During winter break, I was back in Massachusetts visiting family. The conversation turned to the difference in the cost of living between my home state (Massachusetts) and my adopted state (Louisiana).
The difference is quite obvious. According to the World Population Review’s cost of living index, the total cost of living in Massachusetts is approximately 1.5 times that of Louisiana. The difference in housing costs is even greater, with housing prices in Massachusetts approximately 2.3 times more expensive than in Louisiana. To give you an idea of what this looks like, I bought a 1,200 square foot, 2 bed, 1.5 bathroom condo in August for $142,000. A similar condo in Worcester, Massachusetts, sold for just under $400,000 last fall. The cost of living in Massachusetts is so high that there is a net exodus of approximately 30,000 residents to other states.
I am a major supporter of free markets and YIMBY (Yes In My Back Yard, a movement to increase housing availability and reduce building restrictions). My position is that Massachusetts should “build, baby, build.” My aunt objected, pointing out that there was a lot of construction going on in Massachusetts. And she’s right. Approximately 90,000 homes are under construction in the state. My answer was, “We still don’t have enough housing.”
In that response, I committed an Econ 101 error. In other words, we were inferring from changes in quantities. Reasoning from changes in quantity is a companion problem to the problem of reasoning from changes in price, which my former co-blogger Scott Sumner often writes about.
When we reason from changes in price, we consider the change in price to determine the direction of quantity. For example, assume that because the price is rising, the quantity demanded in the market will no longer be met. It is a mistake to make inferences from changes in prices because determining what happens to the equilibrium quantity requires understanding why prices are rising.
If you don’t understand the “why,” you can’t make rational decisions about the “what.” There are two reasons why prices are rising. Either an increase in demand or a decrease in supply. Depending on which event occurs, the quantity will be affected differently. If the price increases due to a decrease in supply, the market quantity will fail because each supplier will sell fewer units at a given price. However, when price increases due to increased demand, the market quantity increases because buyers as a group are willing to buy more at any given price.
The same problem applies when reasoning from changes in quantities. Just as a change in price does not tell us what the expected change in quantity will be when we infer from a change in price, a change in quantity does not tell us what the change in price will be.
Changes in quantity are also caused by changes in supply and demand. When demand decreases, the price decreases and therefore the quantity exchanged in the market also decreases. People are willing to buy fewer quantities at any price, so producers cut production to lower marginal costs and protect profits. When supply decreases, prices increase because it costs firms more to produce, and output decreases because the marginal unit costs more to produce.
In the Massachusetts example, there are two explanations for the change in the amount of housing (i.e., total buildings). Either an increase in demand or an increase in supply.
If the demand for housing in Massachusetts is increasing, so is the price homebuyers are willing to pay for a home. Suppliers may be building more just to reach a supply that matches the price increase on the shifted demand curve. They believe that would-be homeowners in Massachusetts are willing and able to pay more for a home, and that they are simply offering the home at the price they want.
In contrast, if new housing is being built because supply is increasing, prices will fall as more housing is built. Builders lower the price of their homes to attract buyers to their homes. (I won’t speculate on what factors are driving the Massachusetts housing market, as that is irrelevant to this post).
It is possible to temporarily lower prices simply by increasing supply. When supply exceeds demand, there is a surplus in the market. In that case, companies (and sellers) will try to move the unsold inventory by lowering prices. But the resulting decline in house prices will only last until the market reaches equilibrium. The equilibrium price still does not fall, as it would if the supply as well as the quantity supplied were increasing.
So what I told my aunt was a mistake. “If we want to make housing more affordable, we need to reduce the cost of building homes in Massachusetts and increase the number of homes that would be delivered if all the homes on the market were built. If the demand for housing is increasing along with the supply, simply building more homes won’t make housing more affordable. We need to look at the barriers to affordable housing, such as permitting processes, zoning, and other building regulations, to lower construction costs. [that is, increasing supply] “This is the only sustainable way to reduce housing costs.”
