Artical Analysis

Economics and Housing

The Wall Street Journal article "Housing Market Shows Further Signs of Cooling" (Hagerty and Simon, 2005) reveals the beginning of the decline in the housing market, citing that the number of home-purchase contracts signed in October, 2004 dropped 8% from a year earlier at 48 of the nation's large real-estate brokerage firms. The article continues to explain that there has been a change in supply as well as demand, with substantial increases in the inventory of homes available for sale. The analysis in this paper uses economic theories of consumption and supply and demand (Arnold, 2005) to explain housing factors described in the news piece.

The article mentions that there has been a slow growth in personal income. Current income is the most relevant determinant of consumption including home purchases. Inflation reduces the real current income; thus, real consumption. The article states that the housing bubble pushed up housing prices, but new factors have also come into play such as higher oil prices and higher interest rates. Higher oil prices are serving as a tax on consumers, leaving them less money to spend on other goods such as housing. And, higher interest rates mean buyers cannot afford higher home prices because the mortgage that must be paid is higher. Previously low interest rates had served as a form of price reduction, but now, according to the article, have risen from 5.2% in June 2003 to 6.5% for a 30-year fixed rate mortgage.

The article discloses that prices are at record highs. The higher the price of housing, the less people will demand because housing demand is elastic (Housing demand is elastic, 2006). The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid home purchases because they will force them to forgo the consumption of something else they value more. Higher prices reduce the utility of buying a house which is both an investment and a consumption good. Potential buyers are less likely to make a positive return on their investment and the appeal of owning vs. renting declines. As demand decreases, excess supply will be created because housing supply is highly inelastic (Housing demand is elastic, 2006). But, as prices fall, the supply will eventually fall because profit for the suppliers is declining. Even though the housing market is slowing, the article speculates that it may take six to eight months before sellers accept that the market has softened and reduce their prices. This demonstrates the economic theory that the supply relationship is a factor of time. Suppliers do not always react quickly to a change in demand or price, but eventually they must. The article suggests that demand will decline 3.5% next year, but that median home prices will still increase by 5%.

Suppliers are beginning to react to falling demand through a decline in price increases and incentives which are really indirect price decreases. That's why this is referred to as a "cooling off" period in the article which mentions that some condo buyers are being offered a car to make a purchase of a condo. The use of incentives may be viewed by the suppliers as a way to mask the fact that prices are falling. They are trying to hide the fact that market power has switched away from sellers to buyers. This change in power will only motivate potential buyers to negotiate a price that is far lower than the published price. And, suppliers may be hoping that demand will pick up. If it does, it's easier to take away the incentives than to adjust prices.