If there is too little of the item available, so that excess demand exists, prices will rise. As the prices rise, less will be demanded while more will be supplied. If the market is then flooded with the item, prices will fall. We can say that the price is too low if there are lots of people trying to buy a good and they cant get it.
Otherwise, when arguing prices are too high or too low, one is either stating his individual judgment of how much he values the good or service, or he is speculating that there will be a shift in demand conditions. In the latter case he is not really saying prices are too high or too low, but that he thinks they are going to change soon.
When looking at housing prices, it is important to realize that prices are set at the margin that is, by how much the next buyer is willing to pay. Recent studies have found the price of housing in certain cities much higher than could be sustained by the income of the current residents. One example is the conclusion of National City Corp.s Richard DeKaser, as reported by USA Today on August 17. DeKaser labeled 53 communities extremely overvalued and declared that in 85 percent of the cities studied, home-price gains outpaced income gains during the past year. Measuring prices against incomes in this way, people tend to conclude that there is a housing bubble and prices are due to drop; however, this needs to be taken with a grain of salt.
If you look closely at such studies, you will find that housing markets in cities that are becoming bedroom communities for larger, wealthier cities, or are becoming a substitute location for another high-priced housing market, will have prices that are higher than you would expect from current residents. But this is simply a reflection of the fact that higher-income people from nearby areas are taking advantage of the low housing prices in the target city and moving in, bidding up the price of the houses that are for sale. Since the housing prices used in these studies would be the value of the houses that are sold, but the incomes of the city will be the incomes of the current residents, it will appear that housing prices are very high relative to income.
An example should make this clear. Suppose there are 1,000 families in Suburbia. The average income of people in Suburbia is $40,000, and the average house value is $100,000. Suburbia is located 50 miles from Big City, which has 500,000 residents, an average income of $250,000, and an average house value of $500,000. Ten residents of Big City decide to take advantage of the low housing prices in Suburbia and move in. Since there are only a few houses for sale in Suburbia, they end up paying $150,000 for each of the 10 houses. It will then appear that houses in Suburbia are now worth $150,000.
The 10 new residents will only increase the average income in Suburbia by a small fraction, but it will appear that houses are now much more valuable there. Thus a study would show housing prices are rising much more rapidly in Suburbia than incomes are, and that a housing bubble exists.
At any point in time, the total amount of housing for sale in a given city is small relative to the total housing stock, and most residents will have purchased their houses in a prior year. In a market where people are moving in and the demand for housing is driven by people from outside, the sales of homes will reflect the incomes of those moving in. The large majority of residents will have already purchased their homes and will have mortgages consistent with their incomes. It may be true that most residents could not afford to purchase a new home in their community, but they will not have to.
Is there a housing bubble and are housing prices set to fall? That depends upon the particular city involved, but it is only important if you are speculating either by purchasing housing in order to sell it at a higher price or spending the unrealized equity in your current home. If you are like most of us, if the price of housing fell, nothing would change for you other than a decline in the potential you had to borrow on your house or to sell it at a higher price. But if it is important for you to know, then you must look for changes in the relevant demand for housing in that city, which may well include demand from people from outside the area who have greater incomes than the current residents.
Dr. Gary L. Wolfram is the George Munson Professor of political economy at Hillsdale College in Hillsdale, Mich. He also serves as an adviser to the Business & Media Institute.