Tuesday, 11 August 2015

What You Need To Understand Most About London House Prices

Hardly a day goes by without hearing someone complaining about London house prices. I think London is a fantastic city - far and away the best in the UK. A lot of other people agree, and because of that they want to live there. Such demand means London house prices are high, but that's not bad for society. The negatives of high house prices for buyers are offset by the positives of high house prices for sellers. There is no net loss for society.

So how, then, do low prices benefit society? There's only one way - when they cause consumers to buy more of what they want. Consider a large Domino's pizza costing £12. If you buy a Domino's pizza for £12 you are signalling that you value it more than the £12, otherwise you'd buy something else. Suppose you value a £12 large Domino's pizza at £15, the £3 difference is what is known in economics as your consumer surplus. If Domino's makes £7 on the pizza (their producer surplus) then society has a net value gain of £10. That applies to anything – cinema tickets, washing machines, clothes, DVDs, and so on.

Now suppose the price of a Domino's pizza falls to £11 and Domino's producer surplus drops to £6. Nothing has changed in net terms because Domino's loss is the customer's gain. But something else does change. What then happens is that more people are willing to buy Domino's pizzas. All the people who were willing to pay £11.50 for a pizza didn't buy one when they were £12, but will now. All these extra purchases create more consumer surplus, which creates more societal value. Remember Domino's gains too because they sell more pizzas (the very reason businesses cut prices).

Why doesn’t the same thing happen with housing? The key difference between Domino's and housing is that Domino's don't have a fixed supply of pizzas - they can make as many as the demand necessitates. Housing supply increases are severely restricted by regulations, bureaucracy and influential lobbying groups, which means even a theoretical drop in property prices couldn't benefit consumers in the same way lower pizza prices could.

The other factor to consider is utility. When there was a petrol crisis in the UK some of the more unscrupulous garage owners put their petrol prices up to account for the increase in demand and decrease in supply. This is very ignoble - but increased prices when supply-side diminishes tells us one key bit of information - it tells us who most values the product. Suppose there's only one garage in a town, and the garage owner puts up his prices to £7 per litre during the shortage. By and large the people who buy the fuel are going to be the ones who most need it. People for whom driving in the next week is less of a necessity won't buy the over-priced fuel. Yes it's unfortunate for the average consumer but it does at least separate the must-haves from the rest of society.

London house prices involve the same logic - by and large the properties go to people who most value owning property in London*. People with alternatives to living in highly priced London will take those options, leaving in most cases the people in London who most value living there. Moreover, as demand to live in London drives up prices, much more prudent use is made of the limited space available. Not only do prices that rise with demand ensure the best allocation of residents to the fixed number of properties, it also ensures that the best use is made of the land.

The primary cause of London's housing problem is overly-stringent regulations that starve supply in an inelastic market (the inelasticity being the limited supply of land). London is the main place where the demand to live there is hugely greater than the supply-side availability, not least because the supply is limited to a 1500 km2 area, whereas the buyer-side demand comes from anywhere in the world, and not always from people who want to buy those properties to live in.

The real truth of the matter is that politicians artificially choke the supply of housing in places like London by restricting supply and driving up prices. In doing this they are only succeeding in restricting competition, which hurts the people they are pretending to try to help – particularly young people looking to get on the housing ladder. 
* I know all those buyers who purchase properties in London as an investment but have no intention of living in them make many of you mad, but you've no reason to be, as I'll talk about in my next blog post.