Factors that affect the demand and supply of houses

Factors that affect the demand and supply of houses Introduction The past couple of years have seen dramatic fluctuations in the demand and supply of houses. It has been observed that movement in house prices is a balance of the quantity demanded and supplied. In this essay, we first look into the factors that affected the prices of houses in UK in the past three years. Then, we will discuss factors that affect the sizes of elasticities of demand of houses. Factors affecting demand of houses The table below shows the various factors that affect demand of houses. Table 1: Factors affecting demand of houses. S. no. Factor Trend Reason Change in the demand curve 1. Affordability As affordability of houses increases, demand for houses increases and vice versa. Because when the price of houses goes down more people can afford to buy houses. Movement along the demand curve. FIG. 1 2. Disposable Income As the disposable income of the people increase the demand for houses increases and vice versa. People tend to buy houses when they have sufficient disposable income with them so that their weekly budget is not affected significantly. Shift in the demand curve. FIG. 2 3. Economic Trends If the economy is booming, then there is a net increase in demand for houses. Similarly, in case of a recession, the demand for houses decreases. A booming economy means a good overall health of the economy which translates into greater demand of all goods. Shift in the demand curve. FIG. 2 4. Supply of substitutes If the supply of substitutes such as rented accommodation decreases, then there is a net increase in demand for houses and vice versa. If the supply of rented accommodation is less, then there is an increase in the price of rented apartments. Therefore, in the long run people find that it is cheaper to buy houses than to live in a rented accommodation. Hence, then they will tend to purchase a house. Thereby, increasing the net demand for houses. Shift in the demand curve. FIG. 2 5. Availability of mortgage finance If the mortgage finance is easily available then this results in a net increase in demand and vice versa. This is because it is easier for people to arrange for money to finance their houses. Shift in the demand curve. FIG. 2 6. Interest rates If the interest rates are high, then there is a net decrease in demand and vice versa. This is because at higher interests rates people will have to shell out more money to repay their loan. As people have a fixed monthly income, a higher interest rate would mean that the loan instalment would form a higher portion of their monthly income. Thereby, decreasing the demand for houses. Shift in the demand curve. FIG. 2 7. Consumer confidence As consumer confidence in the housing market increases, the demand for houses increases and vice versa. If prices of houses are expected to rises then consumers think it is profitable to enter the market. However, if the prices fall or remain static then consumers find no urgency to enter the market. Shift in the demand curve. FIG. 2 8. Demographic factors As increase in immigration, number of divorces, life expectancy, results in an increase in demand for houses. An increase in immigration, number of divorces, life expectancy will result in more people needing independent houses. Shift in the demand curve. FIG. 2 9. Inherited wealth An increase in number of people inheriting a huge wealth would result in an increase in demand of houses. Because these people have more money to spend on luxury products, such as houses. Shift in the demand curve. FIG. 2 10. Tax benefits If people receive greater tax benefits by buying houses, then this would result in a net increase in demand for houses. This is because people prefer to use their hard earned money on themselves rather than paying it to the government. Shift in the demand curve. FIG. 2 Source: Nationwide, Besanko et. al 2007 FIG. 2: Shifting of the demand curve. D D Price P1 Q2 Q1 D D Quantity FIG. 1: Movement along the demand curve. Price P1 P2 Q2 Q1 D D Quantity Factors affecting the supply of houses The table below shows the various factors that affect the supply of houses. Table 2: Factors affecting supply of houses S no. Factors Trend Reason Change in supply curve 1. Price If the price of houses increases then there is an increase in supply of houses and vice versa. Because sellers can then sell houses at higher rates thus making more profit. Movement along the supply curve. 2. Cost of building a house If the cost of building a house increases then there is a net decrease in supply of houses and vice versa. As this would mean a larger initial investment for the builder. Shift in the supply curve. 3. Government regulations If government regulations are inclined towards building/selling of houses then there is a net increase in supply of houses and vice versa. This would mean lower costs from the perspective of a builder/seller, which would result in more building/selling of houses. Shift in the supply curve. Source: Nationwide, Besanko et. al 2007 FIG. 1: Movement along the Supply curve. Price P1 P2 Q2 Q1 S S Quantity FIG. 2: Showing shifting of the supply curve. S S Price P1 Q2 Q1 S S Quantity Factors that have led to changes in the prices of house in UK over the last 3 years Source: Nationwide FIG. 5: Average house rates in UK from 2008 to 2010 During the first half of 2008 there was a 5.1% drop in house prices. With the financial crisis and a looming economic recession this price fall was expected. This was evident from the clear change in the consumers housing market sentiments, with people being more reluctant to buy houses. It should be noted that there is a direct relationship between the demand of houses and the confidence consumers have in the market (See table 1). In addition, factors such as high mortgage rates, tighter lending criteria, and higher interest rates affected the house prices in early 2008. The fall in demand from the buyers was also due to the rise in unemployment and associated job insecurity. Further, the problems in the credit market led to tighter lending conditions which made it difficult to obtain loans at higher loan-to-value ratios. However, these strict rules were predicted to lead to a more stable housing market. FIG. 6: Consumer House Price Expectations and House Purchase Approvals An anomaly in this trend was the slight increase in the prices in June and July 2008. This was probably because the suppliers had responded to price decline by reducing the supply of property. The reduced supply combined with an increased demand from potential buyers, who had been priced out previously, translated into a slight price rise of houses. In addition, the slight increase in prices was because of latent demand for houses. Earlier, due to the banking crisis there was reluctance among buyers to purchase houses. However, once the buyers saw that the government was taking corrective actions to stabilize the banking system, they re-entered the market along with the added assistance of low interest rates. (Nationwide, 2008) However, this was a mere aberration and between August 2008 and March 2009 the house prices fell by 10.1% due to the overall lack of consumer confidence in the economic and market conditions. In addition, there was an additional supply of houses from homeowners, whose financial positions were impacted by higher unemployment and lower income levels. FIG. 7: UK GDP and House Price Growth between 1985 and 2007 With UK slipping into recession, even drastic cuts in interest rates didnt help in increasing the demand for houses. The reduced access to credit resulting from the financial crises catalysed the fall in prices. Then, a combination of initial fall in prices, widespread news of financial turbulence, and slowdown in the real economy prompted consumers to expect further price falls. As consumers expectations turned negative, the incentive to enter the market reduced and this led to a sharp price fall. (Nationwide 2008, 2009) Then in June 2009, the low interest rates and extension of stamp duty holidays were welcomed by borrowers as they reduced the costs of already high priced housing market. Further, notwithstanding the economic downturn, there was a notable shift in house price expectation from negative to positive. These two factors resulted in increasing the demand for houses and thus increasing the price of houses. (Guardian 2009, Nationwide 2009) The second half of 2009 was marked by rebound in house prices. This was contributed by the better than expected performance of the labour market. Even though workers were forced from full-time to part-time work resulting in a reduction in income, the impact was less severe than if they had lost their jobs completely. In addition, reduction in mortgage rates meant that fewer borrowers had fallen into arrears than expected. This led to lesser number of second-hand properties being on sale and thus stabilizing the housing markets. (Nationwide 2009) The first half of 2010 also saw a 4.1% rise in prices of houses. An important factor of price rise during this period was the low level of stock for sale as many homeowners and buy-to-let landlords preferred to wait for prices to rise. And this approach was supported by the very low levels of interest rates. As a result, many potential sellers could easily afford to wait for prices to recover further before they decided to sell. Between July and October, there was a fall in the prices of houses. The impact of increasing capital gains tax from 18% to 28% was seen in the housing market, with many second homeowners choosing to sell them in response to the tax increase. Further, the spending cuts by the new government had clearly put a pressure on the disposable incomes of households. As a result there was a decrease in the prices of houses during this period. (Nationwide 2010) Factors that affect the sizes of different elasticities of demand for houses The responsiveness of the quantity of houses demanded to the change in prices, income, price of other goods, etc. is measured by the corresponding elasticities, i.e., Price elasticity of demand of houses, Income elasticity of demand of houses, or Cross prices elasticity of demand of houses. Factors that affect the sizes of different elasticities are as follows: Availability of substitutes: It is observed that more the number of substitutes, more elastic the demand will be. If the availability of rented accommodations is high, then a slight price rise will result in a large change in demand for houses because people will prefer to live in a rented apartment than to buy a house. Therefore, making the demand for houses elastic. On the other hand, if availability of rented accommodations is low, then even a large change in price would not affect the demand because everyone needs a place to live. Therefore, the demand for houses will be inelastic. Importance of the good in the consumers budget: Expenditure on housing, according to R.K. Wilkinson (1973), is an outcome of three sets of influences on the consumer, i.e., their needs, their aspirations, and their ability to realize their needs and aspirations. The latter is measured by the consumers income and the two former qualify the way in which income and changes in income affects housing expenditure. If there is a need for a house and consumers have the ability to realize that need, then the demand of houses would be inelastic. In contrast, if there is no real need and an aspiration to buy a (bigger) house combined with no real income to realize that aspiration, then the demand for houses will be highly elastic. Time: It was observed by Hanushek and Quigley (1980) that the demand for houses is elastic in the short-run. However, in the long-run the demand tended to be inelastic. This was because higher prices dissuade buyers to buy houses in the short-run. However, in the long-run he may realize that the price of houses will rise and thus he finds it better to buy a house. Conclusion In this essay we determined the factors that affected the prices of houses in UK during the last three years and the various factors that affect the elasticities of demand of houses. Based on the above discussion, I think consumer expectation of house prices is one of the most important drivers of prices in the short-run. As for the long-run, the drivers of house prices are the economic conditions, the fiscal policies, and supply of houses.