How Does Price Elasticity Affect the Housing Industry?

If you have ever lined up for big retail discounts on "Black Friday," you have seen firsthand the effects of price elasticity of demand. This basic economic concept compares the change in demand for products that results from a certain price increase or decrease. When a slight price change creates a major change in demand for a product, it is said to have high elasticity.

Housing Market Basics

The housing market includes the homes available for sale and homebuyers looking to make a purchase. A number of basic economic factors affect the level of elasticity in the housing market.

In general, if there are more people looking to buy homes, home prices rise. If a lot of homes are listed for sale relative to the number of interested buyers, home prices are typically lower. Because homes are normally your biggest purchase, they tend to have a relatively high elasticity of demand.

Luxury or Need

As you go up in price range, elasticity increases significantly for housing. Demand exceeds the proportional increase in home prices. This is because luxury items have a higher level of elasticity. If you have plenty of disposable income, you are likely more willing to pay to get what you want.

At lower price points, buyers with more middle-class incomes have more budget restrictions and concerns. Thus, a price change from $500,000 to $525,000 likely affects you less than a change from $100,000 to $105,000, even though the percentage price change is the same.

Number of Available Substitutes

The number of available substitutes also has an impact on elasticity of demand. When the housing market is saturated with numerous homes for sale and foreclosures, you usually get a better deal because buyers are less willing to pay more than they need to for a good home. Also, if there are plenty of rental properties available, you may decide to rent if you can't get the right house at the right price.

This factor also relates to the price range of homes. Since there are usually fewer homes available at higher price points, buyers typically stretch to get what they want. Lower home price ranges usually have more inventory.

Loan Interest Rates

Mortgage loan interests rates also affect price elasticity in housing. When interest rates are lower, you can afford a larger loan. This enables you to stretch a bit more on home prices, which means an increased elasticity of demand.

When mortgage rates increase, the costs of borrowing are higher and you have a more inelastic demand. When the housing market is in a slump, the Federal Reserve may reduce its loan-funding rate for banks to encourage them to offer homebuyers lower rates on borrowing.

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