Economic Concepts and Theories Applied to Housing Market - Economics Assessment Answers

August 17, 2017
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Question: Economics Assignment

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Your task is to analyse the conditions facing potential first home buyers entering the property market by applying the economic theories and concepts introduced in the Unit. The objective of the Report is to illustrate the application of economic concepts and theories to a real-world issue. Thus you will be required to review economic concepts that apply to your task, such as:

  • Demand conditions.
  • Supply conditions.
  • The nature and determinants of elasticities for the product/service.
  • Tax issues such as negative gearing, capital gain tax etc.
  • Macroeconomic factors including demographic changes, economic growth rates, inflation/deflation expectations, monetary and fiscal policy changes.

The assignment must incorporate the following:

Make suggestions or give advice to the stakeholders as to how to deal with the issues and problems identified. Include graphs illustrating changes in demand and supply conditions.

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Solution:  Economic concepts and theories applied to Housing Market

Introduction

Housing market is important and significant to the economic growth.  Housing industry substantially contributes to economic progress of an economy. Actually housing market is vast, complex and highly sensitive to the macroeconomic factors. The key macroeconomic parameters like interest rate, mortgage payments, property tax or the business cycle have a huge influence in housing market. Any turbulence in the economy can be first observed in the housing sector.  Housing market is the source of vulnerabilities and crisis because it is one of the essential sectors in the economy. In most of the nations, housing market has experienced several boosts and bursts in their history. For example, current severe recession in 2008 also deeply rooted on the housing market bubble and then spread over all the sectors.

Due to liberalization in financial market, substantial reforms have been observed in the housing market across the world today. In the perspective of macroeconomics, investing on housing is considered as a major source of investment. In many nations, housing constitutes the greatest component of wealth. Statistical data reveals that in United States one third of the non -financial assets accounts for real estate. The interaction between the buyers and sellers can be well explained by the fundamental demand –supply concepts of economics.

The trends of the housing market and its prices are one of the major indicators to evaluate the health of the economy. Growth of the housing market clearly signifies economic progress. The growth of the housing market is critical for the economic health of a nation. Hence it is highly crucial to have a close watch on the trends of the housing market in order to predict the future outlook of the economy (Min Zhu, 2014).

First time home owners are important   because they indirectly act as an indicator to devise the housing policies as well as promote the home ownership in the economy. First home buyers face significant challenges as they are uncertain about several aspects and thereby unable to make a responsible financial decision. This recent study puts an attempt to explore the key factors and the conditions that the first home buyers face when they enter the property market. The primary objective of this paper is to gain a deep insight in the trends of housing market and the conditions of the first home buyers with the help of economic theories, concepts and models applying to the housing market.

Economic principles applied to housing market

Several economic principles can be applied to the housing market like demand –supply, elasticity, market structure or the tax rate. Like any other product or service market, housing market is also controlled by the driving forces of demand and supply. Equilibrium price of the housing is determined by the intersection of housing demand and supply. Demand for housing is downward sloping showing an inverse relation between the price and quantity demanded. As far as the elasticity for housing market is concerned, the supply is inelastic in nature at least in the short run. Let us consider the microeconomic factors in details.

Demand conditions

Buying a home is one of the crucial financial decisions for an individual because it constitutes a larger share of an individual’s budget. The most critical factor that affects the demand price and the quantity demanded. The demand for housing is also of no exception. The inverse relation is reflected in the downward sloping demand curve for housing. There are various other factors that affect the demand: the neighborhood, the design, layout, built up area, security, convenience and developer’s reputation. The complex decision making process of home purchase can be summarized as follows (Lizawati Abdulla,2015).

Supply conditions

The supply of appropriate quantity and quality of housing is very important for economic welfare and prosperity. There are two key factors that influence the supply of housing and its responsiveness of changes in prices: one is the fixed supply of land resource that can be utilized in number of economic and social uses. The other factor is the long lead time for construction of housing. Since supply of housing is associated with huge investment and sufficient time lag, risk is an inherent feature in housing market. In case of any uncertainty in the market, suppliers choose to restraint the supply. Government must have a prominent role to ensure the supply of affordable housing ( FTI Consulting , 2012).

The nature and determinants of elasticity for housing

Housing is inelastic in supply at least in the short run. The imbalance between the demand and supply is very common in housing market and that puts a heavy pressure on price of housing. While demand increases at a higher pace, supply follows at a slower rate. This microeconomic phenomenon can be analyzed with the help of following  demand –supply graph:

During the economic boom, the demand for housing is growing at a rapid pace, causing a rightward shift of the demand curve from DD to DD’. But supply is constrained due to its inelastic nature. Due to relatively inelastic nature of supply curve, the supply is unable to meet the demand at the same pace. An imbalance between the demand and supply is frequently observed in housing market caused by the supply constraint, especially in the short run that leads to escalate the price significantly (Renigier, Wi?niewski, n.d).

Impact of Tax issues, capital gain

A higher capital gain from the asset of housing will lead to boost the demand for housing and thereby increase the housing prices. The fiscal policy, monetary policy and other government policies can have a noticeable impact on the demand for property and its prices. Tax credits, deductions, subsidies are some of the policies enacted by the government can encourage the demand for housing temporarily. As for example US government introduced the tax credit for the first time home buyers in 2009. The key objective was to jump start the home buying in a sluggish economy. The attempt was successful because the tax incentive alone led to increase approximately 900,000 home buying, as reported by national Association of realtors. This was definitely a sizeable increase that gave a boost to the economy at the time when the economy was struggling to recover from the acute recession (Joseph Nguyen, 2016).

Impact of Macroeconomic factors

The sensitivity of the housing market in mortgage rates, down payment constraints and leverage availability are the key to understand the effect of macroeconomic policies over the housing market. It significantly affects the behavior of both the buyers and the sellers. Booms and bursts in the housing prices are the critical drivers of broader economic cycles.  The effects of interest rate on housing prices are also studied in various empirical literatures. Willingness to pay for the house, especially for the first time buyers is highly dependent on the mortgage rates. On the other hand, decrease in the required down payment also increases the willingness to pay for the house (Fuster A & Zafar B. 2015).

In the dynamic analysis, it has been observed that mortgage loans have the most explanatory power for the variation of the housing price index. The recent subprime crisis and the collapse in the housing market during the current recession definitely revived our focus on housing market.  Various literatures further examined the strong relation between the GDP, income and the housing prices. Higher the investment on housing market, greater will be the economic growth.

Interest rate is one of the key determinants of the housing prices. When the interest rate rises, the cost of borrowing is also rising and the potential buyers are discouraged from home buying. On the other hand when the interest rate falls, there is a rise in the demand for home buying. The correlation between the loan interest rate and the housing prices are found to be negative and largely depends on the competition among the banking sectors.

Mankiw and Weil (1989) were the first to review the relation between the demographics and the housing market. An increase in the baby boomers has a short run effect on housing market. Likewise an increase in the average age of the population in the economy or the decrease in the new born will lead to decrease the demand for housing in the long run (Theodore Panagiotidis and Panagiotis Printzis, 2015).

Recommendations and Conclusion:

The recent study explores the influence of various microeconomic and macroeconomic factors on the residential property price indices in general. During the recent times the real estate market in United States and also in Europe had difficult times.  The economic and financial fluctuations of the nation have a strong influence in the real estate market. An accurate prediction of home price is very important for the prospective first time buyers. The factors like the mortgage loans, interest rates, unemployment rate, and demographic factors like population growth are some of the very important factors affecting the demand for home buying and therefore its prices.  Despite the fact that private market produces an economically efficient quantity of housing, government must play a prominent role to ensure the affordable home especially for the first time home buyers. At the bottom line, though the above mentioned factors have a direct impact on the housing prices, there are some complex aspects that also play a significant role and claim a comprehensive evaluation.

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