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The supply side of housing markets.

Article Excerpt
For a long time there has been an imbalance in what we know about housing markets--we understand much more about housing demand than housing supply. This has been driven in part by policy interests, although data availability also has played a role. Fortunately, this knowledge gap has begun to narrow in recent years, allowing for a much better understanding of housing markets in general. Given the importance of housing in the economy, and the recent dramatic swings in home prices, better insights into the residential market are very helpful, both to policymakers and to households.

Economists understand that supply, not just demand, is critical to understanding housing markets. High prices always reflect the intersection of strong demand and limited supply. If demand in a market is weak, then prices cannot be high, no matter what the supply. And, if supply is unrestricted, then prices cannot be much higher than production costs, no matter what the demand. In practice, the strong negative correlation between housing permits and the level of house prices across markets makes clear that supply-side conditions matter. (1) The highest price markets tend to have the least permitting. If demand alone differed across markets, then we would expect to see abundant new construction in the costly markets. We do not, and the most intense new construction occurs in lower priced markets, indicating that supply conditions vary across markets. In particular, supply appears to be restricted in many high price metropolitan areas.

Prices have escalated relative to production costs in various markets over time, with the temporal and spatial patterns roughly as follows: in 1970, there was no metropolitan area (including New York City and San Francisco) in the United States in which average house prices exceeded fundamental production costs by more than 20 percent. Fundamental production costs are defined as the sum of the physical costs of construction for a basic, modest quality home, plus a 20 percent land share, plus a 17 percent gross profit margin on structure and land costs for the builder (which is typical over the cycle). By the 1980 census, mean house prices had become much higher than production costs in the major metropolitan areas along the coast of California. A similar phenomenon occurred during the 1980s in many east coast markets running from Washington, D.C. to Boston. The 1990s saw the...

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