Wednesday, April 28, 2010

Why rising house prices and rising oil prices are different

Casey Mulligan has an interesting post today lauding the return of rising prices in the housing market, saying:
The housing crash is the single most important factor that started this recession, so it would be nice to know when it will end.
I initially wondered whether an increase in the price of an important durable good could improve individual well-being. Usually, we think of price increases as making consumers worse off. Consider a standard good: gasoline (or apples or iPads if you wish).

In the diagram, the plotted point is the initial choice of the household. Then, the price increases. On account of the price increase, the household can no longer afford its original favorite bundle. Indeed, the price change means that all of the shaded gray region is unattainable. This is unambiguously bad for the household because an increase in the price does not expand consumption opportunities, and therefore, can make the consumer no better off.

Given this standard case, Casey Mulligan's praise of rising housing prices is strange. But, if we think a little about what is different in the housing market, Mulligan's claim that housing price increases can be a good thing turns out to be well-founded (even for reasons beyond this post). The difference is ownership. In the housing market, plenty of people own the product, and that ownership has a significant effect on the household's consumption opportunities.

If the price of housing increases, household wealth increases if you own a house. If the household cashes in on a seller's market by selling and downsizing, this price increase affords greater consumption opportunities. That wasn't a possibility with gasoline, and it is all due to ownership. Here's a simple diagram illustrating the difference.

A household can always stay in their house, which means the original favorite choice is affordable.* Also, as with the case of gasoline, if the household spent as much as it could on housing, it could buy less housing. That is, we still have a gray area of lost consumption opportunities. But, because of ownership, households have a stake in price increases, and because households can cash in on a seller's market, they now have a yellow region of expanded consumption opportunities.**

Contrary to our first-graph intuition, price increases can be good for consumers if they own (and can sell) a significant amount of the product. This offsetting effect is called an endowment effect. There are plenty more complicating factors to this market that are worth discussion, but the ownership aspect is one that is often overlooked.

*In my simple model of housing, people own their houses outright, and there are no property taxes and other variable assessments that increase with the price. Reality is more complicated as these factors combined with an expensive mortgage may force a household to give up their current consumption bundle to stay in their house. But, the forces I highlight above are forces that act in the real world, and abstracting from messy details allows us to see them more clearly.

**Interestingly, the second diagram is almost exactly the graph that an economist will -- by default -- use to analyze the effect of a wage increase on labor supply. In that case, a worker owns his time and sells his time to the firm at the market price. In supplying labor, a worker cannot sell negative time, so there is no gray region of lost consumption opportunities due to a wage increase.

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