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.