Explainer: Markets efficiently delay building feasible new homes

Note: Monthly FET subscription prices are rising for new subscribers. This is intentionally to make an annual subscription much more attractive. Current monthly paid FET subscribers are unaffected and will always keep their original price. Yearly prices remain unchanged. I hope you find it in you to support my efforts here to raise the quality of our economic conversation with an annual subscription (it might even be tax deductible for you!) Markets are good at making trade-offs. Even if everyone in the market is irrational, the constraints of the system—of money balances and property rights—often lead to acceptable and favourable trade-offs. I explained that logic in more detail here. Markets also encourage innovation because new technology can break down old trade-offs by getting more output (in terms of its value to others in the economy) per input. The market in real estate is no different. This market efficiently uses high-value locations for high-value uses. This means people with a low value for a location will be excluded from that location. It is the same in other markets. Those who place a low value on luxury goods won’t buy them. You might claim this is often because of unequal wealth and income. And you would be right. Some people don’t like the inevitable inequalities in market outcomes, and they often search for market failures to explain it, especially in real estate markets (as I document in this academic article). Today’s topic is not inequality. The topic today is the forgotten temporal dimension of the trade-off that participants make in all markets. As well as allocating products to who values them most, markets allocate across time to when new products are valued most. In other words, markets will efficiently delay or bring forward production decisions across time. For example, Toyota is bringing its new Prado model to Australia this year. But it isn’t pricing them to maximise its 2024 profits only, even though the market for four-wheel-drives in Australia is very competitive and lower pricing could greatly increase 2024 sales. Toyota is pricing in a way that it expects will maximise not just its 2024 profit (quantity of sales in 2024 times the margin per vehicle) but the present value of its flow of profits in 2024, 2025, and beyond. Toyota will bring forward sales with lower prices only if it increases the total present value of production profits by more than it gives up in future sales at higher prices. All firms are forward-looking and consider the effect of their choice of production rate and pricing on their future profitability—not just this year’s, this month’s or this week’s profit. Back in 1931, a popular concern was that markets would use up natural resources like coal, minerals and oil, too quickly. Were markets just wasting these resources? Harold Hotelling pondered that question and explained how (like Eric Crampton explained more recently) markets won’t inefficiently use up resources too quickly. They trade off extracting more resources now with extracting more later. Unfortunately, most economic analysis assumes away the intertemporal trade-off, which can lead to major errors in reasoning and interpretation of evidence. This intertemporal trade-off in real estate means that most feasible housing development projects are delayed into the future, even when prices or rents appear to be high and projects are profitable today. As I noted earlier, some people don’t like this inevitable market outcome, so they search for market failures to explain it. But it’s not a failure. We want markets to efficiently delay building homes, don’t we? Why isn’t this well-known? I admit that it took me a while to notice intertemporal trade-offs and fully recognise their significance. That’s probably because most economic analysis at best consists of assuming away time altogether, simplifying to a short-run (single static period) and a long-run (some other single static period) with no way of bridging the two. Because economists are trained this way, it leads to a blind spot across the discipline when it comes to timing decisions. On X, I was surprised to see that a seemingly innocuous post below garnered over six million views in a few days. It simply asked why landowners in private markets would build so quickly that prices fell. Which is a very good question! The thousands of replies almost unanimously explained most smugly the crossed swords of supply and demand from Economics 101 that they learnt, forgetting that this simplified model assumes away the time dimension. The replies showed complete ignorance of the dynamics of housing supply and price effects from supply today on profits tomorrow— a hot topic of study in the academic literature with many researchers trying hard to understand it. People, for some reason, don’t believe me. They want settled science—preferably ECON101. So today’s article is a deep dive into the forgotten economics of inter-temporal market trade-offs when it comes to housing production. It takes you far beyond ECON101 and to the cutting edge of knowledge about when and why homes are built. Let’s start with a quote from urban economist Alvin Murphy, who noted in a working paper version of his 2018 paper entitled A Dynamic Model of Housing Supply that: A static model would predict that a parcel owner would build the first time it becomes profitable, whereas the dynamic model allows a parcel owner to delay building (even when profitable) in order to attain higher profits at a future date. [p15] That line didn’t make it into the final version of the article (which in typical fashion was published eight years later) but that version makes the same point clearly in its opening sections. In the model, landowners choose both the optimal timing of and the optimal size of construction. These owners take into account current profits and expectations about future profits, balancing expected future prices against expected future costs. Analyzing these decisions with a dynamic framework allows one to meaningfully separate the effects of current profits on supply from the effects of expected future profits on supply, which is the key mechanism through which forward-looking behavior reduces the housing supply elasticity. Here’s more Forward-looking behavior substantially reduces the responsiveness of landowners to current price changes. This reduction occurs because rising prices make building today more attractive, but also signal higher future prices, making waiting more attractive, thus reducing the responsiveness to current price. Interestingly, this forward-looking behavior suppresses the responsiveness to current price by a much greater extent during boom periods with rapidly rising land and house prices. That forward-looking behaviour considers the returns given up on the assets required to develop new homes (the cash to pay for construction and the land asset) for the returns to the new home (net rent and capital gain) after consideration of local price effects from faster development. A simple demonstration The tools most relevant for understanding intertemporal trade-offs come from a field of economics known as real options, which analyses timing choices of irreversible capital investment—clearly relevant for understanding housing production. The logic of real options and the intertemporal trade-off means that for new housing, two conditions must hold to make it worthwhile to build a dwelling today rather than tomorrow (though not really today or tomorrow, it could be this year instead of many years in that future or any other trade-off between some future period and the present). These are: * The market value of a dwelling must equal the development cost plus the value of the land (which itself gets a value because it is a financial derivative—an option). In the lingo of real options analysis, this is called the value matching condition. * The total return to the developed home must equal the total return to the assets swapped for … This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit www.fresheconomicthinking.com/subscribe