There has been a lot of main stream media coverage of the Housing Bubble lately. I've been covering it for over two years. A lot of the discussions over at Patrick.net recently have focused on buyers, sellers and prices. So, let's talk some basic economics...
Prices in residential real estate tend to move rapidly on the way up but sticky on the way back down. That is in a normal market. The market has been anything but normal over the past few years -- it has been an out and out Bubble in many parts of the country, including the San Francisco Bay Area.
The Bubble started to come apart when upwards stickiness, or Buyer Stickiness, started to kick in. This caused there to be an ever smaller pool of willing buyers at sellers' prices. In short, buyers ceased to be price takers.
Now that we've hit the top, we enter the period where there are essentially no buyers at sellers' prices and no sellers' at buyers' prices. Both sides are trying to be price setters.
What happens next is some sellers start accepting the market and accept buyers' prices. Over time, more and more sellers convert to this understanding of the market and eventually equilibrium is returned, where neither side holds a commanding price setting advantage.
The Inflating Bubble:
- Pre-Bubble prices started out at the equilibrium price of P(-1)
- As the Bubble expanded, a few buyers started opting to refuse sellers' prices, and are represented by the right-portion of D(0). There are not yet enough buyers on this portion of the curve to affect sellers' prices.
- However, most buyers continued to participate in the market, and are represented by the left-portion of D(0). The vertical span on D(0) is the break between buyers who buy into the bubble and those who refuse.
- Sellers, who started early in the Bubble on S(0), selling at P(0), quickly adjust their expectations. Sellers shift to S(1), requiring even higher prices.
- As sellers shift to S(1), buyers shift to D(1), but the number of unwilling buyers continues to grow. Sellers are still able to get fairly consistent prices even though there are less buyers because there are still enough to support a definable market. (This is represented by the sloped, upper left portion of D(1).
- Eventually the pool of buyers at D(1) dries up enough to shift to D(2). This curve shows that most buyers are sitting out the market.
- Sellers on S(1) start finding erratic prices, represented by P(1). This is because they are selling into the disconnect between buyers. This period was marked by a wide variation in prices of homes sold compared to one another.
- Eventually sellers climb all the way to S(2). Note that now sellers are unwilling to accept any price below somewhere in the range of P(1).
- A few buyers on D(2) are left, even at the sky high prices P(2). Eventually those buyers dry up.
Popping the Bubble:
- There are now no buyers left willing to take sellers' prices. The upper portion of buyer demand is gone. The buyer curve is represented by D(0).
- D(0) comes in under S(0), so sellers cannot even get their minimum price of P(0).
- Sellers start shifting their prices slightly, and minimum prices fall somewhat as the quantity of unsold homes grows. But even at S(1), there are still no buyers on D(0) willing to pay sellers' prices. The lower leg of S(1) are sellers who have moderated their prices slightly.
- Some sellers defect, and the curve moves to S(2). The few sellers willing to drop their prices substantially find buyers on D(0), but the prices they get are erratic. This is again because of the vertical portion of the curve, this time in S(2).
- Buyers, sensing declining prices, shift down to D(1) and the few willing to buy at higher prices purchase the available supply on S(2).
- More sellers realize that lowering their prices is necessary. Their curve shifts to S(3), which clearly delineates price-taking sellers from price-setting sellers. Ironically, some sellers may actually be expected to raise their prices during this phase, even in the face of adversarial demand.
- Buyers purchase the lower end of S(3) and shift a bit further to D(2) as they still expect prices to fall, seeing the large inventory of overpriced, unsold homes.
- Between S(3) and S(4) sellers make a critical decision to either sell or not sell. Sellers either leave the market indefinitely or convert to price-takers.
- Finally, equilibrium is reached at P(3), where S(4) and D(3) intersect. Neither sellers nor buyers control prices.
Price stickiness is a fact of life in the residential real estate market. It occurred upwards near the end of the Bubble's inflation period, and it is occurring now, early in the Bubble's deflation.
This analysis is basically of a hypothetical set of comparable homes at an equivalent price, within a homogeneous region. In real-reality, of course, real estate is heavily affected by hyper-local factors. Therefore this analysis is merely a mental exercise to help in understanding general price movements in the face of sellers and buyers.