Current House Demand and Supply

Question

Home prices are at an all time high so according to supply and demand, that means suppliers will supply more homes due to the high prices. Demand for a house on the other hand is also at an all time high. I really am confused on why demand is high when prices are high. From my understanding of demand and supply when supply is low, demand will be high and so will prices. When the price is high, supply is also high but the demand is low.

There are some articles saying supply is low which is why home prices are at an all time high. But that doesn't make any sense to me since home prices are very high right now so it incentivize suppliers to make more to provide for the buyers. Also, bidding wars are very common when supply is low, but there is lack of bid wars happening in the housing market.

My questions are:

Are the principles behind demand and supply pointless in this scenario?

How come demand for a house is very high but the prices are high and the supply seem to be relevantly adequate?

Answer 1

The principles of demand and supply are always operating in the background so they are not pointless.

1. The magnitude of the effect that increase in price has on increase in supply is given by the price-elasticity of supply for housing. If the supply is inelastic then it takes large increases in prices to increase the quantity supplied. In a an extreme case when supply is perfectly inelastic it would not respond to price at all (but this is completely consistent with supply and demand theory - so it would not make it 'pointless', you just always have to take into account the parameters of supply and demand before trying to predict what will happen).

   Empirical research (Green, Malpezzi & Mayo 2005) actually shows that housing supply is in many metropolitan areas inelastic so that is one explanation.

2. In many places government puts heavy restrictions on building of new housing. Especially in historic cities (e.g. Amsterdam) it is excruciatingly difficult to actually build a new housing. Even outside historical cities many places will be heavily zoned. If government restricts supply then of course it will not be able to increase. Also research shows that this is one of the leading causes behind high housing prices (see this empirical study by Glaeser & Gyourko (2002) that examines the effect of strict zoning on prices in Bay Area in US).

3. You should also not confuse movements along demand or supply curve and changes in demand or supply. Changes in prices produce movement along demand curve. If demand curve is fixed then increase in price (excluding extreme cases such as perfectly inelastic demand or Giffen good) will lead to lower quantity demanded. However, no matter what price is demand can always shift to the right (for example due to change in preferences) which will make people demand more at any price.

   If there would be no changes in demand or supply the price should remain constant. The high prices are likely due to the fact that demand for housing is increasing as economies grow and people are having on average higher incomes (since owning a house is likely normal good), and the prices increase because this demand outpaces supply. Of course, that is just gross generalization every city/area will be different. It is not even universally true that house prices increasing in every single area even though on average they do there are areas where they fall (see IMF global housing watch).

Answer 2

High prices do not immediately imply supply when supply is constrained. Houses aren't widgets. They sit on real-estate, each parcel of which is unique. As a metaphor, think of an island: the supply is limited. As demand rises, so the price rises. But supply can never increase, so prices just keep rising forever.

The land around most cities aren't islands, but they are made island-like by various factors. The limits of the 'island' are how far someone is willing to travel to work and back in a day. Most land already built on is excluded from the supply. And various land use regulations limit the amount of new development by limiting the amount of development--only so many units per acre, for example. This is why housing prices are so high--not scarcity of land, but land use regulations limiting supply of homes.

The 'size of the island' can be expanded by making it faster to travel to places, using railroads or expressways, but those are expensive. Expanding an urban area is like expanding an island through the use of land-fill.

If you want more detail, there is a whole branch of economics dealing with land - 'Urban Economics'. Von Thunen, Alonso, Mills, Muth are the classic authors.