Economic Principles and Purchasing a House
Economics Principles and Purchasing a House
This essay discusses principles of economics as they apply to making decisions about purchasing a home. The essay also reviews the decision making process and how it is affected by marginal benefits and marginal costs. The health of the economy and also international trade are factors to think about too, along with looking at conditions which could have lead to making a different decision.
Supply and Demand
Buying a home is one of the single most important economic decisions that most people make. Because it is such a big decision, it is important to look at all the right considerations. The way to do this is to understand how economic principles apply. One principle that affected my decision was the law of supply and demand.
The number of homes available for sale is influenced by supply and demand. On the supply side, how many homes are for sale is influenced by the selling price of homes. If people see that they can sell their homes for higher prices, more of them are willing to sell, with all other things being equal. The converse is also true; more people are discouraged from selling when prices are low, as they are today.
The unemployment rate also affects the supply of homes. The more people there are out of work, the more people there are who fall behind on their mortgages and cannot afford to keep their homes. These homes add to the overall supply either through voluntary short sales or through involuntary foreclosures. The U.S. currently has a high number of homes available for sale. As of January 2012, the in the U.S. amounted to a 6.1 month supply at the current sales rate (RealEstateABC.com, 2012). This rate does not take into account what analysts call the shadow inventory, which includes distressed inventory that is being kept off the market. Experts believe that shadow inventory will continue to keep prices low for years to come (Time, 2012). Knowing that home prices will not increase significantly in the next few years means that I didn’t have to buy right now to get the best price.
On the demand side, a large number of people looking to buy homes would drive up the prices. This situation is called a sellers’ market and is a normal part of the economic cycle. In today’s market however, there are not enough people who want to buy homes, which works to my advantage. Some people are waiting for prices to fall even more, some cannot qualify for bank loans, while others are worried about keeping their jobs and don’t want to buy a house and risk being laid off. All these reasons together help to keep demand for housing lower than normal.
Interest rates also affect supply and demand and made a difference in my decision. Changes in interest rates can make a huge impact on my ability to buy a home. When interest rates drop, the cost to obtain a mortgage goes down. This change creates more demand and pushes prices up. The opposite is also true (Investopedia, 2012). But the more significant impact for me is not the short-term effect on housing supply and demand. Higher interest rates increase marginal cost and opportunity costs for me. Government intervention kept interest rates low during much of the recession, but rates have risen in recent months, making home-buying less affordable.
When all these factors are taken together, supply is currently greater than demand in many housing markets across the U.S. This lack of demand keeps down prices and affects the rest of the economy as well. A recent report by a Raymond James investment analyst describes weak GDP growth for the first quarter of 2012 and concludes that the housing industry, consumer spending and the economy in general are still depressed (Brown, 2012).
Trade-offs
Another important principle that affected my home-buying decisions was the concept of trade-offs. Even in a bad economy, there are only so many houses available, so there is a limited supply at a given price. Choosing from the homes available in my price range involves trade-offs that affected my home-buying decision. I could choose to buy a home in the suburbs where housing prices are lower, but this trade-off required me to drive farther to get to work. Given the increase in gas prices, this is a significant trade-off. Or I could choose one location over another because of living in a better school district, or having a lower crime rate, or having a faster rate of appreciation. Given all these options, I had to decide how to allocate my income to get as many desirable features in a home as possible.
Opportunity Costs
The single biggest factor that affected my decision to buy a home was my income. I know that I can spend only just so much of my income on the mortgage. I know that for every dollar I spend on the house, I’m giving up money that I could spend on a car and gasoline, on a vacation, on buying furniture for the new house, on saving and so forth. There are always opportunity costs that come with buying a house. Thinking about money that I could spend buying other things almost decided me against buying a house.
Marginal Benefits and Marginal Costs
Thinking at the margin also affected my decision. I debated whether I could afford another bedroom or bathroom in the house, whether I could afford a larger garage or bigger yard, or whether I could afford a new home or an older one. I found that the process of shopping for a home affected my decision and caused a marginal change in my plans.
As part of deciding whether to buy a house, I compared the marginal benefits and marginal costs. Because my resources are scarce, that is I do not have unlimited income to spend on a house, I had to decide what provided the greatest possible return from the resources I have available. I decided the maximum amount that I would spend on a house by comparing marginal costs and marginal benefits. I realized that the more I decided to spend on the house, the less money I had left for other things. I got to a point where the opportunity cost was too high by comparison with the marginal benefit. That was the point at which I knew how much I was willing to spend on buying a house.
Incentives
Incentives also affected my decision. Especially in a buyer’s market, a seller may offer additional incentives to get someone to buy their home. Sellers may throw in extras, like appliances or paying for extra repairs or upgrades, as added incentives to get a buyer like me to act. Hoping to be a smart buyer, I was on the lookout for these possibilities, and asked my agent to negotiate such incentives for me. On the other hand, knowing that are likely to be depressed for years to come in some areas was a disincentive to purchase right now.
The Effect of the Economy on Analyzing Marginal Benefits and Costs
The strength of the economy affected my analysis of marginal costs and marginal benefits by raising the cost of some options and lowering the corresponding benefit of others. Because there is so much uncertainty about the possibility of future layoffs, I had to decide how much of a gamble buying a home would be. In effect, this made buying a larger house and spending even more of my income less attractive. In a better economy I might be more confident that I could quickly find another job if I were laid off; knowing that finding a new job can take a lot longer now made me more cautious about buying a bigger house. A bigger house would require a larger down payment now, reducing my savings even more, and would also require a larger mortgage payment. This larger payment would also affect my ability to continue saving in the future. Since having a nest egg to fall back on during tough times is important to me, the additional benefit of keeping my savings at a certain level was higher than the marginal benefit of buying a larger house.
Conversely, I also thought about how the weak economy affected the price of houses, making the marginal cost of buying a bigger house lower than it would be otherwise. I had to decide which marginal benefit was higher for me, buying a bigger house or having a bigger savings account.
The Domestic Economy and International Trade
International trade was a bigger factor in my home-buying decision than I would have expected. The most direct effect was on my employment. International trade affects the long and short-term outlook for the domestic economy. The U.S. needs to be able to sell what we produce abroad, which means our goods and services must be competitively priced. Practically speaking, if my employer can outsource or offshore my job at lower cost, then that increases the chances of me being laid off. For the same reason, it also decreases the chances of me getting large salary increases.
Even if my job were not in jeopardy, international trade still affects the health of the U.S. economy. The bigger the U.S. trade deficit grows, the more U.S. businesses potentially feel the negative effects. It becomes harder for them to raise capital, and government intervention in some form of protectionist action, which frequently does not produce the desired results, becomes more likely.
A Different Decision
If housing prices had not fallen drastically because of the crisis in the housing market, I probably would not have decided to purchase a house now. Likewise if interest rates were to climb much higher, I might have decided that I could not afford to buy a home. If there were no oversupply of housing, I might have made a different decision. Because of the law of supply and demand, fewer houses for sale would mean higher prices and less affordability for me.
Fewer foreclosures and short sales would mean less housing inventory. Fewer houses for sale mean that the remaining houses would sell for higher prices; this would increase my marginal cost and therefore my opportunity cost. At best, I might still be able to afford a house, but would have to buy a smaller, less expensive house, or one located in a less affluent neighborhood.
Government policies, such as the first-time homebuyer’s tax credit that has since been discontinued, might also have provided an additional incentive to buy that would have affected my decision.
If the recession had not ended, I might have decided against buying a house, especially with the increase in gas prices. The longer the recession continued and the more homeowners were forced into foreclosure, the less confidence I would have had about keeping my job. Even if I believed I was not going to be laid off, the marginal benefit of owning a home would be lower. Depending upon the city and how hard it was hit by the housing industry downturn, the cost of renting a home and be significantly lower than buying one. This relationship between marginal benefit, marginal cost and scarcity would have combined to change my decision.
Reference List
Brown, S.J. (2012, March 19 — March 30). Weekly economic commentary. Retrieved March 20, 2012 from: http://www.raymondjames.com/monit1.htm
Nguyen, J. (2011). 4 key factors that drive the . Retrieved March 20, 2012 from: http://www.investopedia.com/articles/mortages-real-estate/11/factors-affecting-real-estate-market.asp#axzz1pj62jpXH
RealEstateABC.com. (2012). Existing home sales — March report. Retrieved March 20, 2012 from: http://www.realestateabc.com/outlook.htm
Tarbox, K. (2012, February 8). How ‘shadow inventory’ is killing the housing market. Time Magazine online. Retrieved March 20, 2012 from: http://business.time.com/2012/02/08/what-is-the-shadow-inventory-how-many-homes-could-be-for-sale/
