Chapter 13. Why Is Housing Different? Why is Housing Different? Questions to Address. Questions to Address

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1 Why is Housing Different? Heterogeneous: dwellings differ in size, age, style, features, location Chapter 13 Durable: Deterioration rate depends on maintenance and repair decisions Costly Moving: Adjustment when gap between ideal and actual large Why Is Housing Different? McGraw-Hill/Irwin 2009 The McGraw-Hill Companies, All Rights Reserved 2009 The McGraw-Hill Companies, All Rights Reserved 13-2 Questions to Address Questions to Address Why do we care about heterogeneity, durability, and moving costs? Is it efficient for low-income households to live in used housing? Who benefits from subsidies for new housing? How do growth controls affect the housing market? Features that make it different. Base price. The average house, has three bedrooms, is five miles from the city center. Access price. The price drops for every additional mile from the city center. Size. The price increases for every additional bedroom. Air Quality. Price decreases for every additional unit of air pollution. Schools. The price increases for every one- unit increase in the test score of students in the local elementary school. The classic hedonic study (1970). Used data from the St. Louis housing market in the 1960 to estimate values of different housing attributes The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved 13-4

2 Hedonic Pricing Approach Each dwelling has a different bundle of characteristics Dwelling features: quality, age, size Neighborhood effects: quality of other dwellings For each component of the housing bundle, there's a price 2009 The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved 13-6 Results of Other Hedonic Studies Positive influence: proximity to jobs, schools, transit stations, churches Negative effects: crime, toxic waste, noisy highways Housing Quality Ladder Normal deterioration moves dwelling down the ladder Moderate expense: keep dwelling at same level Large expense for remodel & renovate to raise level 2009 The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved 13-8

3 Durability, Deterioration and Maintenance The total- cost curve is convex, reflecting diminishing returns to maintenance: As quality increases, it becomes progressively more costly to maintain the dwelling at the given quality level. The total- revenue curve is linear, reflecting the assumption that consumers, willingness to pay for a dwelling increases linearly with quality. Owner's objective is to maximize profit, equal to the gap between total revenue and total cost. The gap is maximized at a quality level q*. The profit-maximizing quality is where the marginal benefit of quality equals the marginal cost 2009 The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved Changes in Quality and Retirement As a dwelling ages, the cost of maintaining increases shifting the marginal- cost curve upward. If the price hasn't changed, the profit- maximizing quality decreases. Eventually, the marginal- cost curve will lie entirely above the marginal- revenue curve. At that point, the property is retied from the market. Increase in price shifts the marginal- revenue curve upward, increasing the profit- maximizing quality. In the case, the extra revenue from a higher quality dwelling exceeds the extra cost of upgrading 2009 The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved 13-12

4 2009 The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved Retirement Scenarios Possible scenarios when a dwelling is retired from the market Boarding up: short-lived reduction in price; low opportunity cost of funds Conversion: Profit from alternative > Conversion cost Abandonment: Profit from alternative < Conversion cost Abandonment and Public Policy Declining income from property and constant property tax Abandon when Income < Property tax A flexible property tax declines with income, prolonging use New York: Elasticity(abandonment, property tax) = 1.65 Externalities from abandoned buildings: Eyesores and crime havens During the 1980s the property tax was the most important factor in abandonment in New York City The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved 13-16

5 Durability and Supply Elasticity Increase in price of housing increases quantity supplied Increase the quantity of new dwellings (2-3 percent per year) Increase maintenance on used dwellings Remodel and renovate used dwellings Supply is Relatively Inelastic for Long Periods Most of the stock (97% - 98%) is used Rate of deterioration relatively slow Upgrading (Remodel & renovate) costly, so large price hike required Estimates of Supply Elasticity Ozanne & Struyk: 10-year elasticity for used housing = 0.20 to 0.30 The supply of used housing is relatively inelastic for two reasons. 1. Rate of deterioration is relatively low, 2. Renovation are relatively expensive. DeLeeuw & Ekanem: Long-run elasticity for rental housing = 0.30 to The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved Moving Costs and Consumer Disequilibrium Large moving cost: move possessions and detach from neighborhood Households tolerate mismatch until large enough to justify a move Figure 13-4-A: Increase in income causes mismatch Figure 13-4-B: Decrease in housing quality causes mismatch 2009 The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved 13-20

6 2009 The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved Filtering and the Housing Stepladder Over time, Quality of dwelling decreases Response to decrease in quality Costly upgrade of old dwelling New house with new materials, technology, fashion Used house filtered down from higher level Filtering: Income level of occupant decreases over time 2009 The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved 13-24

7 Filtering and the Housing Stepladder Filtering process has two basic features. Decrease in quality- because of physical deterioration, technological obsolescence, and changes in housing fashion. Decrease in occupant income- occupied by households with progressively lower incomes The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved What About the Highest Quality Housing? Filtering doesn't always work: Some features don t filter downward Wealthiest households remain in highest quality houses 2009 The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved 13-28

8 Filtering with Rising Income Increase in income increases demand for housing quality Larger advantage of filtering process Remain in old dwelling: costly upgrade (renovate/remodel) to higher level Move to vacated dwelling: move up quality ladder Effects of Growth Controls [Building Ban] Direct effect on high-income: tolerate mismatch or incur high upgrade costs No filtering to middle-income household: tolerate mismatch or costly upgrade No filtering to low-income household: tolerate mismatch or costly upgrade Result: cost of building ban borne by everyone in market 2009 The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved Price Effects of Growth Controls Step 1: High-Quality Submarket How does ban on new housing (high quality) affect housing prices? Market interactions generate higher prices for all types of housing 2009 The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved 13-32

9 Step 2: Supply Effects on Medium-Quality Submarket Step 3: Demand Effects on Medium-Quality Submarket 2009 The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved The McGraw-Hill Companies, All Rights Reserved 13-35