Question

Every year in Houseville, California, builders construct 2,000 new homes-the most the city council will allow them to build. And every year, the demand curve for housing shifts rightward by 2,000 homes as well. Using supply and demand diagrams, illustrate how each of the following new events, ceteris paribus, would affect the price of homes in Houseville during the current year, and state whether home prices would rise or fall. a. Houseville has just won an award for the most livable city in the United States. The publicity causes the demand curve for housing to shift rightward by 5,000 this year. b. Houseville's city council relaxes its restrictions, allowing the housing stock to rise by 3,000 during the year. c. An earthquake destroys 1,000 homes in Houseville. There is no affect on the demand for housing, and the city council continues to allow only 2,000 new homes to be built during the year. d. The events in a., \(b .,\) and \(c .\) all happen at the same time.

Short answer

a) Prices rise, b) Prices fall, c) Prices rise, d) Prices rise. The reason being the shift in demand and supply of homes due to various factors.

Step-by-step solution

Event a Solution

This event increases the demand for homes in Houseville due to the city's positive publicity. This causes the demand curve to shift rightward by an additional 3,000 houses (5,000 - 2,000), since there are only 2,000 homes being built annually. Therefore, an increase in demand with no corresponding increase in supply drives prices up.

Event b Solution

In this case, Houseville's city council allows for more homes to be built in a year. This means the supply of homes increases by 1,000 houses (3,000 - 2,000), causing the supply curve to shift rightward. With demand remaining constant, an increase in supply would lower the price of houses.

Event c Solution

When 1,000 homes are destroyed by an earthquake, this effectively reduces the housing supply. Even if 2,000 new homes are built, it only balances the lost ones and the regular growth in demand. So, the net supply is actually 1,000 homes, causing the supply curve to shift leftward and driving prices up due to decreased supply.

Event d Solution

All events happening together will combine the effects of a), b) and c). The demand will increase significantly, the supply will also increase but to a lesser extent, and the destruction of homes will decrease the supply. This means that the overall effect will be a greater rightward shift in the demand curve than the supply curve. The imbalance between supply and demand will lead to an increase in home prices.

Key concepts

Supply and Demand Diagrams

Supply and demand diagrams are essential tools for visualizing how the market for a certain good or service operates. In microeconomics, these diagrams illustrate the quantity of a good that buyers are willing and able to purchase at different prices, which is known as the demand, and how much suppliers are willing and able to sell, referred to as the supply, on a graph.

Let's consider the housing market in Houseville, as described in our exercise. A point of great importance is that any shift in either the supply or the demand curves can signal a change in the market dynamics, leading to a new market equilibrium. For example, when an award makes Houseville more desirable (Event a), we depict this as a rightward shift in the demand curve, reflecting increased interest and willingness to pay for housing in the area.

On the other hand, events that change the number of houses built (Event b and c) would result in shifts of the supply curve. A relaxtion in building restrictions shifts the supply curve to the right, reflecting an increased number of houses that can be supplied at every price. Conversely, destruction of homes, such as from an earthquake, would shift the supply curve to the left, indicating that fewer homes can now be provided at the same prices.

Price Elasticity

Price elasticity measures how responsive the quantity demanded or supplied is to a change in price. If a small change in price leads to a significant change in the quantity demanded or supplied, we say the good is 'elastic'. Conversely, if the quantity hardly changes with a significant price fluctuation, the good is 'inelastic'.

In the context of Houseville, the price elasticity of housing demand would influence how significant the price differences are when the demand curve shifts. If housing is highly inelastic, which is often the case since homes are a basic necessity, even a large increase in demand resulting from Houseville winning an award (Event a) might not substantially increase prices. However, since the award increases demand significantly, we can expect prices to rise unless there is a proportionally significant increase in supply.

Regarding supply, if the elasticity is low, builders may not respond quickly to allow the construction of additional 3,000 homes (Event b), because it might not be feasible for them to ramp up production due to labor or material constraints. This informs us that understanding elasticity is critical in predicting how changes will affect market prices.

Market Equilibrium

Market equilibrium occurs where the quantity demanded equals the quantity supplied, resulting in a market where there is neither a surplus nor a shortage. The equilibrium price is where the supply and demand curves intersect. When either curve shifts, the equilibrium price and quantity will also change, restoring balance in the market.

In Houseville's example, we learn that when demand increases due to the city's newfound popularity (Event a), and supply does not match this growth because of a cap on construction (Event c), the equilibrium price will rise until it reaches a point where quantity supplied equals quantity demanded once again. A relaxation in the building cap (Event b) will raise the equilibrium quantity of homes and potentially lower prices, assuming the demand stays constant. However, when all events occur at once, as in Event d, the combination of increased demand, increased but limited supply, and reduced existing housing stock from an earthquake will generally result in a higher equilibrium price. These scenarios highlight the constantly shifting nature of markets in response to various external factors and the importance of understanding both supply and demand to predict these movements.