question:
Homes are durable and can last for decades. Consider Cleveland’s housing market.
Assume that in 2026:
Cleveland has 250,000 existing homes, all built before 2000. Housing does not depreciate. No new housing has been built in Cleveland in the past 26 years. The marginal cost of building a new home in Cleveland is $200,000, and the construction industry has consistently achieved returns to scale.
(a) Using a standard supply and demand graph, draw the aggregate housing supply curve for Cleveland in 2026. Be sure to clearly label key prices and quantities.
(b) Assume that the demand for housing in Cleveland increases. Using a diagram, explain how this affects the equilibrium price and quantity of housing.
(c) Now suppose that the demand for housing in Cleveland has decreased. Using a diagram, explain how this affects the equilibrium price and quantity of housing.
(d) Do increases and decreases in the demand for housing have symmetrical effects on the price and quantity of housing in Cleveland?Explain your answer using a supply curve.
Solved:
According to the question, there are two important characteristics of Cleveland’s housing market. First, there is an existing inventory of 250,000 homes, all of which were built before 2000 and are not depreciated. Second, new housing can be built at a constant marginal cost of $200,000. These two facts, durability and constant construction costs, determine the shape of the supply curve and, in turn, how the market responds to changes in demand.
Start with supply.
Because housing does not depreciate, the existing inventory of 250,000 units is fixed. No new homes are built for less than $200,000. Builders will incur losses if they try to build at that price. As a result, the total number of housing units supplied will be fixed at 250,000 units. In a standard supply and demand diagram, this corresponds to a vertical supply curve of 250,000 units, all priced below $200,000.
Now consider what happens with $200,000. At this price, builders are willing to build new homes. The construction industry has constant returns to scale, so no matter how many homes are built, the marginal cost of building an additional home remains $200,000. This means that once the price reaches $200,000, the builder is willing to supply additional housing at that price. Graphically, for quantities greater than 250,000 units, the supply curve is flat at $200,000.
Overall, the supply curve is kinked. Vertical for 250,000 units priced up to $200,000 and horizontal for $200,000 above that.
Once you have established the supply curve, consider how the market will react to changes in demand.
Suppose demand increases. Initially, equilibrium lies in the vertical part of the supply curve. Since the quantity of housing is fixed at 250,000 units, an increase in demand causes the price of housing to rise without changing quantity. Buyers compete for existing inventory and drive up prices.
As demand continues to increase, the price eventually reaches $200,000. At that point, new construction becomes profitable. Builders enter the market and begin supplying additional housing. Further increases in demand will not cause the price to exceed $200,000. Instead, we increase the amount of housing through new construction. Price is fixed at $200,000, but quantities are expanding.
Importantly, this process changes the supply curve itself over time. When new housing is built, the total housing stock increases. What was previously a vertical supply curve of 250,000 units shifts to the right to, say, 260,000 or 275,000 units, reflecting an increase in the existing housing stock. In this sense, past increases in demand leave a permanent imprint on the market through the expansion of the housing stock. The vertical portion of the supply curve is not fixed forever. When new homes are added, they move outward.
Now let’s consider the reduction in demand.
Even if demand decreases, the vertical part of the supply curve remains in equilibrium. Existing housing stock (which may now grow further due to past construction) remains unchanged. There is no mechanism to reduce the quantity of housing in response to a decline in demand. The house never disappears and no one can “rebuild” it. As a result, the overall adjustment is through prices. The decrease in demand leads to a decrease in the equilibrium price, but the quantity of housing remains fixed at the existing inventory.
This emphasizes the asymmetry. Increased demand causes prices to rise and eventually induces new construction, expanding the housing stock and shifting the supply curve outward. However, this process does not reverse when demand decreases. Housing stock will not shrink. Instead, the price cannot clear the market.
This asymmetry has important real-world implications. In cities where demand continues to decline due to population decline, industrial hollowing out, and changes in economic conditions, housing stock is maintained even as demand declines. The result is continued oversupply at prevailing prices, manifested in falling home values, rising vacancy rates, and underutilization of housing. In extreme cases, properties can become abandoned or poorly managed because their market value falls below the cost of maintaining them, contributing to urban blight.
The key constraint is simple. Houses can be added, but cannot be easily subtracted. As demand increases, prices eventually drive construction, expanding housing stock and shifting supply out of the country. When demand decreases, that adjustment range disappears. Quantity is fixed by existing inventory, so price drives everything. The result is an inherent asymmetry. Upward shocks in demand lead to both higher prices and more housing, while downward shocks primarily lead to lower prices. This is not limited to housing. In any market for durable goods, past production decisions constrain current adjustments, and those constraints determine price and quantity responses.
