Friday 5 July 2019

Economic myths: "It's all about lack of supply"

I was involved in another Twitter spat recently with a Faux Lib who insisted that high house prices are all about lack of supply.

Despite our best efforts, he was ignoring logic and facts, so I'll try to explain again why it is nonsense (for my own sanity and for future reference).

OK, first you have to understand the rent-setting process, which I covered here in a separate context (why a Universal Basic Income would not change rents).

It is easily observable that differences in average rents between different areas are pretty much equal to the difference in average wages between areas (plus or minus lots of other things, like nice/poor views, good/bad state schools, ease of commute, but average wages are easiest to quantify so let's stick with that).

To simplify the example, a country has a low wage Area A and a high wage Area B. Averages wages in Area B are £10,000 higher than in Area A, so average rents in Area B end up £10,000 higher than in Area A. This is because people will move from Area A to Area B to earn the extra £10,000, provided the extra rent they have to pay is no more than the extra wages of £10,000. If the difference were greater, people would move from Area B back to Area A, so there is an equilibrium where the higher rent soaks up the higher wages.

The location rent in Area A is zero; the rent you pay in Area A is just enough to justify maintaining existing stock with no surplus. Even in the wealthiest countries in the world (excl. city-states) you will find areas where the location rent is zero and you can buy homes for less than they cost to build, that's just a fact.
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Let's assume they build more homes in Area B. So people will move from Area A to Area B for the same reasons as before. Let's assume that this migration has no effect on average wages (agglomeration benefits mean that average wages will go up in the medium term; it could be argued that new comers will be slightly less skilled than current residents, so overall let's assume no effect).

The average location rent in Area A can't fall below zero and the equilibrium difference in rents is still £10,000, and there is no change in rents in Area B, despite the additional supply.

You can build as many new homes in Area B as you like. Even at peak capacity, new construction will only add a couple of per cent to existing housing stock and people can move just as fast as new homes can be built (at least ten per cent of the population move home each year, against a three per cent increase in housing stock, let's say) and the equilibrium will always re-establish itself.
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Circling back to real life, the Faux Libs claim that rents in London are only so high because of lack of supply. What they are saying is that people in London pay £15,000 extra in rent to be in an area where wages are only £10,000 higher. That is clearly nonsense - most people who move to London are in their twenties and they move there because they want to be better off. It is madness to say that people move to London to be worse off (they might take it on the chin short term, i.e. do an unpaid 'internship' but not medium or long term).

UPDATE, James Skillen posted this chart, saying it supports the idea that there is a need for more housing in London:


Maybe there is, maybe there isn't, that's not the issue here. If you do the maths, you will find that net incomes after paying rent are pretty much flat in absolute £ terms across the UK, which is a basic law of rent and the basis of the whole thing. For example, London wage £30,000 minus rent £15,000 (50% of wage) leaves £15,000 disposable. North East wage £20,000 minus rent £5,000 (25%) leaves £15,000 disposable.
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What is slightly more interesting is to look at Area A once some people have moved away. There are now more households than homes.

Two things can (and do) happen:

a. People spread out a bit; people leave home at a younger age; unhappy couples are more likely to split up etc. So the average number of people per home goes down a bit, and you can now rent more home for the same money - which discourages people from moving to Area B, so the effect is weak.

b. Less desirable homes in less desirable parts of Area A are simply abandoned. Once a couple of homes on a street are left empty for long enough, there is a domino effect and after a few years the whole street or whole estate is almost empty. For every new home built in Area B, one home is abandoned in Area, so the process is only gradual.

These abandoned homes simply fall out of the equation; they are no longer homes and can be ignored - it would be like including the selling price of beat-up MOT failures in a scrap yard when calculating the average price paid for second hand cars. The remaining people in Area A all end up occupying the same amount of housing and paying the same rent as before in the parts which have not been abandoned. The equilibrium rent difference between Area A and Area B is maintained.
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Whichever way you twist it, either you accept the simple logic of the rent-setting process which is easily observable in real life (comparison of average wages and average rents) - or you believe that people will move to a high rent area, knowing full well they will be permanently worse off; or will not be tempted to move to a low rent area if it made them permanently better off.

10 comments:

Dinero said...

My summary. Regardless of the quantity of the housing stock People buy the best houses at the best locations that exist in that stock and so building more houses increases the amount of empty houses but the price of the houses actually occupied stays the same. That price is at the edge of affordability as people compete for the best houses at the best locations. House prices are a product of people's propensity to spend the most they can afford to occupy the best house they can afford.
Shorter summary , people spend the most they can afford to occupy the best house they can afford.
A caveat, it could be said that more houses built results in more owner occupiers in areas where there are otherwise no houses for sale.

Mark Wadsworth said...

Din, agreed, good summary (apart from the last sentence).

Phil Jones said...

My daughter moved to Brighton because she wanted to live in Brighton. Same wages as Portsmouth but the rent is much much higher. There are many reasons why people live where they do, rent and wages are just two factors. I used to work in London, I wouldn’t have lived there if it was free to do so.

Mark Wadsworth said...

PJ, I said there are other factors. For some reason Brighton counts as cool, so people pay a bit more. If they built more homes, it would still be cool, and people would still move from Portsmouth to Brighton.

L fairfax said...

@"It is madness to say that people move to London to be worse off (they might take it on the chin short term, i.e. do an unpaid 'internship' but not medium or long term)."
True however
a) people don't always make good economic decisions
So they might be moving to be poorer but not know it.
b) they might not only have economic factors in mind. They might be worse off but like something in London they could not have where they lived before.

Mark Wadsworth said...

LF, re b), there are some things in London which are worth extra to some people.

If they are getting something extra for the rent they pay and are getting value for money, then they are not 'worse off'.

Tim Almond said...

Exactly.

And the whole thing is ridiculous. I'm not saying everyone can work remotely, but there's a lot of people who can. People in London aren't working in factories or breweries where you have to go to where the CNC machine or mash tun are. They mostly work on computers. You can work from the kitchen table, or rent a cheap Regus office nearby.

It's why London house prices are slowly falling. Everyone's talking about Brexit, but that's just journalists looking for the laziest explanation. What's happening everywhere is that the work culture is, more and more, accepting people doing more work away from the office. And if people only have to travel 1 day into the office a week rather than 5, they'll take a hit on living further out and save money.

Lola said...

TS
The same logic applies to 'falling high street rents'. Lots of stuff you used to need to struggle into a town to buy / source you can now get delivered to your door by a friendly educated Pole driving a white van. A few mouse clicks has replaced the 'struggle in to town'.

benj said...

Spending preferences change because the benefit received from one good/service improves relative to another.

All these supply-siders don't really mention how much the inner cities of most western countries has improved over the past few decades.

Instead they choose to see this as evidence of poor planning, when quite the opposite is true.

Lets say government policy resulted in higher aggregated incomes. Neo-classical economists tell us there should be no economic distinction between land, labour, capital. So if higher incomes are good, then why not land?

Lola said...

benj. I am not sure I follow your post.

But, last para, I don't think that that is what is meant at all. The issue is that 'all profits return to (economic) rents' so how do you do something about that, assuming it is a Bad Thing? There may be no economic distinction between the factors of production, but that assumes a level playing field. Which currently there ain't, land in the UK being at best under-taxed and at worst Damn' well subsidised.

I just don't understand your second paragraph.