The supply side of housing markets.

• Author: Gyourko, Joseph
• Position: Research Summaries

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 expansion of this pattern to a very few interior markets, such as Austin and Denver. Even so, average house prices are still quite close to fundamental production costs in most metropolitan areas. (2)

Local Regulation and the "Zoning Tax"

Local building regulations and zoning codes could explain at least part of this pattern. Essentially, local regulation acts as a "zoning tax"--raising the price of housing above what it would be in the absence of supply restrictions. (3) The research approach to gauging the size of the zoning tax has been to estimate the marginal cost of producing a home and then compare that cost with the actual market value of the house. More specifically, standard neoclassical economics indicates that the price that households are willing to pay for an extra square foot of lot size (the intensive margin) should equal the price of land...