Real Estate Economics: Chapter 5 Important Economic Features of Real Estate Essay

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*Economic Characteristics of Real Estate Markets
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A market was previously defined as a place where buyers and sellers meet to exchange items of value. The market for each product or service is somewhat different. The nature of a particular market influences the level of prices paid. *In a perfectly competitive market, there are numerous buyers and sellers, each assumed to be knowledgeable and free to move in or out of the market at will. Neither party has any control over the market. *Because the products being sold are assumed to be nearly alike, buyers will usually select the one offered at the lowest price. *In such a perfect market, prices would be established purely by the principles of supply and demand. Another important feature of a perfect market is that prices move relatively quickly, either up or down, with minor changes in demand or supply. Both real and perceived changes cause prices to change. *Buyers who anticipate a drop in supply will bid up prices, even when supply really is not changing! With perfect markets, price movement is equally smooth in both the up and down directions. Prices in the stock market (for actively traded stocks) display such a pattern of price movements. In practice, most markets are imperfect. Some of the characteristics of a perfect market are either missing or distorted, preventing the principles of supply and demand from operating efficiently. What can we say about real estate market characteristics? Are real estate markets perfectly competitive or are the imperfect? The Characteristics of a perfect market and typical real estate market are: 1. Number of buyers and sellers 2. Product knowledge and ease of exchange 3. Standardized products 4. Mobility 5. Size and frequency of purchase 6. Government’s role 7. Prices This shows that real estate market are very imperfect! Characteristics of the imperfect real estate markets include the following: 1. Real estates buyers and sellers are frequently relatively uninformed about real estate issues, values and market trends 2. The transfer of real property requires a legal and technical knowledge not possessed by the average citizen 3. Each real estate parcel is separate and unique from all other parcels 4. The location of the land can’t be moved to benefit from better market conditions in other geographic areas.
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Number of buyers and sellers
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In a perfect market: Many participants; no monopoly, oligopoly, or monopolistic competition. Typical Real Estate Market: Few participants; seller controls during a “seller’s market,” and buyer controls during a “buyer’s market.”
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Product knowledge and ease of exchange
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In a perfect market: Buyer and sellers are knowledgeable; exchanges take place with ease. Typical Real Estate Market: Buyers and sellers are not always knowledgeable; the exchange is legalistic complex, and expensive.
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Standardized products
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In a perfect market: All products are alike and interchangeable; little difference between products of different sellers. Typical Real Estate Market: Each parcel of real estate is unique and separate from all others; no two are exactly alike.
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Mobility
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In a perfect market: Products can be moved elsewhere to sell at a better market. Typical Real Estate Market: The location is fixed; a parcel can’t be moved to another, more profitable location; a real estate market is local, not regional or national.
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Size and frequency of purchase
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In a perfect market: The item purchased is small and relatively inexpensive; it is purchased frequently. Typical Real Estate Market: Real estate is purchased infrequently (rarely more than four or five times in a lifetime); for example, a home is the largest single investment for an average family.
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Government’s role
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In a perfect market: Government plays little if any role; laissez-faire prevails. Typical Real Estate Market: Government plays a dominant role in encouraging or discouraging real estate development, with fiscal and monetary tools and zoning, environmental, and health codes.
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Prices
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In a perfect market: Prices are established by the smooth action of supply and demand. Typical Real Estate Market: Prices are influenced by the interaction of supply and demand, but this interaction is not smooth; a lack of knowledge by either the buyer or seller can distort the prices paid.
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-Does This Mean That the Principles of Supply and Demand Do Not Work in Real Estate Markets?
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No, the principles of supply and demand are still important influences on the value of real estate. It’s important to recognize that supply and demand operate differently in real estate markets. In a perfectly competitive market, supply and demand react quickly to changes in market conditions. *In real estate markets, supply is fixed in the short run and can’t respond quickly to changes in market conditions. Under the best of circumstances, it take a minimum of several years to subdivide raw land, develop lots, and build the first house. With very complex properties, it can take a decade. Even with a supply of vacant buildable lots, it can take a year for a builder to buy a lot, obtain financing and permits, and complete construction. Real estate supply can be very slow to change.
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The Total Supply of Land is Fixed
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One of the most fundamental principles of real estate economics is the recognition that there is a fixed land supply. The land surface can’t be increased or decreased according to the whims of demand. At any point in time, every inch of land is being used for some purpose. It might be vacant land that is not being farmed, but only held in anticipation of higher prices. That’s its current use. Any use of land can be changed to another use, but that can take time. A change in use could require annexation to the local city, or to a sewer or water service area. Rezoning might be required. Sometimes, an environmental impact study is needed. The intensity of land use can also change, and in time this will act to increase or decrease the supply of real estate. *It may be impossible to increase the number of acres within the city limits, but it can be easy to increase the number of housing units per acre. This can generate an increase in the supply of homes, without any increase in the supply of land. Any change in the intensity of land use usually also takes time. If the demand for residential or other real estate projects was suddenly to increase, developers would need considerable time to acquire land, get is rezoned to a higher intensity of use, and obtain permits and financing. The state and local permit process could take years. Environmental groups and unhappy neighbors might sue, seeking to block further development. In a practical sense, there is a fixed short-term land use. Once a building is constructed, it tends to have a long life, regardless of any short-run changes in the real estate market. This keeps supply from declining. *Ex. If the demand for homes within a community declines, a builder with an unsold supply of new houses will not demolish them, simply because the demand for the homes has diminished! The homes will sit vacant on the market until they are sold. If they remain unsold very long, the lender will foreclose, and then sell the inventory at discount prices. (When houses are foreclosed before construction is completed, the damage from the weather could result in their demolition!) If demand continues to be less that the existing supply, buildings could simply sit vacant. This happened to a few poorer neighborhoods of New York City in the 1980s, and Detroit in the mid-2000s. Many mining towns just turned into ghost towns, when mining no longer was profitable. If demand shifts to another use, there will be an over-supply of buildings designed for the old use. It may be possible to adapt an existing building to another use. Many large older residences have been converted into apartments or even rooming houses. Many residences located along streets that have become arterial roads, with heavy traffic, have been converted into offices, stores, or even small churches. Most buildings are not that easy to adapt to a new user. Rezoning might be required. Costly remodeling may be necessary. Both take time, making any change in use of existing buildings a slow process. This can act to keep supply somewhat fixed in the short run. Real estate supply can be complex to figure out. Consider the supply of homes. At any one point in time, there are only so many existing homes. We can say that supply is fixed. But the key issue in pricing is not the total number of homes. It’s the supply of homes for sale. That number isn’t fixed in the short-run. What would happen if a new government program lowers interest rates for home loans? The lower interest rate would mean that monthly payments would be less (if prices do not change.) *Lower payments means that more people would qualify for a loan. This would increase demand! With more demand, prices would rise. With higher prices, the supply of homes for sale is likely to rise! Speculators holding houses are more likely to sell. People renting out “the old family home,” but living elsewhere, are more likely to decide to let go. Some will decide that the increase in their equity will allow them to sell and retire to the country, or sell and move up to a better home, better school district, or more convenient location. Therefore, the supply of homes for sale is not really fixed in the short run. This is also true of homes or apartments for rent. What if a small town is to host some large gathering? There aren’t enough hotel rooms within a reasonable travel time. Every vacant housing unit will quickly be converted to house the guests. As all available regular units books up in advance, overnight rental rates for the week in question climb! Some people offer a room in their home, or fix up an unused mother-in-law unit. Others move in with family, and offer their unit for rent. *The supply grows, in a very short time, with no new construction! Commercial property has the same supply pattern. The total number of income property of any type is fixed, at any one point in time. The number for sale, or for rent, can increase quite rapidly, when prices increase.
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Fixed Land Supply
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The land surface is fixed, and can’t be increased or decreased according to the whims of demand. However, the intensity of use can be changed.
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Intensity of Land Use
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A measure of neighborhood change. A change of land use intensity in time will act to increase or decrease the supply of real estate.
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Fixed Short-Term Land Use
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In the short run, land use and land supply are fixed, as a change in land use generally is a slow process, requiring many studies and approvals.
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*How Real Estate Markets React to Changes in Demand
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What happens with a real estate demand change? An increase in demand for a particular type of real estate, at a particular location location, will generally have the following consequences: 1. An increase in demand will reduce the number of existing real estate vacancies, be it in office space, stores, apartments, or in the inventory of homes for sale. 2. This reduction in vacancies will be followed, relatively quickly, by an increase in rents and prices (assuming no rent controls) as more people continue to bid for the existing supply. 3. As demand pushes rents and prices up, a point is reached at which investors and builders, motivated by profit potential, are drawn into the construction market. 4. Assuming favorable economic and governmental conditions, new construction takes place slowly, and the supply of real estate gradually increases. 5. However, as this new construction grows, eventually it overtakes the increase in demand, and vacancies begins to rise. 6. This increase in vacancies causes a decline in rents and prices. Price and rent declines may not be readily apparent at first, but instead often initially show up as rent concessions, or favorable seller-aided financing. 7. With lower rents and prices, the difference between building costs and sales prices begins to narrow, and developer profits decline and then disappear. This change in developer profits is rapid, because the increased construction actively forces up building costs, catching builder profits in a fast-moving squeeze, between rising costs and falling sales prices. A decrease in the demand for a particular type of real estate, in a particular location, will generally have these consequences: 1. A decrease in demand causes and increase in vacancies in offices, store, apartments, or a larger number of unsold homes. 2. The increase in vacancies will cause rents and prices to decline. 3. With lower rents and prices, people can now obtain more spacious quarters, at no increase in costs. This may absorb the vacancy. If not, the continued vacancy will eventually force owners to demolish structures and reuse the land. 4. The real estate market will remain in this state until demand once again increases. The 2007 Mortgage Crisis contained many superb examples of supply and demand in practice. Ex. There were many home loan mortgages in the processing pipeline, between the time of a loan commitment, through close of escrow, sale on the secondary market, bundling into a security (“securitization”), and the time of final sale to investors as tranches. Once a loan commitment was made, all parties were committed, except the ultimate tranche buyer! When the market for mortgage-backed securities froze, the securitizers — usually investment banks–had a supply of securities, but no demand for them. Prices collapsed, followed by company bankruptcies. And as home prices no longer climbed rapidly, many people who had paid deposits on new homes defaulted or cancelled. The absence of buyers left many completed unsold homes–supply without demand. Completed lots lacked builders willing to build, and lenders willing to lend–supply without demand. Prices fell, drastically in some overbuilt areas. Ultimately, prices fell far enough to interest buyers. In addition to price drops, demand was increased by Congress, passing several significant stimulus measures, including the first-time homebuyer credit. This noticeably increased demand in 2009. Actions by The Fed lowered interest rates, as well, which further increased demand.
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-What Causes Supply and Demand for Real Estate to Change?
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Changes in real estate demand can be caused by real or expected changes in population, income, availability of mortgage credit, personal lifestyles, or governmental actions. Recall the discussion, above, and in prior chapters about the impacts of governmental actions and economic change. Long-run changes in supply result from changes in the rate or cost of construction, conversion to another use, or demolition, and from how governmental actions impact these three alternatives. The cause of a change can vary for each type of real estate market and location. The reasons for a change can vary for each type of real estate are often different from the reasons for changes in commercial, industrial, or rural real estate markets. Where does cost enter into this? For demand, the cost to build it is not a direct factor. It would cost a lot of money to build a modern computer chip manufacturing facility in the middle of the Sahara Desert, in Africa. But that high cost would not change the reality that there is no demand at that location for such a plant, at any price. Cost could be a demand factor, if the choice to meet demand was to either purchase an existing home, or buy a lot and build a new one. Everything else being equal, and if time to build the new home is not an issue, the price for the existing house is likely to be less than the total cost for the new one. This assumes that the new one is more desirable, because the materials, colors, layout, and appliances can exactly match the buyer’s preferences! And cost of a new home wouldn’t be relevant if the buyer wanted to buy an older or historical building. The supply curve can be closely tied to the cost to supply the product. In an older neighborhood with no vacant lots, there is little connection between the supply of homes and the cost to build a new home. In areas with available vacant lots, there is a close connection. Sometimes, producers end up selling below their costs, they make a larger profit than expected. Over time they have to cover all of their costs, including a reasonable profit, or they will go broke. In the short run, real estate supply has no close connection to cost at all: What is for sale simply is there. At all times and all locations, cost doesn’t determine price or value. One can see a mansion, listed for sale but in escrow, that seems absolutely perfect to a buyer. Since it’s no longer on the market for sale, why not find a lot, and have the same builder build another? The next town over is closer to work, so the next step is to buy a lot there. The best lot is rather small, but will do. When completed, can it be sold, or appraised, to cover its costs (assuming that markets have stayed stable during this time period)? Not necessarily! For this town, the mansion may be too big, the school district not as favorable, or the neighboring houses not attractive enough for mansion buyer. The best house in an area almost always is penalized in this way, because it is not in balance with its surroundings. On the other hand, the worst house in an area usually will sell at a good price relative to its costs.
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-Foreign Ownership of U.S. Real Estate
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Foreign investors form part of the demand for U.S. real estate. Investors, agents, lenders, and appraisers need to recognize this impact on demand, and when it changes. In the 1980s, major segments of real estate gradually shifted, from being controlled by local developers, investors, lenders, and agents, to a global business, with many foreign investors playing a key role. Foreign investors initially acquired fully leased commercial properties with a triple “A” tenants, at excellent locations in major U.S. cities. By the mid-1980s, foreign investors were perceived to be overpaying for the properties, and driving up prices in the local real estate market. Some foreign investors either purchased or founded U.S.-based real estate companies, to acquire and manage their properties. Later, foreign development companies created projects from the ground up, rather than depend on finding existing buildings for sale at reasonable prices. With the crash of commercial real estate market prices in the early to mid-1990s, many foreign investors took heavy losses on their U.S. real estate. Using the accuracy of hindsight, it appears that many U.S. real estate owners sold at the peak of the market to foreign buyers, getting out just before the crash. By the early 2000s, some foreign property owners had resold their buildings at a loss to U.S. interests. The rise in prices in the mid-2000s caused a mixed flow of overseas investment capital. The decline of prices in the late 2000s lead to an increase in overseas investors, seeking to buy at what was perceived to be a cyclical bottom in the real estate price cycle. This reflected the growing understanding of American real estate markets by foreign investors and their advisors and money managers. Foreign investment is heavily influenced by factors beside the prices of U.S. real estate. A second major influence is the exchange rate between the U.S. dollar and other currencies. When the dollar falls in value, relative to other currencies, then U.S. real estate looks less expensive and foreign investors tend to buy more. The exchange rate for the dollar doesn’t move the same for all other currencies. Some go up; others go down. This means that buyers will come from varying countries, depending on changes in the exchange rate for each currency. A third major influence arises from the political, social, or economic issues in each country. Ex. Around the time when the British turned over control of Hong Kong to China in 1997, some well-to-do Hong Kong investors purchased U.S. and Canadian real estate, to diversify their investment, out of concern for future Chinese action. In the 2000s, well-to-do Russians became major buyers of high-end New York and Miami condominiums. In the San Francisco Bay area and Seattle, Asian buyers have become more numerous. This factor or motivation has existed for centuries. It just varies, from decade to decade, depending where there is money, combined with some instability. The entire issue of foreign ownership of U.S. businesses and real estate has had emotions running high. No matter where a person stands on the issue of foreign ownership, it should be pointed out that U.S. citizens have been buying assets of other countries for many decades. Americans supported free trade when they were buying into foreign countries; when the reverse became true, some U.S. citizens lobbied for restrictions!
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Advantages of Foreign Ownership
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1. Generates income for U.S. real estate owners who sell. This income is reinvested, which stimulates the economy and leads to additional employment. 2. Provides tax revenue to the government from the profits on the sale. This helps cover some of the budget deficit, without raising income tax rates or cutting government spending programs. 3. Generates commissions and fees for the real estate industry. 4. Increases the number of prospective buyers, which strengthens demand and helps to maintain or improve prices.
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Disadvantages of Foreign Ownership
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1. Makes the United States less self-sufficient and more dependent on foreign investment. It constitutes a “selling of America.” 2. Gives the U.S. government less incentive to solve the budget deficit problem, by providing a short-run “quick fix” using foreign capital, instead of reducing government spending or raising taxes. 3. High prices paid by foreign investors replace local investors in the real estate market.
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-Why Have Real Estate Professionals
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What is the real estate professional’s role? In perfectly competitive market, there is no need for the services of a real estate professional or any other third party. Buyers and sellers are considered to be fully knowledgeable, and are able to handle transactions themselves. Because the real estate market is imperfect, the real estate professional’s role is to help buyers, sellers, landlords, tenants, lenders, and others overcome these market imperfections. Many people are involved in real estate transactions. This includes obvious examples, like real estate brokers and agents, escrow agents, and title insurance companies or title researchers. Lenders are also involved, including loan brokers or loan bankers, underwriters, and appraisers. Now, there also are secondary market investors, and people to bundle mortgages into securities. There are wood-destroying organism inspectors, roof inspectors, building inspectors, and septic system inspectors. Property managers are active with properties that were purchased as investments. Working behind the scenes are people who post and remove the “For Sale” signs, those who take pictures of the property for the Multiple Listing Service (MLS), and the people who handle the advertisements, print the brochures, and run the MLS. Some consult on “staging” a property, so that is shows well. And behind it all are the numbers of invisible but indispensable support people. Real estate professionals fill gaps in market knowledge, by providing the following services: 1. Improve a property’s exposure to buyers, by marketing, including MLS listing, advertisements, flyers, brochures, and open houses. 2. Improve buyer’s awareness of alternative properties, by use of the MLS, property tours,a dn research. 3. Increase buyer and seller knowledge by: a. Providing current market information regarding selling prices, rents, and market trends. b. Advising clients and customers on investment opportunities, property characteristics, and market issues. c. Providing information on sources and alternative methods of financing. d. Helping the parties to negotiate an agreement, and close the real estate transaction. 4. Increase the number of market participants, by persuading owners to offer their property for sale, and by encouraging people to overcome concern and acquire real estate. These efforts can increase the number of buyers and sellers, and help to reduce one of the major imperfections of a real estate market: too few participants.
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-Impact of the Internet
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The internet is a means of communicating information. It improves the ability of markets to change, as supply and demand change. As more data becomes available on the Internet, the traditional role of all real estate professionals is being changed. With a few clicks on a search engine, consumers can find nearly all properties that are currently offered for sale, estimate market prices and find sites that tell you step by step how to buy, finance, or sell a home. A good example is Zillow.com, a leading online real estate marketplace to find and share vital information about homes and mortgages. When you view their Web page, notice the tabs at the top of the page, and all of the information sources that are immediately available. As more and more consumers utilize the Internet, many of the information functions of the real estate professional outlined above will fade away. Because market conditions change, Web sites often lack good information on the most recent price trends, and the currently used local listing and buying strategies. In turn, Web sites offer agents, appraisers, lenders, etc., new way to reach out to customers. The primary role of all real estate professionals is evolving. Buyers and seller will be more knowledgeable than is the past, but often will still need real estate professionals for advice on current trends and issues at that particular location and on listing or buying alternatives, for transaction negotiations, and to handle the time-consuming follow-up, needed to close a real estate transaction. All of the major economic impacts of the Internet has been to reduce the role of the so-called “middleman.” Use of the Internet has noticeably reduced the needed number of travel agents, stock brokers, insurance agents, mortgage brokers, and so on. Consumers can log on and then buy direct, cutting out the middleperson. Real estate, as emphasized earlier, is an unusually complex product to buy or sell. Only the future will show what impact the Internet will have on the needed number of real estate appraisers and agents, and on real estate practice.
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*Analyzing Demand and Supply Using Graphs
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According to economic theory, prices, and output in perfect markets are established by the smooth interaction of demand and supply. To show this visually, economists use lines on graphs. For theory purposes, straight lines are commonly used. In the real world, demand and supply lines are usually curved, which is why they are referred to as “curves.”
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Demand
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The quantity that buyers are willing to buy, at a given time and location, at certain prices. A downward slope of the demand curve to the right reflects the law of demand. *The law of demand states that the lower the price, the more consumers will buy; the higher the price, the less they will buy. The price is always shown on the vertical axis or side of the graph. The quantity is shown on the horizontal axis or bottom side. By tradition, where the vertical and horizontal sides meet is always either zero, or else it’s the lowest number on that line. Thus, any point on the demand curve has a matching price, and a matching quantity. We analyze a graph by selecting a price on the vertical line,”Price.” Next, from that price, we go across level, until we hit the demand curve. From where we hit, we look straight down to the bottom line, “Quantity.” Now, we know the quantity that will be demanded at that price. The graph can also be read in the other direction. If we are planning to build 200 condominium units, we would find “200” on the bottom “Quantity” line. From there, we would go straight up until we hit the demand curve. Next, we would look straight left, to see what price we need to have, in order to sell all 200 units in a reasonable time. Almost never is there adequate data to do this in the real world! As you move along the demand curve from point X to point Y, the price declines, from Px to Py. But the quantity increases, from Qx to Qy. At lower prices, the quantity that existing buyers are willing to purchase increases, just as the law of demand states. If you move back on the curve, from point Y to X, prices will increase, from Py to Px, and quantity will decline from Qy to Qx. A change in price doesn’t move or shift the demand curve right or left. *Instead, a change in price results in movements up or down, along the existing demand curve.
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Supply
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The total quantity that sellers are willing to sell at a given time at certain prices. The upward slope of the supply curve to the right reflects the law of supply. The law states that sellers or producers will offer more goods and services for sale as prices increase, and fewer as prices decrease. As you move from point A to B, prices increases for Pa to Pb. Quantity increase from Qa to Qb. As the prices increase, the existing suppliers, motivated by profits, will increase their output. If you move back from Pb to Pa, the decline in price will cause suppliers to cut back in quantity from Qb to Qa.
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Equilibrium
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Where the demand and supply curves intersect is where buyers and sellers agree on price in the marketplace. This intersecting point is called the equilibrium point. At any higher price, some buyers choose not to purchase, thereby creating a surplus. Sellers will then gradually mark down the price to the equilibrium point, in order to sell the surplus. At any price lower than the equilibrium point, sellers will not supply enough goods and services, because profit is too low. Only at the equilibrium price will demand and supply be balanced, and the market cleared. This term means that all of the goods or services for sale at that time are sold.
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-Why Use Demand and Supply Graphs?
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The advantage of using demand and supply graphs is to help understand what may happen with an economic change.
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Short-Run Impact
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A fundamental principle of real estate economics is the recognition that the total amount of land is fixed. The land surface can’t be increased or decreased, according to the whims of demand. The intensity of land use can change. This will increase or decrease the supply of real estate units. Any change in the intensity of land use take time. If the demand for residential or other real estate was suddenly to increase, a small increase in demand probably could be handled with the existing supply of buildings. But a big increase in demand essentially would face a fixed supply. To expand supply, developers would need considerable time to acquire land and obtain permits and financing. A down-sloping real estate demand curve, with a short-run fixed supply curve, intersecting at equilibrium. If the supply of real estate is relatively fixed in the short run, and change in current market prices and rents will be heavily influenced by local changes in demand for that type of real estate. When the demand goes up, and the demand curve shifts right, prices and rents must rise, as buyers and renters attempt to outbid one another for the fixed supply. Short-run increase can’t immediately increase the supply of real estate. The price and/or rent levels of the existing real estate increase from P1 to P2. When the demand goes down, and the demand curve moves or shifts to the left, prices and rents decline, because the decrease in demand creates some vacancies, and owners and landlords attempt to fill these vacancies by lowering prices and rents. A decrease in demand decreases prices or rents, but this short-run decrease can’t immediately decrease the supply of real estate. The price and/or rent levels of the existing supply decrease from P1 to P2.
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Long-Run Impact
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Once financing and building permits are obtained and construction is completed, the supply of real estate units offered for sale or rent can be increased. When this occurs, the supply curve for real estate will change, by shifting to the right. This will then create a new equilibrium for prices/rents and quantity. If the new increase in supply matches existing demand, prices and rents should remain stable. If the new construction exceeds demand, overbuilding will have occurred and prices and rents should decline as owners attempt to reduce the excess supply.

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