall there should be more and better houses for the same number of people, but the poorer people who benefit would mostly come from areas that the newcomers left.
Feb 1 2023 at 2:06pm
I’m reminded of the famous line (from The Leopard?) that if you want things to stay the same, then things must change.
Knut P. Heen
Jan 31 2023 at 8:55am
Price is important. What good is it to have a huge supply of something people cannot afford? You may say the price will fall to an affordable level because the construction cost is sunk, but building $1 million apartments and selling them at $500,000 is a waste of resources because the willingness to pay is lower than the construction cost.
Jan 31 2023 at 10:10am
Well, part of the problem is that one doesn’t know that the costs exceed the benefits until after the fact (both estimates take place in the future). That’s why the costs are sunk and it makes sense to sell for less than the cost.
But note that it also sends a strong signal: don’t build homes for more than $500k. Other homebuilders see this signal and adjust.
So, the market is working; it’s not a waste of resources. Just the opposite! We get an increase in the supply of housing and suppliers get more information about what demanders want.
Markets are about profit and loss. Loss is just as instructive as profit. The resources are not wasted any more than they are if a firm is earning extra-normal profits.
Jan 31 2023 at 12:53pm
“What good is it to have a huge supply of something people cannot afford?”
Reminds me of the old joke, “Nobody goes there anymore, it’s too crowded.”
I’m afraid that you are wrong about prices. (A common cognitive illusion.) For living standards, it’s quantity that matters, not price. Fallacy of composition.
Jan 31 2023 at 10:09am
A more plausible explanation for people’s expectations than that they believe new housing will increase the value of and demand for existing housing, is that they are smuggling in assumptions the question does not make or ask them to make about the new housing.
A common thing you’ll hear from people is “developers only build luxury housing” ie many people are assuming that a large addition to the housing stock *must* come from additions to the highest end of the market. The real question is why people believe this.
Jan 31 2023 at 4:56pm
They believe it because its mostly true.
Builders tend to build on the high end. Even if they build the same exact house as they did a decade previously, the new one will cost more, because its new.
But also, quality tends to increase over time.
But everyone moving into new construction is leaving older construction, so there is a trickle down effect, creating more supply at lower and lower price points.
Feb 1 2023 at 2:05pm
A while back I did a post on why most new houses should be “unaffordable” for the median income:
Jan 31 2023 at 11:42am
good things come in small packages
Richard W Fulmer
Jan 31 2023 at 11:53am
Suppose that zoning laws, land use restrictions, and other regulations reduce the number of homes that can be legally built in an area. Builders would likely tend to concentrate on high-end homes – if they can’t profit on volume, they’ll do so on mark-up. It’s possible, then, that the area’s average home price will rise. However, wealthier home buyers will likely stop competing for more modest homes, resulting in prices for those houses dropping. It’s possible, then, that while the average home price will rise, the median price will fall.
Jan 31 2023 at 5:35pm
A natural experiment along these lines has been conducted in the Boston metro area for the past 30 years. The first part of your assumption is correct–builder/developers targeted the high end market and this tended to contribute to increased sale price averages. However, because the supply restrictions continue to be so severe, modest and marginal homes appreciate far faster than inflation. There was a brief and minor dip in prices during the Great Recession, but the supply constraints still overwhelmed anything resembling a bargain. A junk house in a good neighborhood can sell for $1,000 a s.f. and need $400-500 a s.f. in renovation and repair costs.
It’s a raw deal for everyone and there are no serious efforts to improve supply. I think that Scott Sumner owned property in Boston during this period so he might have some personal perspective as well.
Jan 31 2023 at 5:41pm
I remember reading a study that a low end home created one move (presumably from a renter into a house). However, a high end home created seven moves! As people upgraded, their old homes became available on down the income ladder. What is seen and what is unseen.
Jan 31 2023 at 6:00pm
Another incentive driving the run up in house prices is the way that the tax code punishes high income earners. For example, a 40 year old lawyer making 400,000 USD can only put 20,500 USD in a 401k. What to invest in next? Any investment that increases income faces an over 30 % federal income tax penalty, plus state and local. Real estate allows for tax advantaged saving, so people buy more second homes than they otherwise might. Et voila, real estate gets expensive fast
Feb 1 2023 at 3:01am
Happy to acknowledge that I shouldn’t concentrate on prices but on the quality and benefits of new houses. Cool. Now, let me see where I can find £700,000 to afford 60sqm flat in London, and avoiding to relocate myself outside urban boundaries.
As long as the cost of the land is huge, luxury housing will be the only way to go for private real estate. We don’t just need “more houses” we need the will – political or private – to build more affordable (if not social) housing and allow everyone – not just high-paid people – to live within a city center. It’s not a dream, as long as there are rich places like Austria, France or Germany where you can witness something like that.
Feb 2 2023 at 10:05am
Wilmington, Delaware is home to (among other things) the headquarters for Dow Chemical. All of those executives used to live in townhomes a few miles from the HQ. However, as the city (and nation) got wealthier, new luxury homes were built for the execs. They moved out of the townhouses and into the bigger, better homes. The owners of the townhouses did not want their assets sitting idle, so they converted them into middle income townhouses. The middle income homes that were previously occupied then became affordable housing.
The same pattern has repeated itself in city after city. Just from my own experience, I have seen former luxury homes that now house low-to-middle income families in Syracuse (NY), Baltimore, Frederick (MD), Washington DC, Fairfax (VA) and, to a lesser extent, Asheville (NC).
Yes, it is true that in time period t, building only luxury homes may only benefit the wealthy. However, even the wealthy do not hoard homes (and typically not in the same area). Even the wealthiest man in the world only owns 5 homes. So, as these people move, their old homes become open for other individuals, typically of relatively lower income.
Feb 1 2023 at 10:12am
Isn’t this the gentrification case? Been happening in DC, one block at a time, for decades now. Granted, most of the change isn’t from adding new housing stock but from modernizing old stock. Nevertheless, the number of available units has probably been going up in those areas, not down.
Doesn’t it boil down to network effects (and the opposite of the broken glass effect) – by increasing the value of existing units and building a few new ones, you increase the value of all local units?
Put differently, increase supply a little (and quality a lot, i.e., the value of existing assets rather than their number) and that induces even more extra demand as the area becomes way more attractive, driving prices up. It is a collective action process, though, which is why it seems to have proceeded block-by-block – investors can’t get too far ahead of the trend or they risk having their capital stranded in locations that fail to appreciate in value.
Feb 1 2023 at 2:01pm
Don’t conflate gentrification with supply increases. If you ban new construction, you still get gentrification occurring in popular areas as existing homes get remodeled. But in this case, you also have fewer places for people to live, and hence more homelessness.
Feb 1 2023 at 1:25pm
“Don’t follow the money -follow the goods and services”: Exactly. Supply follows demand with housing, not vice-versa. If a neighborhood is run-down and prices are low and falling, then it’s likely due to the fact that there’s no demand to fix it up or grow it. Maybe it’s because of local policy, but it may not be. If prices go up in a neighborhood due to an increase in supply, it’s because there’s something in that neighborhood that has incentivized developers to build there. What would it mean if they hadn’t built in your neighborhood? It would probably mean that there was no demand, and your neighborhood had some issues with lack of access to jobs, schools, amenities, or something else that people would need in order to demand more housing.
Gentrification follows when a neighborhood is fixed up. I haven’t seen anyone model this issue in a way that I find compelling. It seems that the only real future for an impoverished, run-down, low-demand neighborhood is to develop infrastructure and amenities that would incentivize development and investment in the community. But when that happens, if the current residents can’t keep up, they’ll be forced to move, and may lose their community -which is usually the case. The long-term issues for that local community seems to only be partly fixed, at the cost of serious displacement.
Feb 2 2023 at 12:15pm
Thank you! It seems overwhelmingly obvious to me that building more housing doesn’t drive prices down. And that it would be better to build more, anyway.
The Chinese experiment seems to have been massively successful on precisely this point: they built a lot more properties, let the prices come up, and created an instant middle class.
In the long term, it’s hard to imagine where this trend plateaus out, but in the medium term, building seems to be positive for everyone.
Feb 3 2023 at 2:12pm
To be clear, building more housing usually does drive prices lower than otherwise.
Thomas Lee Hutcheson
Feb 2 2023 at 5:04pm
It’s still a mistake, but I think what people have in mind (no matter what the question actually said) is a quite marginal increase in supply when a small area is up-zoned. Somewhere there is a marginal decrease in prices/rents, but not necessarily anywhere near the up-zoned parcel where the new development will almost certainly have a higher price than the housing it replaced.
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