Economics of the Housing Market Cooling: Supply and Demand

Introduction: Signs of a Cooling Housing Market

The Wall Street Journal article "Housing Market Shows Further Signs of Cooling" (Hagerty and Simon, 2005) reveals the beginning of a 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 explains that there has been a change in both supply and 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 the housing market factors described in the news piece.

Income, Interest Rates, and Reduced Purchasing Power

The article mentions that there has been slow growth in personal income. Current income is the most relevant determinant of consumption, including home purchases. Inflation reduces real current income and, consequently, 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 effectively serving as a tax on consumers, leaving them less money to spend on other goods such as housing. Higher interest rates mean buyers cannot afford higher home prices because the mortgage payment is larger.

Previously, low interest rates had served as a form of price reduction, but according to the article, rates rose from 5.2% in June 2003 to 6.5% for a 30-year fixed-rate mortgage. This shift significantly curtailed the purchasing power of prospective homebuyers and contributed to the broader slowdown in housing demand.

Price Elasticity and the Demand for Housing

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 quantity of a good that buyers purchase at a higher price is lower because, as the price of a good rises, so does the opportunity cost of buying it. As a result, people will naturally avoid home purchases that force them to forgo consumption of something else they value more.

Higher prices also reduce the utility of buying a house, which functions as both an investment and a consumption good. Potential buyers are less likely to earn a positive return on their investment, and the appeal of owning versus renting declines. As demand decreases, excess supply is created, because housing supply is highly inelastic (Housing demand is elastic, 2006). However, as prices fall, supply will eventually decline as well, because profit margins for suppliers shrink. 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 asking prices. This demonstrates the economic principle that the supply relationship is a function 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% in the following year, though median home prices were still projected to increase by 5%.

Bibliography

Arnold, Roger A. (2005). Economics, 7th Edition. South-Western Publishing.

Hagerty, J. R., & Simon, R. (2005, November 15). Housing market shows further signs of cooling. Wall Street Journal.

Housing demand is elastic. (2006, March 8). Affordable Housing Institute.