November 16, 2012

Inelasticity of Supply is Allowing Home Prices to Increase

November 16, 2012

Inelasticity of Supply is Allowing Home Prices to Increase

I believe that one of the reasons why home values have gone up lately is that the supply of existing homes is what economists call inelastic. In lay terms, what is happening is that prices are rising because the supply of existing homes which would ordinarily be coming to market is constrained by the fact that so many homeowners are underwater. People don’t want to have to pay $75,000 to sell their home. Ordinarily, as prices increase would-be sellers would see the opportunity to sell and list their property. Those would-be seller would be moving up to larger homes, moving down to smaller homes when the kids are gone, or become renters.

The implication is that prices will increase until such time as supply becomes elastic and, at that point, prices will flatten or even decrease slightly as those homes no longer underwater come to market.

The main economic effect of housing is in the building of new homes. While inelasticity induced by borrowers being underwater pertains to existing homes, those prices also set the level for new home prices. The latest rate of New Home Sales is 389,000 annualized. The latest rate of Existing Home Sales is 4,750,000 annualized. The recent increases in home values offer hope but also risk to home builders. As values increase, builders and the banks which back them will see profit potential and start building but they should be aware that as inelasticity dissipates values are likely to flatten. The good news here is that there will not be a housing bubble.

I think that this supply inelasticity is highly unusual. There can be supply inelasticity of cartelized commodities such as oil. There are not many instances where inelasticity exists because the owners of a good simply refuse to sell it because they would lose rather than make money. Companies can sell assets at a loss but it is a lot tougher for families.

Below is an attempt to explain, in general terms, elasticity and inelasticity as they refer to both supply and demand.

Demand, Supply, and Elasticity.

“Demand” is the amount of stuff that consumers are willing and able to buy at a given price.

The amount of a stuff demanded depends on:

– the price of the good
– the income of the would-be buyer
– whether the buyer likes it (consumer taste)
– the demand for alternative goods which could be used (substitutes). In the case of housing this is the rental market.

Supply is the amount of a good producers are willing and able to sell at a given price. The amount of stuff supplied depends on:

– the market price of the good
– the cost of producing the good
– the supply of alternative goods the producer could make with the same raw materials, plants, equipment and labor force
– the supply of goods produced at the same time (joint supply)
– unexpected events (i.e. “disasters”) that affect supply.

The housing market has two sources of supply: new homes and existing homes. It is mainly existing home supply which I am addressing here but the prices of existing homes constrain the prices of new homes as well.


The price elasticity of demand measures how much the quantity demanded responds to a change in price. Reductions is selling in selling prices (sales) and supposed to spur gross revenue.

Elasticity is not a vague description but rather can be defined numerically as the change in demand divided by the change in price. (Since demand goes up as price goes down this number is actually negative and elasticity is more correctly mathematically defined as the absolute value of this number.)

Elasticity greater than one means demand is elastic. When the elasticity is greater than one, the percentage change in quantity demanded exceeds the percentage change in price. When the elasticity equals zero, demand is perfectly inelastic. There’s no change in quantity demanded when there’s a change in price.

Supply also has elasticity. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by percentage change in price. It measures how much the quantity supplied responds to changes in the price.

By the differences in nature between supply and demand (by that I mean that demand can change in a very short period of time) the price elasticity of supply is usually larger in the long run than it is in the short run. Over short periods of time, firms cannot easily change the size of their factories to make more or less of a good, so the quantity supplied is not very responsive to price. Over longer periods, firms can build new factories or close old ones, so the quantity supplied is more responsive to price – in the long run.

Elasticity vs. inelasticity is not a neutral proposition. Elasticity is better than inelasticity because it allows a means to stimulate production, GDP, jobs, taxes when the economy is languishing. Elasticity is good; inelasticity is bad.