Elasticity of Supply: Why Housing is Unaffordable

Why are houses and apartments so expensive in some big cities? To an economist, the real question is, “Why is housing supply inelastic in some cities?”

Alex Tabarrok explains the definition of elasticity with a simple real-world example. When good jobs are created in a city, more people want to move there–an increase in demand for housing. A supply and demand graph shows that this should lead to a new market equilibrium with a greater quantity of housing sold, at a higher price. But which will increase more, price or quantity? This depends on the elasticity of supply.

In many cities (like San Francisco), natural and legal constraints on building new homes make it hard to produce new housing, so the supply is inelastic–price increases a lot; quantity increases only a little. Other places (like Auckland, New Zealand) have liberalized their housing markets, leading to more elastic supply. Affordable housing often comes down to elastic vs inelastic supply!

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00:00 Why is housing so expensive?
01:17 Housing market graph - ELASTIC supply
01:30 Housing market graph - INELASTIC supply
02:14 Geographical restrictions - water
02:27 Zoning restrictions
02:39 San Francisco
03:11 More hurdles to build new housing
04:06 Graph - Increase in demand, Inelastic supply
05:02 Bidding up the price - Buyers compete with buyers
05:41 Incentives for higher property values
05:56 Losing the bidding war
06:30 Zoning reform - Good news from New Zealand!

- [Alex] Why is this house selling
for more than $2.5 million?

Or this apartment,

renting for almost $3,000 a month?

Is it greed? Conspiracy?

No.

Just a powerful economic concept,
the elasticity of supply.

Sounds complex,
but it's actually quite simple.

In the United States
and around the world,

many industries and jobs

have been concentrating
in a few dynamic cities,

like tech in Silicon Valley,
entertainment in LA,

and pharmaceuticals in Boston.

So more and more people --

they want to live
in these dynamic cities,

and that increases
the demand for housing.

And remember, what happens
with an increase in demand?

The demand curve
shifts to the right,

and buyers are willing to buy more
at any given price.

This leads to a new equilibrium,

with a higher quantity
sold at a higher price.

But which increase will be larger?

The quantity change,
or the price change?

That depends upon

whether the supply
is elastic or inelastic.

If the supply is elastic,

meaning that producers
can easily produce more housing,

then the quantity supplied
will increase a lot,

and the price
will only increase a little.

But if the supply is inelastic --

that means it's not easy
to produce more housing,

and our supply curve
looks more like this.

In this case,

the quantity supplied
only increases a little,

but the price goes up a lot.

That happens when housing suppliers

can't easily expand
their production

in response to the higher price.

Now, unfortunately, many cities
have inelastic housing supplies.

So as people flock to these cities,
we see higher and higher prices,

with little increase
in the quantity of housing.

Why?

Well, first, there are
natural problems.

Many of the in-demand cities --

they're surrounded
by beautiful water.

Nice, but that means
a limited supply of land.

But we compound natural problems
with unnatural ones.

In many cities,

zoning laws and other regulations

prevent builders
from creating more housing.

Take San Francisco, for example --

it's surrounded by water,
so there's limited land.

But if you can't build out,
how about building up?

There's plenty of land in the sky.

San Francisco's
zoning laws, however,

have made it impossible
or very expensive

to build taller buildings
in many parts of the city.

Even changing single-family homes
to duplexes or fourplexes

has typically been prohibited.

And that's not all.

Suppose a builder does find
a plot of land to use.

Well, next, they need
a building permit.

And the process for filing
for building permits --

they can be hard to understand.

City officials can leave applicants
hanging for years.

In San Francisco,

it takes an average of 627 days

to receive a building permit
for a new house.

That delay adds a lot
to the costs for builders.

And if a builder does get
a building permit, it's not over.

Many people can still veto
the project:

environmental agencies,

planning commissions,

historic preservation societies,

and groups of existing residents.

They can slow things down
with lawsuits, protests,

and bureaucratic objections.

So now that we better understand

why the supply of housing
is inelastic,

let's revisit our supply
and demand graph

and illustrate what happens
in the housing market

with an increase in demand.

Suppose a city is thriving,

and the demand to live
in that city increases.

The demand curve
shifts to the right.

To keep it simple,

say that ten people
want to move into the city.

Builders see
the increase in demand,

and they try to build more,

but they're stopped

by water, height restrictions,

zoning laws, bureaucracy, lawsuits.

That's our inelastic
supply of housing.

So imagine, somehow a builder
finds a way to construct one home,

increasing the quantity
supplied a little.

But ten people want to move in!

So who gets the new home?

Well, the potential
new residents --

they compete to get the new home
by bidding up the price.

The price for the new home goes up.

First, one person drops out,

and then the price
goes up some more,

and another person drops out.

The price keeps going higher
and higher and higher

until just one person is left,

and the high bidder
wins the new home.

Notice that it's not
the owners of housing

jacking up the price --

it's the buyers who must bid higher
to out-compete one another,

given the limited supply.

An inelastic supply of housing --

it does mean higher property values
for existing residents.

So existing property owners --

they have an incentive
to block new construction.

And that's one reason
why reform is difficult.

And who's harmed?

Well, lots of people,

but most especially
the potential residents

who are bid out of the market.

They'll have to live further away,
with longer commutes,

or they may not even be able
to live near good jobs at all.

And notice that the people
who are harmed --

they don't get a vote.

By definition,

the potential residents --

they don't live in the city
that priced them out of a home.

It's not all bad news, however.

Slowly, some cities
are starting to change.

In 2016, Auckland, New Zealand --

they liberalized their laws

to allow upzoning
in much of the city.

And the number
of new houses skyrocketed,

and housing prices moderated.

The rest of New Zealand
is now following suit.

Even San Francisco
is starting to allow

new duplexes and fourplexes.

So let's hear it for a more
elastic supply of housing.

[cheering]

Okay. There you have it.

If you want to understand
why housing prices are rising,

you must first understand
the elasticity of supply

and what makes housing supply

in many parts
of the world inelastic.

Now, you can test
your understanding of elasticity

by checking out
our practice questions.

We also have test banks
and lesson plans

for Economics teachers.

Or, if you're ready
for more microeconomics,

click for the next video.

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