Question

In a study session, one of your fellow students says, "I think our econ text book has a mistake: It shows the supply curve for housing as a vertical line, which implies that a rise in price causes no change in quantity supplied. But everyone knows that if home prices rise, construction firms will build more homes and supply them to the market. So the supply curve should be drawn with an upward slope: higher price, greater quantity supplied." Explain briefly the mistake this student is making.

Short answer

The student's mistake lies in misunderstanding the nature of housing as a good. Unlike many goods, housing cannot instantly adjust to price changes due to factors such as building regulations and time constraints. Therefore, in the short run, the housing supply is rather fixed, which results in a vertical supply curve.

Step-by-step solution

Understanding the Supply Curve

The supply curve is a graphic representation that shows the relationship between the price of a good and the quantity of that good that the seller is willing and able to supply. Traditionally, the supply curve is drawn as upward sloping - higher price, greater quantity supplied because the supplier is willing to supply more at a higher price.

Clarifying the nature of the Housing Market

In housing, however, the supply curve tends to be vertical or inelastic. This is because the amount of available land and housing is relatively fixed in the short run. This means that no significant amount of new housing can be built quickly in response to changes in price because of factors such as zoning laws, time required to build, and the finite amount of available land.

Explaining the misconception

The student would be correct if construction could be done instantly and without limits, however reality proves otherwise. Construction firms indeed respond to higher home prices by planning to build more homes, but these homes may not hit the market until years later. Thus, in the short run, the supply of housing is pretty much fixed, hence the vertical supply curve.

Key concepts

Elasticity of Supply

The concept of elasticity of supply represents how responsive the quantity supplied of a good is to a change in its price. This is a crucial concept in economics because it affects how suppliers react to changes in the market. Elasticity is calculated as the percentage change in quantity supplied divided by the percentage change in price.

When the supply is elastic, a small change in price leads to a significant change in the quantity supplied. This is often the case for products that can be easily produced in larger quantities, like manufactured goods. Conversely, when the supply is inelastic, the quantity supplied changes very little with price changes. This situation arises in markets where production cannot be easily increased, often due to constraints like limited resources or technology.

In summary, the elasticity of supply is a measure that helps us understand how the supply of different goods responds to price changes, directly influencing production strategies and market dynamics.

Housing Market Supply

The housing market supply is unique compared to many other goods. One might expect, as with many products, that an increase in home prices would lead to a surge in the quantity of homes supplied. However, the housing market does not conform to this principle in the short run. Several factors contribute to this divergence.

Constraints in the Housing Market

The available land, especially in urban areas, is limited and cannot be expanded quickly. Zoning laws and regulations also play a significant role in controlling how land can be used and thus, how many houses can be built on it. Furthermore, the construction of new homes requires time and planning; it's a lengthy process that cannot be expedited in the short term simply because prices have increased.

As a result, the supply curve for housing in the short run doesn't slope upward as it does for many other goods; rather, it can appear nearly vertical, suggesting that the quantity supplied is relatively unresponsive to changes in price.

Short-Run Inelastic Supply

The phenomenon of short-run inelastic supply is evident in markets like housing. This inelasticity means that in the short term, the supply of a good is not sensitive to changes in price. In other words, even if there's a sudden surge in demand that pushes prices up, suppliers cannot immediately increase the quantity of the good they provide.

Why is Housing Supply Inelastic in the Short-Run?

For housing, the sheer complexity of constructing new buildings creates inelastic conditions. Builders can't simply ramp up production overnight. There's a substantial time lag between a rise in housing prices and the availability of new homes due to planning, obtaining permits, construction, and several other factors. During this period, the quantity supplied remains largely unchanged regardless of price increases.

Understanding the concept of short-run inelastic supply can help explain why certain markets, such as housing, don't always behave in ways our intuitive understanding of supply and demand might suggest. It's a lesson in patience and planning when it comes to market expectations and responses.