Luxestate INC – Delay or Develop? What really determines the rate of new housing supply

Recent reports by Grattan Institute and the Reserve Bank of Australia have argued that zoning is a significant cause of Australia’s high home prices. Yet neither organisation has applied the appropriate economic theory to the property market, leading to conclusions that are almost the complete opposite of reality.

The main issue in property is that the static equilibrium assumptions of short-run supply and demand economics do not apply. If you try to apply these models you will interpret the market, and policy effects on it, incorrectly. Please read this article for some background on the gap between reality and what static equilibrium means when applied to land markets.

I’m not being radical. I’m not trying to earn street cred by being the anti-establishment economist. All I am doing is applying the totally standard, but correct, economic framework of real options.

It took me a long time to learn about property markets and how important real options are to understanding them. When I began studying economics the stories most economists were telling about property markets conflicted with my previous experience as a trained valuer working in the development industry. I had to really search to dig out this often-ignored but crucially important part of economics.

I want to use this post to explain why static-equilibrium analysis of the supply and demand type does not apply to property, provide a quick lesson on real options, and show how real development behaviour is best predicted by a real options approach.

First, the monopoly question
Land is a monopoly. This is fundamental to understanding property markets.

The reason is that there is no free entry — any potential market entrant must buy land from an existing monopoly owner. In practice, this means that property developers cannot be in the business of maximising turnover or undercutting each other on price since once they have sold all their new dwellings on one parcel of land they are out of business. They must buy back into the market from another land monopolist.

It is only because of this monopolistic power that land has a non-zero market value at all. Indeed, for a land market to be competitive we must be able to produce land (locations) with non-land (non-location) inputs.

In practice this means that each landowner is their own ‘little monopolist’ and their individual incentives are reflective of the incentives of the market as a whole.

The vacant land problem
The trick to understanding the dynamics of land development is to ask the question ‘why is there vacant or underdeveloped land’? In a short-run equilibrium model of supply and demand this can’t happen — all options to develop must be taken up (this underlying model gets a geographical twist in the Alonso-Muth-Mills model).

Luxestate INC


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