Case Study:

The determinants of house prices

House prices are determined by demand and supply. If demand rises (i.e. shifts to the right) or if supply falls (i.e. shifts to the left), the equilibrium price of houses will rise. Similarly, if demand falls or supply rises, the equilibrium price will fall.

So why did house prices rise so rapidly in the 1980s and again in the late 1990s and 2000s, but fall in the early 1990s and from 2008? The answer lies primarily in changes in the demand for housing. Let us examine the various factors that affected the demand for houses.

Incomes (actual and anticipated). The second half of the 1980s and from 1997 to 2007 were periods of rapidly rising incomes. The economy was experiencing an economic 'boom'. Many people wanted to spend their extra incomes on housing: either buying a house for the first time, or moving to a better one. What is more, many people thought that their incomes would continue to grow, and were thus prepared to stretch themselves financially in the short term by buying an expensive house, confident that their mortgage payments would become more and more affordable over time.

The early 1990s and 2008/9, by contrast, were periods of recession, with rising unemployment and either falling or much more slowly growing incomes. People had much less confidence about their ability to afford large mortgages.

The desire for home ownership. Mrs Thatcher (prime minister from 1979 to 1991) put great emphasis on the virtues of home ownership: a home-owning democracy. Certainly, from the 1980s onward it became generally accepted that it was very desirable to own one's own home.

The cost of mortgages. During the second half of the 1980s, mortgage interest rates were generally falling. This meant that people could afford larger mortgages, and thus afford to buy more expensive houses. In 1989, however, this trend was reversed. Mortgage interest rates were now rising. Many people found it difficult to maintain existing payments, let alone to take on a larger mortgage. From 1996 to 2003 mortgage rates were generally reduced again, once more fuelling the demand for houses. Even when interest rates rose gradually over the period from 2004 to 2007 they didn't come close to the rates reached in the early 1990s. By 2008, however, higher mortgage interest rates were becoming increasingly unaffordable for many people and this was one factor contributing to the initial downturn in house prices.

The availability of mortgages. In the two housing boom periods of the late 1980s and from 1997 to 2007, mortgages were readily available. With house prices rising, banks and building societies were prepared to accept smaller deposits on houses, and to lend a larger multiple of people's income. After all, if borrowers were to default, lenders would still have a very good chance of getting all their money back.

In the early 1990s, however, and again from 2008, banks and building societies were more cautious about granting mortgages. They were aware that, with falling house prices, rising unemployment and the growing problem of negative equity, there was an increased danger that borrowers would default on payments. In 2008/9 the problem was compounded by the credit crunch, meaning that banks had less money to lend.

Speculation. In the two housing boom periods, people generally believed that house prices would continue rising. This encouraged people to buy as soon as possible, and to take out the biggest mortgage possible, before prices went up any further. There was also an effect on supply. Those with houses to sell held back until the last possible moment in the hope of getting a higher price. The net effect was a rightward shift in the demand curve for houses and a leftward shift in the supply curve. The effect of this speculation, therefore, was to help bring about the very effect that people were predicting (for more on speculation see section 3.2 of Economics by Sloman).

In the early 1990s, and again from 2008, the opposite occurred. People thinking of buying houses held back, hoping to buy at a lower price. People with houses to sell tried to sell as quickly as possible before prices fell any further. Again the effect of this speculation was to aggravate the change in prices - this time a fall in prices.

Speculation in recent years has been compounded by the growth in the 'buy-to-let' industry, with mortgage lenders entering this market in large numbers and a huge amount of media attention focused on the possibilities for individuals to make very high returns.

What of the future? At the time of writing, the credit crunch has resulted in a huge decline of mortgage advances and a rapid decline in house prices. Will this continue? As central banks, governments and the finance industry around the world take measures to improve the flow of credit, so mortgages should become more available again and interest rates should remain low. At the same time, the long-term growth in demand for houses is likely to outstrip the growth in supply. This is a recipe for rising house prices once more.1. Draw supply and demand diagrams to illustrate what was happening to house prices (a) in the second half of the 1980s and the period from 1997 to 2007; (b) in the early 1990s and the period from 2008.

2. Are there any factors on the supply side that influence house prices?

3. Find out what forecasters are predicting for house prices over the next year and attempt to explain their views.