Question:
The housing market represents a durable asset, often lasting several decades. Let’s examine the situation in Cleveland’s housing market.
Imagine the year is 2026, and the following conditions exist:
- Cleveland has a total of 250,000 homes, all constructed before 2000.
- Homes maintain their value and do not depreciate.
- For the past 26 years, no new homes have been built in Cleveland.
- The marginal cost of creating a new home in Cleveland is $200,000, with the construction industry exhibiting constant returns to scale.
(a) Using a standard supply and demand graph, illustrate Cleveland’s aggregate housing supply curve for 2026, making sure to label all pertinent prices and quantities.
(b) Consider a rise in demand for housing in Cleveland. Using your graph, describe how this will impact the equilibrium price and quantity of housing.
(c) Now think about a decline in demand for housing in Cleveland. Using your graph, explain how this will alter the equilibrium price and quantity of housing.
(d) Are increases and decreases in housing demand symmetric with respect to their effects on housing prices and quantities in Cleveland? Justify your answer using your supply curve.
Solution:
The Cleveland housing market can be understood through two primary characteristics. First, there exists a fixed stock of 250,000 homes built before 2000, which remain constant in value. Second, new homes can be constructed at a consistent marginal cost of $200,000. Together, these factors—durability and constant construction costs—shape the supply curve and subsequently influence the market’s reaction to changes in demand.
Let’s begin by examining the supply side.
Since homes do not lose value, the existing stock of 250,000 homes remains unchanged. If the price falls below $200,000, no new homes will be constructed, as such pricing would lead to losses for builders. Therefore, the quantity of housing supplied is fixed at 250,000 units. In a typical supply and demand graph, this creates a vertical supply curve at 250,000 homes for any price below $200,000.
Now, consider the scenario at $200,000. At this price point, builders are willing to start constructing new homes. Because the construction industry operates under constant returns to scale, the cost of building an additional home remains at $200,000 regardless of the number of homes built. As a result, once the price reaches $200,000, builders will supply any quantity of housing at that price. Graphically, this results in a horizontal supply curve at $200,000 for quantities exceeding 250,000 homes.
In summary, the supply curve is kinked: it remains vertical at 250,000 homes until it reaches a price of $200,000 and then becomes horizontal beyond that point.
With the supply curve established, we can explore the market’s reaction to changes in demand.
When demand increases, the initial equilibrium is found on the vertical segment of the supply curve. Since the quantity of housing remains fixed at 250,000 homes, the rise in demand triggers an increase in housing prices without changing the overall quantity. Buyers compete for the limited stock, driving prices higher.
As demand continues to grow, the price eventually reaches $200,000, making new construction viable. Builders then enter the market and begin to increase the supply of homes. In this scenario, further increases in demand do not push the price beyond $200,000; instead, they lead to an expansion in the quantity of housing through new development. The price stabilizes at $200,000 while the quantity expands.
Importantly, this process effectively alters the supply curve over time. As new homes are built, the total housing stock rises. What was previously a vertical supply curve at 250,000 homes shifts to the right, potentially to 260,000 or 275,000 homes, reflecting the newly added inventory. Consequently, past demand increases permanently alter the market by enlarging the housing stock. The vertical segment of the supply curve is not static; it can expand as new homes are added.
Now, consider the effect of a decrease in demand.
When demand declines, the equilibrium continues to lie on the vertical segment of the supply curve. Although the total stock of homes may have grown from previous construction, it does not diminish. Homes cannot simply vanish, nor can they be “unbuilt.” Thus, the adjustment occurs solely through price changes. A drop in demand results in a decrease in the equilibrium price while the housing quantity remains fixed at the existing stock.
This scenario underscores the asymmetrical nature of the market. Increases in demand elevate prices and prompt new construction, thereby expanding the housing stock and shifting the supply curve outward. Conversely, decreases in demand do not retract the housing stock; instead, they lead to falling prices to balance the market.
This asymmetry carries significant real-world consequences. In cities experiencing prolonged demand declines—due to population loss, deindustrialization, or shifting economic landscapes—the existing housing stock remains intact, even as demand wanes. This situation culminates in a persistent surplus of homes at existing prices, resulting in depreciating property values, heightened vacancy rates, and underutilized housing. In dire situations, this can lead to urban decay, as properties become abandoned or poorly maintained when their market value dips below the cost of upkeep.
The essential constraint is clear: while housing can be added, it is not easily removed. When demand surges, prices eventually motivate construction, broadening the housing supply and shifting the supply curve outward. Conversely, when demand contracts, the adjustment option evaporates—demand remains confined to the pre-existing housing stock, leading to price fluctuations alone. The result is a fundamental asymmetry: upward demand shocks translate into both elevated prices and increased housing availability, while downward shocks primarily result in lower prices. This phenomenon is not exclusive to housing. In any market dealing with durable goods, previous production choices limit current adjustments, influencing how prices and quantities react.
In conclusion, understanding the dynamics of the housing market in Cleveland reveals critical insights about how supply and demand influence prices and quantities. The permanence of the housing stock, combined with the responsiveness of builders to price changes, underscores the asymmetry in market behavior. This framework not only applies to Cleveland but is a vital consideration for housing markets everywhere.
