Monday, November 10, 2008

A note on real estate bubbles

Don Arthur had a good post, Lessons from California’s housing bubble, on Club Troppo that is relevant, among other things, to my discussion on the views of Reserve Bank Deputy Governor, Ric Battellino. I will leave you to read the post, but in the meantime I wanted to make a simple supply and demand observation on one point arising.

The amount people pay for a house depends in part upon how much cash they have, in part upon the value placed upon the house This may reflect personal utility, but also takes into account expected future returns on the house from capital gains and, in the case of rental properties, rentals.

Just because housing is in short supply does not mean that prices will not decline. In simple terms, if people cannot afford to or are unwilling to buy because prices have got so high, then prices will fall.

In a bubble, the demand curve shifts because of people's expectations about the future. With inelastic short term supply, this quickly drives prices up.

In a crash, the demand curve shifts back. Prices fall quickly.

A very interesting feature in Don's article lies in the role of scarcity.

Where rising prices can be accommodated by increased supply, price rises are choked off. Bubbles depend upon inelastic supply responses.

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