Professor Paul Palley's
          Economics Seminars

Transactions occur because; in an example we are most familiar with, businesses and consumers meet and the consumer pays for a good or service. This indicates that the factors that affect supply and demand affect the transactions that occur. This then implies that it is cost-benefit analysis, comparisons between the marginal costs and marginal benefits, that lead to the decision on the part of the consumer to buy the good or service and the business to sell the good or service.

Businesses supply goods and services only if it is profitable to do so. In other words, if the marginal benefits associated with producing and selling the product exceed the marginal costs then the business will produce and sell that product. Or, to state this another way, if the transaction yields a profit greater than what would result from an alternative use of the time and effort to produce that product then the business will be willing to produce and sell the product. This explains why businesses focus so much time and effort on marketing. Smart marketing efforts help businesses differentiate their products and elevate the prices they can charge, and as a result increase the marginal benefits associated with producing and selling their products. At the same time businesses will also focus on improving productivity to control costs, decreasing marginal costs. The greater the differential between marginal benefits and marginal costs the more likely businesses will continue to pursue further production and transaction opportunities.

On the demand side, consumers also evaluate marginal benefits and costs. The decision to spend your money on A or B will depend on your evaluation of the relative benefits and costs associated with buying A or B. If the marginal utility or benefits associated with consuming good A relative to its price exceeds the marginal utility or benefits associated with consuming good B relative to its price, then the consumer will by A. In other words, if MU_A/P_A > MU_B/P_B, then the consumer buys A. This is a formal representation of how we make decisions, but imagine that you want to buy a new car. You may have to decide between a Toyota and Ford. Why do you pick one or the other? Won’t this depend on the utility you derive from these choices and the prices you pay for them?

As a result, if both the consumer and business determine that the marginal benefits associated with a transaction exceeds with the marginal costs then the transaction will occur. What we are seeing with this process is an important factor that is not always focused on, the increasing ease associated with transactions. Technology has greatly facilitated this. It is easy to buy products online and participate in auctions like those on eBay, greatly enhancing choice. It is also easier to pay now due to the availability of credit, and the ability to use credit and debit cards has been expanding. In this case it is technology that is facilitating this. Payment systems are another important element in this in that payment card networks facilitate the exchange of information between a store’s bank and the consumer’s bank in order to facilitate a purchase made using a credit or debit card. These systems facilitate the buying and selling process in exchange for an interchange fee. The Federal Reserve has details about this that may be interesting to read (http://www.federalreserve.gov/paymentsystems/default.htm). In addition, the modern cash register where these payments occur is a computer as much as a cash register, facilitating inventory control and productivity gains.

Furthermore, additional technological improvements can be noted. Cell phones are now being used to make payments just as a debit cards have been used. This not seen as much in the U.S., but it is readily available in Asia. Cell phones are also used as a computer, and as a result shopping online is facilitated. You may access information through electronic bill boards using cell phones in Japan, and this gives the consumer access to product details. It also gives businesses access to consumers, facilitating future transactions. Here is an interesting article in the New York Times related to this and the acceptance of these cell phone products (http://www.nytimes.com/2009/07/20/technology/20cell.html).

The marketplace, the interaction of supply and demand, determines the prices that will be charged and consumers will pay for a good or service. This point is well understood, but there are many times in which the prices consumers are willing to pay is not as well understood as it should. We know that these pricing decisions made by consumers are based on their perception of the utility they expect to derive from that product, but we can focus further on this point. More specifically, many people determine the price they are willing to pay based on their perception of the value of the attributes or characteristics of the product. The models that are built to better understand these pricing decisions is called “hedonic pricing models” and what we learn from them helps with marketing efforts and to better understand current and future consumer behavior.

Consumers can be very discerning about the prices they are willing to pay for many goods and services. In line with this, this focus will often be on the characteristics and attributes of the product. A case in point is that of housing. Prospective buyers will assess price based on the value they assign to the size of the home; size of the lot; the number of bedrooms and baths; whether or not it comes with a pool; the age of the home; and several other factors as well. When people determine the price they are willing to pay for a car the focus will fall on the make and model of the car; the reliability of the car; the resale value of the car; the style; fit; and finish of the car; etc. What these two products have in common is that they are expensive and the demand for these products tends to be very price elastic. In other words, the consumer is very sensitive to changes in the price of the product. In addition, the consumer is willing and able to shop and compare prices.

The same holds true also for less expensive products and the ramifications of this is that demand becomes more price elastic and profit margins become thinner. The firm needs to create other profit centers in order to overcome this. For example, the automobile manufacturer makes a significant amount of money through its financing arm. Another applicable example of a less expensive product is the personal computer and laptop computers. Consumers can very easily use the Internet and other media resources to better understand the capability of different hardware and software components of these computers, and the prices of these components, in order to make decisions related to the value of these products. In addition, a firm like Dell which facilitates the consumers’ efforts to build and price their computers online furthers the education of consumers. The impact of this is that demand becomes more price elastic as the consumer learns to comparison shop and better understands the value of the attributes of these products, and profit margins becomes thinner.

What should a firm do about this? The process I described can’t be stopped. Instead the firm needs to build increasing amounts of value into their products that are the result of innovation, quality enhancements, and improvements in capability. The firm needs to develop and market related products that are profit centers that the consumer values relatively highly. Finally, the firm needs to build systems that facilitate innovation and value enhancement with the understanding that the consumer is always adapting and loyal to only their desire to enhance the value they derive from the goods and services they consume.

The future direction of the housing market is being debated today and some are worried that the market is set for continued substantial weakness. This creates a real concern for the strength of the overall economy because the housing market is a very big part of the economy. What is clear is that the housing boom turned in the 2005 to 2006 period into bust. Home prices have fallen in many markets, and the direction that development and construction will take is more uncertain. The question is; are we set for a protracted decline, housing market stability, or the resumption of the boom? What I will present below is an analysis of the factors that affected the supply of and demand for new and existing homes during the boom, the recent downturn, and look at a reasonable forecast.

In order to identify the factors that contributed to the housing boom that started in the 2002-2003 period and peaked in 2005 it is useful to focus on supply and demand. First, I will focus on the demand side. Mortgage rates were generally in the range of 7.0 to 8.0 percent in the 1990s, but declined from over 8.5 percent in 2000 to less than 5.5 percent by 2003 and stayed at rates between 5.5 percent and just over 6.0 percent through 2005 and positively affected the demand for housing.

Economic growth as measured by real GDP exceeded 3.0 percent during every year of the 1990s except 1990-91 (there was a recession in 1991), 1993, and 1995. This economic growth fueled by such factors as the baby boomers entering their prime earning years, increasing productivity, generally low interest rates, and the strong stock market built up a store house of resources including the combination of higher incomes and greater wealth that benefited the housing market during the 2002 to 2005 period.

Demographic factors were also working. The numbers of people over the age of thirty-five, the prime home buying years, swelled during the late 1990s into the first years of this decade. In addition, the baby boomer generation had by 2001 reached the ages of 40 to 55, a time of life when families are more likely to move up to more expensive homes or ready to purchase second homes.

There were two sources of changing expectations related to home prices during the first half of this decade that led to an increase in demand for homes that in turn contributed to rising home prices. One came from the financial markets. The second came from the housing market itself. The relatively poor stock market and lower interest rates encouraged many investors to look for opportunities to find higher returns elsewhere. They increasing looked to real estate. Secondly, as home price appreciation grew from over seven percent in the 2002 to 2003 period to nearly 12 percent in 2004, speculators where increasingly looking to enter the housing market. Home price appreciation exceeded 13 percent nationwide in 2005. These figures are from Freddie Mac.

A key factor on the supply side was related to the cost of building new homes. Based on Producer Price Index (PPI) data extracted on December 27, 2006, the prices of materials and components for construction increased 8.3 percent 2004 and 6.1 percent 2005 versus increases that were generally in the range of 1.0 to 2.0 percent per year from 1996 and 2003 except for a slight decrease in 2001. On balance, the prices of lumber and wood products declined during the period of 1996 to 2003, but there was a 16.8 percent increase in 2005. The same pattern existed for the prices of metals and metal products as there was an increase in prices equal to 33.7 percent in 2004 and 5.4 percent in 2005. The prices of construction machinery and equipment increased only marginally during the 1996 to 2003 period followed by 3.5 percent and 6.2 percent increases in 2004 and 2005 respectively. Outside of sizeable declines in the prices of lumber and wood products, the other prices discussed above have continued their above trend increase into 2006. These increasing prices tend to decrease supply and put upward pressure on home prices.

Many communities around the country have responded to urban sprawl, transportation constraints, and local communities of private and public interests looking to limit new development, by restraining development. The result was blocks of developable land being designated as open space or the enactment of very low density zoning restricting both commercial and residential development. An example is Scottsdale, Arizona designating the vast majority of developable land within its borders as open space, a process that started in the late 1990s. The impact of these policies is a reduction in the amount of land that can effectively be developed resulting in higher prices for raw land, and raising the cost of development and the value of existing homes as well.

Other important contributors on the supply side include interest rates and expectations related to the future strength of the housing market. Lower interest rates lower the cost of doing business by reducing the cost of borrowing money. As many home builders finance a significant percentage of their operations, lower interest rates facilitate investing more money in an effort to build more homes at a faster pace. The effect here is to increase the supply of new homes leading to lower prices than what otherwise would have been the case. Important factors in the calculus businesses work through when making decisions to invest revolve around the following question; do the expected benefits exceed the expected costs? Over time, as housing starts increased from 1.6 million units in 2001 to almost 2.1 million units in 2005, home builders increased their investment in new development projects. Given the time that it takes to plan new developments, secure entitlements, and install infrastructure it is logical that home builders would want to be ahead of the curve. That being said, the expectation that the housing market would continue to be strong has contributed to the excess supply of new and existing homes on the market that became more obvious by the middle of 2006.

There have been both demand and supply side contributors to the recent housing market contraction. On the demand side, the economy has continued to grow despite the housing market downturn, albeit at a slower rate. In addition, the same positive demographic conditions are in place. The question is, then, what has changed? There are expectations that a recession is more possible in the next year or two than what was reasonably expected in the recent past. This combined with higher home prices has reduced the number of potential home buyers because fewer can afford new homes. Incomes have simply not kept up with higher home prices.

Another important demand side factor that has marginally contributed to the recent downturn is interest rates. Short-term interest rates have risen. The Federal Funds rate has increased from the 1.00 percent level in 2003 to over 5.00 percent, and now the target is 4.25 percent. The expectation is that the rate will soon drop to 4.00 percent. Short-term interest rates do not directly correlate with long-term interest rates such as the 10-Year Treasury bond rate and the 30-Year mortgage rate as these rates are more influenced by the bond market and inflation rates. Yet, adjustable rate mortgages can be directly impacted and this has made it more difficult for new home buyers to qualify for loans and some borrowers are seeing the rates they pay increase at the same time. This has directly led to a decrease in demand for homes. The 30-Year mortgage rate dropped from approximately 8.5 percent midway through 2000 to approximately 5.5 percent midway through 2003. This, as indicated above, stimulated the housing market. Since then, rates have increased and the expectation is that these interest rates will average about 6.25 percent through 2008. These rates are low on the basis of recent history.

Despite the above discussion, the most important contributor to the recent downturn has been a change in expectations. As indicated above, housing price appreciation was extraordinary during the first half of this decade. Markets do not go straight up, and if there is not a decline that ensues then at least future increases will be much smaller. Speculators have moved away from housing in force because they can’t count on gains in home prices and rents are not sufficient to cover their borrowing costs. They have had to move fast, leading to a decrease in demand for homes and also an increase in the supply of existing homes on the market. Secondly, the credit crunch we are experiencing today reflects the expectation that subprime mortgages will continue to decline in value, and this has greatly incapacitated the mortgage market. That being said, once the correction in this market unwinds then the mortgage market will regain its life.

Given that home building is a highly leveraged business, financing costs can be significant. In turn, higher interest rates have led to a decrease in supply due to higher borrowing costs. Plus, any well developed expectations that demand will decrease will lead inevitably to a decrease in supply. The problem can be that home builders can be behind the curve leading to a significant over supply. That was the case by the middle of 2006, and the result has been a sharp decrease in supply of new homes. Other supply side factors have also continued to contribute to a decrease in supply; higher prices for materials and components for construction, metals, and concrete. In addition, continued efforts to fight sprawl will tend to reduce the amount of land available for development and higher prices for developable land.

Why will stability take hold in 2009? When looking at the factors above, it is clear that conditions exist that indicate that the housing market will stabilize to what we see under normal conditions. The positive demographic trends will continue to exist in the near future and interest rates are expected to remain relatively low. The 30-Year mortgage rate is expected to remain in the range between 6.00 percent and 6.75 percent through 2009. On the other hand, economic growth will moderate in 2008, and there is some probability that there will be a recession. On the supply side we can continue to see forces in place that will lead to higher construction costs due to high commodities prices and the cost of building materials. Not withstanding recent indications of housing market stability nationally, the consensus is that housing starts and home price appreciation will establish themselves at levels consistent with long-term trends in 2007. Recent forecasts by the National Association of Home Builders and Freddie Mac indicate that housing starts in the range of 1.1 to 1.4 million units in 2008 and 2009. These are totals are consistent with the upper end seen in the 1990s, and the lower end in the first part of this decade. Freddie Mac’s forecast is that housing prices will depreciate about 3.1 percent in 2008 and 1.0 percent in 2009. The results will differ market by market depending on the degree of home price inflation in the recent past. However, these pessimistic outlooks in my view do not account for the strength of the underlying fundamentals related to demographic trends, economic growth, and low interest rates. Instead, I believe that stability will be the word that best describes the housing market in 2009 and with a stronger market likely in 2010.