Chapter 10: The Market for Housing

Role of Housing Services

1. Americans spend about 15.5 percent of personal income on housing structure and another 12.5 percent on housing operation costs.

2. Housing is, for many, their most important asset. It is certainly the most durable asset of households.

3. The measurement of housing according to price versus quantity is more complex than with about any other commodity purchased.

Quantity of Housing Services

1. May measure by space and quality characteristics. Space and quality both give utility in an indifference curve. All combinations of space and quality that give the same satisfaction are on a single indifference curve that is convex to the origin.

2. Movement up an expansion line represents increased combinations of space and quality associated with higher "units" of housing.

Price of Housing Services

1. May be translated into monthly (or annual) rental price equivalents that give similar housing services (same reference indifference curve).

2. Value price and rental price are related through the present value formula over the useful value of the asset. If the asset lasts forever (with proper maintenance) then

R = iV. Hence, rent is the amount paid for housing services, even for homeowners.

3. Rent, not value, is the price of housing. If property taxes, at rate T, operating costs of rate c, and net capital gain is of rate g, then rent is equal to the following:

R = iV + TV + cV -gV

This is the amount that must be received by the landlord to cover net costs and provide a fair rate of return on investment.

4. Inflation is incorporated into the equation through its effect on capital gains and interest rates. Nominal interest rates and capital gains are higher than real returns by the rate of inflationary expectations. If both are increased by the same amount, then they cancel each other and result in rental prices unaffected by inflation.

5. Hence, a rise in interest rates brought about by a rise in inflationary expectations does not depress the demand for housing. (An 8 percent mortgage with 6 percent inflation is no more costly than a 2 percent mortgage with no inflation.)

6. The reason that inflation is viewed to be good for homeowners is that they concentrate on capital gains rather than interest payments. Interest payments are fixed or variable, but the cost of equity investment has an opportunity cost equal to current interest rates. Those with fixed interest rates that "outguessed" the market in their original home purchasing contracts have benefitted from inflation.

Federal Income Taxation

1. Federal tax law treats owner-occupied housing differently from rental housing.

Interest payments consist of two parts: mortgage interest payments and foregone interest on homeowner's equity. Mortgage interest rates are tax deductable if the homeowner itemizes. Interest on investments that could be made from homeowner's equity are fully taxed, but capital gains taxes on homeowner's equity is not taxed unless realized and then only if not reinvested within two years. (Note: a one-time capital gain can be realized without taxation at an advanced age.)

2. In addition to interest payments property taxes are also a deductable item on federal taxes. Hence, the effect of taxes on rent (housing price) is as follows:

R = [i(1-t) + T(1-t) + c - g]V where t is the marginal tax rate of the homeowner.

3. The neutrality of inflation disappears when federal taxes are included because the inflation rate increases the amount of interest and property tax deductions by the amount of the inflation rate.


The market for housing equates supply with demand. But, a complete understanding of the housing market in an area depends upon an understanding of the influence of externalities or neighborhoods. Market differentiation results in many related supply and demand curve intersections.

Demand for Housing

1. Housing demand depends upon price and income. The housing price is different for owners versus renters, high tax bracket versus low tax bracket households, period of high versus low inflationary rates, and other factors, such as lifestyle and space requirements.

2. Price elasticity appears to be about -0.65 and income elasticity about +0.75 (using permanent income or an average over several years) acccording to a consensus of empirical studies.

3. The demand for new housing makes up less than 5 percent of area demand during any one year, so that most of the demand is for existing housing.

Housing Supply

1. In the short run, housing supply is relatively fixed, so that demand forces affect housing prices and rents.

2. In the longer run, new construction, additions, and modifications add to the responsiveness of supply to changes in demand. The price of new housing sets the upper limit for price and housing services and is determined by construction and land costs or development costs.

3. The long-run supply of housing is perfectly elastic for constant input prices. Higher labor costs, materials costs, or land costs will increase the price of housing. Higher land costs depend upon the value of land for its next best alternative (agricultural productivity). As a city spreads out the periphery cost of land might not increase, but the cost of existing land will increase with population growth.

Market Equlibrium and Neighborhood Filtering

1. The demand and supply in the housing market determines equilibrium price versus quality of services in a given neighborhood.

2. For given schedules the supply of housing depends on the asset price of housing relative to development costs, whereas the demand for housing depends upon rent. Rent and value are linked through the cost of capital.

3. Supply by developers is an increasing function of value per unit of housing in excess of development costs. For a fixed cost of capital, higher value results in higher rents, so that the supply curve with respect to rent values is increasing.

4. Demand by owners increases with asset prices relative to costs which, for a given interest rate, results in more housing demanded at lower rents.

5. The residential developer (or homeowner in the case of remodeling and expansion) respond to market demand conditions in oder to provide housing services. They sometime engage in "speck" building that adds to the severity of the construction cycle.

6. The stock of housing is the legacy of past construction, alteration, depreciation, and retirements (abandonments). The stock of housing depreciates quite slowly with adequate maintenance.

7. The filtering model describes the evolution of housing values within a city, and is the primary source of housing for lower income residents.