Picturing Basic Housing Economics

Originally posted on Housing Matters.

A lot of people have a hard time figuring out how new “luxury condos” actually make housing more affordable for everyone. So I drew some pictures to clarify.

 


Imagine a town called Homesville. Located on a picturesque waterfront, Homesville is a small, quiet community.

Homesville has two main characteristics that people find attractive. Located in a part of the world that gives it very mild seasons — it’s never too hot, or too cold — it is a popular destination for gardening aficionados. The other attraction is that the main employer in town is a locally-owned tech company, called Homestech.

As a relatively stable community, there is one house for sale in Homesville: a bungalow (needing some repair) owned by an octogenarian named Ozzy. Ozzy is looking to sell his home to buy a boat and fulfill his dream of sailing around the world.

As the seller, Ozzy has a minimum price that he’s willing to sell at. He will happily accept any price above the minimum, but will never sell below it. Let’s say that minimum price is $200k. (This is also known as Ozzy’s reservation price.) In the picture below, we will represent Ozzy with a bungalow and a blue bar above it indicating his minimum price.

A humble bungalow. Ozzy won’t sell it below $200k.

An older couple wants to move in to town; we’ll call them the Boomers. The Boomers are from a much colder region to the north. They’re looking to retire soon, and want to have a year-round garden as a hobby. Given their lifestyles, a bungalow in Homesville is perfect for them.

They’ve had humble careers throughout their lives, but they’ve been able to save steadily for decades. Their maximum budget (also called their reservation price) is $700k, which we’ll represent with a red bar. They will happily buy any home below $700k, but will never buy anything more expensive.

The energetic Boomers.

If the market is just Ozzy and the Boomers, then because the maximum price the Boomers are willing to pay is higherthan the minimum price Ozzy is willing to accept, we should expect them to make a deal at a price anywhere between $200k and $700k.

With one buyer and one seller, the sale price is negotiated somewhere between the maximum that the buyer’s can pay, and the minimum that the sellers will accept.

So when there is one buyer and one seller, and the minimum price that the seller expects is lower than the budget of the buyer, then they will negotiate a price between the buyer’s maximum and the seller’s minimum. The exact price will depend on the negotiation skills of the buyer and seller, but to make things easier, let’s say they settle on the middle point: $450k.

 



The Case of More Buyers than Sellers

Now let’s imagine that a young family, call them the Millennials, are trying to move into Homesville at the same time as the Boomers. Matt Millennial was just offered a job at Homestech, and the bungalow is within walking distance. This is perfect for him and his wife Molly, who are expecting their first child. Being walking-distance to work means he can spend more time at home with his wife and new baby, and less time commuting.

Since they haven’t been working for very long, they have a smaller budget than the Boomers. Their reservation price is $500k, which we’ll also represent with a red bar.

The expecting Millennials. Will they be able to live in Homesville?

If there are now two buyers for one house for sale, then there are a few things to observe. First, Ozzy will be very happy, as another bidder means higher prices. How? There is now a higher minimum price that the bungalow will sell for: $500k. That’s because at any price below $500k, the Millennial family can outbid the Boomers.

Thus, even though the the bungalow will now sell at a price between $500k and $700k. Let’s say they settle at a price in the middle: $600k.

When there are more buyers than sellers, the seller can expect to get a high price. The buyer with the smallest budget can expect to leave empty-handed.

Second, even though the Millennials have no chance of ever buying a home under these conditions, they still had an effect on housing prices. Specifically, they added a higher minimum price for entering the market. So while the Boomers are still happy that they were still able to buy a home, they now had to pay a higher price — making them worse off than the situation where there were fewer buyers. This makes them worse off than otherwise. On the other hand, as mentioned above, this situation makes Ozzy better off than otherwise.

An additional, yet equally important, fact to consider is that the Millennial family will be unable to afford any house in this market. They could not find a home in Homesville. They will have to look somewhere else to live. That might mean having to live further away to commute to work, or maybe even not taking the job at Homestech at all.

Finally, recall that our example started with the Boomers being the lone bidder, and then the Millennials followed them to bid the price up. But what would the story look like if the Millennials were the initial sole buyers, and the Boomers showed up later?

The answer is, even though the Millennials did not have a chance of outbidding the Boomers, Ozzy still would have made more money with two buyers than with one. That’s because with no competition, the Millennials would have paid between $200k to $500k — averaging to $350k. But with the introduction of the Boomers, the Millennials effectively set a price floor at $500k; meaning that the Boomers now have to pay between that and their price ceiling of $700k — averaging to $600k. (And, of course, the Millennials would still be priced out of a home.)

Therefore, when there are more buyers than sellers, we can conclude that prices will go up, and some buyers are left with nothing.


The Case of an Equal Number of Buyers and Sellers

Now let’s add in a new seller.

Delly Developments constructs a new luxury condo on a previously empty plot of land. Most of the units have already been sold, but there is one unit available. While the unit faces south, which some people believe has the nicest view of the waterfront, it does have a few drawbacks. First, there is no yard for gardening. And second, commuting to Homestech now requires the use of a streetcar (which stops right in front of the building).

The minimum price Delly will accept for this luxury condo is $300k, which we will represent with a blue bar.

A luxurious condo. The last unit needs to be sold for no less than $300k.

Let’s also stipulate that despite the luxurious newness of the condo, both the Millennials and the Boomers would prefer to move in to the bungalow over the condo.

When we have two buyers and two sellers, there are two things to note: first, the minimum market price for the home that both buyers want (the bungalow in this case) is still the maximum that the Millennials are willing to pay. This is for the same reason as before: at any price below $500k, the Millennials can still pay to stay in the market and bid up the price.

The second thing to note is that the minimum price of the market will be determined by how desirable the condo and the bungalow are relative to each other. Because we’re stipulating that both the Millennials and the Boomers would prefer the bungalow over the condo, we can conclude that the bungalow will be sold first to the Boomers since they have the higher budget. And just like before, the Boomers will buy the bungalow at a price between $500k and $700k. To the Boomers, and Ozzy, adding the luxury condo did not change anything.

With two buyers and two sellers, the seller of the most desired good gets a high price, but everyone will still be able to buy and sell.

However, unlike before, there is still a chance for the Millennials to live in Homesville! Since the luxury condo is still on sale, and Delly’s reservation price to sell is lower than the Millennials’ reservation price to buy, then the two parties can now make a deal.

Even though the Boomers took the bungalow, the Millennials still get to buy a condo in Homesville — for less than what the Boomers paid for their bungalow!

The final price will be somewhere between $300k and $500k. Splitting the difference, we get $400k. The addition of the condo to the market allowed the Millennials to find a place to live, to take part in the job market, and to raise their family in Homesville.


The Case of More Sellers than Buyers

In the interest of completeness of analysis, let’s also consider a case where after the Boomers have bought their bungalow, a new luxury condo unit comes on to the market.

One of the existing condo owners, Candi, has decided to put her unit up for sale as well. This unit is facing north, which some people might say as having a less-nice view. Delly’s original unit faces the more exciting direction of South. Because of this, the new unit has a reservation price of $200k.

Now the Millennials have two options for a luxury condo: the new north-facing unit, and the original south-facing one (which still has a reservation price of $300k). Assuming the Millennials are not very particular about which direction they get to look at, which home will the Millennials buy — and how much will they pay?

One buyer, two sellers: The buyer only pays as much as the seller with the highest reservation price.

The answer is: they will buy the cheaper north-facing unit for somewhere between $200k and $300k. The situation is the reverse of the case where two buyers were trying to buy the same house. Now, two sellers are trying to sell to just one buyer. This puts a price maximum on the market of $300k. That’s because if Candi tries to sell her North-facing unit for more than $300k, then the Millennials would rather buy Delly’s south-facing unit (and will still pay somewhere between $300k and 500k).


Summing up all the scenarios above:

— In the case where the Boomers were the only ones looking to buy the bungalow, they were able to buy it at a price between the maximum they were able to spend ($700k) and the minimum Ozzy the homeowner was willing to accept ($200k), settling somewhere in the middle ($450k);

— When both the Millennials and the Boomers wanted the bungalow, but the bungalow was the only option available to buy, the Boomers had to spend more money than before: the home sold at a price between the maximum they were willing to spend and the maximum the Millennials were willing to spend ($500k), making Ozzy very happy (the sale price is somewhere around $600k); moreover, the Millennials could not live in Homesville (and perhaps could not work there either);

— When both the Millennials and the Boomers wanted the bungalow, and the luxury condos were also available to buy, the Boomers still got to the bungalow — but the existence of the condo give an opportunity for the Millennials to own a home in Homesville; moreover, the Millennials also got to pay less for the condo ($400k) than what the Boomers paid for the bungalow.

— If the case where there are more sellers than buyers, with the Millennials having two options for a condo, then the maximum price of the market will be the highest reservation price of the sellers.

Of course, this story is a simplification of the way housing prices are determined. The real world has many other wrinkles in the market, often with politics involved, that affect the way how homes are priced. But the purpose here was to simply illustrate the basic mechanism of adding new housing supply. Even if it is “luxury condos”, any new supply will necessarily lower prices than they otherwise would be. Not only that, it allows more people to live in a city.

That’s why if we have a situation where more people are trying to move in to a city than there are homes for sale, then the only solution is to build more housing.

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