House Price Mosaic: Demand Elasticity in the Market Essay (Article Review)

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In microeconomics, the concepts of price or demand elasticity refer to the sensitivity of buyers to price changes. When small variations in price bring about relatively large variations in buyer reaction, the price elasticity is high. The situation is reversed for low elasticity. Since various customers react differently to price changes, knowledge of demand elasticities helps to set prices. But the major problem is that detailed data are not available.

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Yet, several techniques can be used to approximate elasticities, including market tests, statistical techniques of historical or cross-sectional analysis, and surveys. Management need not determine precise elasticities; rather it needs reliable estimates and guides as to the break-even levels and likely profitability of price changes. The article “House Price Mosaic” discusses and analyses the problem of home prices and demand elasticity in this sector.

In order to analyze the article, the price elasticity concept will be explained. Following Pindyck and Rubinfeld (2000) there are two basic ways of measuring elasticities – cross-cut analysis and historical data. Cross-cut analysis pertains to a point in time.

Examples are interviewing buyers, using panels, simulating price situations, and conducting pricing experiments. The problems of statistical interpretation are many, however. Historical data are analyzed by time-series analyses that portray the association between prices and sales over time; this method is widely used in estimating elasticities. Regression and correlation analysis are its major tools, and the analysis ignores factors other than price that affect demand (Schiller, 2004).

The article shows that it is difficult to predict price changes in the home market because of diverse economic factors and causes of price decline. The article states that: “This is about 55% off the previous sales price and even more of the apparent appraised value when the homeowner refinanced” (House Price Mosaic 2008). Pricing strategies depend on a point in time. Are markets rising or falling? What are competitors’ reactions? What is happening to costs? Strategies can be adopted that tend to discourage or invite competitors, that relate to the payout in research and development, or that generate images of qualities or bargains.

Industries can decide to have high, low, or competitive prices. They can be price followers or leaders and can use several bases for price variations: geographical price discrimination (single and multiple basing points, f.o.b. factory, freight allowance, and equalization, and zone pricing), discounts and allowances (quantity, seasonal, cash, trade, and promotional discounts), channel and service discounts, guarantees against price declines, and firm prices over time (Pindyck and Rubinfeld 2000).

The article underlines that it is difficult to analyze the current situation on the market because of price differences and geographical diversity. “Foreclosures are ripping through the rows of new homes in the flatlands where Denver turns to prairie. Every week, 10 more families here need to find someplace else to live” (House Price Mosaic 2008). Regardless, pricing strategies must be reviewed and realistically overhauled, for they tend to become “baked in” and to reflect traditional approaches, especially in retailing. In the case of the home market, prices are set mechanistically by following formulas or rules.

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This procedure, although easy to follow, does not lead to “good pricing.” Yet the most common technique of pricing is a mechanistic one — cost-plus pricing, the addition of a margin to a cost base (Schiller, 2004). Prices are often built up from an estimate of average cost and are not necessarily related to market opportunity. Total unit costs are determined and a percentage markup is added that ignores cost-price sales relationships and market factors. In reality, however, pricing is not so rigidly determined, and market factors force modification of prices specified by formula. Often, variations of this average-cost method are used in which different markups are added to various products, based on what each product can bear in the marketplace. New-product pricing presents different problems from those of pricing mature products.

New products place the manufacturer more or less in a monopoly position, but one that will erode. They also create situations in which price reactions are largely guesswork. Two general pricing strategies are used here — skimming or penetration pricing. (Pindyck and Rubinfeld 2000). It encourages new competitors to enter the market because of attractive margins. The author of the article suggests that: ‘Over time the equilibrium between different price ranges will return, but the price dynamics will be different.

Areas with a large number of REOs have seen much faster price declines – and are probably closer to the price bottom. Areas with fewer REOs will exhibit “sticky prices” and the prices will probably decline for some time” (House Price Mosaic 2008). The following graph shows that prices decreased about 24% from the peak in 2005, but the Oceanside REO reached 55%.

San Diego, Case-Shiller home price index

Governmental involvement seems to relate price increases to the impact on inflation and increased productivity. Such actions as withholding governmental orders or dumping metals from stockpiles back up such informal price control. Government has the influence to block or roll back price increases. Price differentials are subject to government scrutiny and regulation. They are established on the basis of quantity, distribution level, geographic area, and cash payment.

Distribution discounts may be instituted on a net or list basis according to distribution levels. Quantity discounts may be cumulative or noncumulative and may apply to part of a line or a whole line. Basing points, f.o.b. factory, and uniform delivered pricing are examples of geographic differentials (Schiller, 2004).

Discounts for cash are very common. Legally, price discrimination can be defended based on meeting competition in good faith, of cost savings in dealing with different customers, and promoting and not injuring competition (Schiller, 2004). It is the effect of price discrimination, and not the act itself, that determines legality. Although these legal constraints are significant in establishing price differentials, the practical guidelines are confusing and the economic consequences are mixed since price discrimination can actually benefit society (Pindyck and Rubinfeld 2000).

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In sum, the article shows that price and demand should consider both cost and demand conditions, and the dynamics of markets, thereby accounting for both internal and external variables. The current situation on the home market is unstable marked by increased prices and decreased supply. Although the determination of an optimal price is usually impossible, a satisfactory one can be developed by analysis.

The major pricing decisions include determining prices for each product or service, discount structures, price relationships among product lines, and price maintenance levels. Problems encountered in establishing prices relate to the inability to determine costs precisely, the difficulties of dealing with expectations, and the variations in the impact of policies on different products in a company’s product line. Marketing intelligence is a critical component of effective price determination.

Bayesian analysis and the use of calculus to arrive at an optimal or best price are illustrated. Various economic models and concepts such as the marginal approach, elasticity of demand, simulations, and other mathematical techniques that have proven useful in establishing prices are noted. Two alternative strategies for pricing new products, penetration and skimming, and the conditions under which each would be used, are examined. The importance of price as a marketing factor varies with kinds of products and market situations. Sometimes nonprice factors become more significant than price ingredients. Pricing programs of firms, even within the same industry, vary greatly.

References

  1. . (2008). Web.
  2. Pindyck, R. S. Rubinfeld, D. L. (2000). Microeconomics. Prentice Hall; 5th edition.
  3. Schiller, B. R. (2004). Essentials of Economics. 6th edition. McGraw-Hill/Irwin; 5 edition.

Article

House Price Mosaic

by CalculatedRisk

Last night I posted a video from Jim the Realtor showing an area of Oceanside, CA with numerous REOs. Jim has an REO listing in the area and he sent me the details.

260 Securidad, Oceanside, California

2 Bedroom 1 Bath, 820 sq ft

The house sold for $318,000 in July 2004, and the owner refinanced a year later for a total of $375,000 in loans.

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The house is now listed (REO) at $127,900, and there are several bidders (investors and owner-occupant buyers) and Jim believes the property will sell for between $140,000 and $150,000. Note: the house is in good condition (for what it is) and appears to be move-in ready.

This is about 55% off the previous sales price and even more of the apparent appraised value when the homeowner refinanced.

This brings up a key point: house price changes vary widely by area, not just by state, but even within cities.

***********

San Diego, Case-Shiller home price index

This graph shows the Case-Shiller Home Price Index for San Diego. Prices are off by about 24% from the peak in 2005 according to the Case-Shiller index, but the Oceanside REO is off by about 55%.

Obviously areas with numerous foreclosures have seen larger price declines than areas with fewer foreclosures.

The following map of Denver, from an article by Luke Mullins at U.S. News and World Report, illustrates this point. Some areas of Denver are being devastated by foreclosures, others are mostly untouched.

Map of Denver

From the USA Today: Mortgage defaults force Denver exodus

Foreclosures are ripping through the rows of new homes in the flatlands where Denver turns to the prairie. Every week, 10 more families here need to find someplace else to live.

On some blocks, as many as one-third of the residents have lost their homes, making this one of the worst hotspots in a city that was among the first to feel the pinch of the foreclosure crisis. Many houses here remain empty, bank lockboxes on the front doors.

But prices in the areas untouched by foreclosures are actually flat, or in some cases have even increased slightly.

What does this mean for future prices? First, some areas are probably close to a price bottom. Looking back at the REO in Oceanside, we can see that this property is now attractive to investors. According to Jim, this property will rent for between $1000 to $1200 per month. Here is a simple cap rate calculation:

Cost: $140,000

Rent: $12,000 to $14,400 per year

Expenses:

Taxes (1% in California): $1,400 (note: no Mello Roos or HOA fees)

Vacancy: 5% or $600 to $720 depending on rent.

Maintenance and Insurance: $1,400 per year.

This yields a cap rate of between 6.1% and 7.8% depending on the rent. Investors provide a floor for house prices, and these are attractive cap rates for some small investors.

But what about prices for areas with fewer foreclosures? These prices are still sticky, but will continue to decline. From Peter Hong at the LA Times yesterday: At the luxury end, home prices are falling

“You can’t have one market hugely cheaper than another forever,” said UC Berkeley professor Thomas Davidoff, who specializes in real estate.

Davidoff and others say the time lag stems from the fact that affluent homeowners generally don’t have to sell under duress, unlike struggling borrowers facing escalating mortgage payments. But wealthy homeowners are increasingly finding out that if they want to sell their homes, they will need to discount the prices.

Housing market

In the end, the housing market is linked as shown by this graphic.

Not all chain reactions start with a first-time buyer using a subprime loan, but the loss of a large number of first-time buyers will eventually impact the entire chain.

Over time the equilibrium between different price ranges will return, but the price dynamics will be different. Areas with a large number of REOs have seen much faster price declines – and are probably closer to the price bottom. Areas with fewer REOs will exhibit “sticky prices” and the prices will probably decline for some time.

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IvyPanda. (2022, July 26). House Price Mosaic: Demand Elasticity in the Market. https://ivypanda.com/essays/house-price-mosaic-article-analysis/

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"House Price Mosaic: Demand Elasticity in the Market." IvyPanda, 26 July 2022, ivypanda.com/essays/house-price-mosaic-article-analysis/.

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IvyPanda. (2022) 'House Price Mosaic: Demand Elasticity in the Market'. 26 July.

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IvyPanda. 2022. "House Price Mosaic: Demand Elasticity in the Market." July 26, 2022. https://ivypanda.com/essays/house-price-mosaic-article-analysis/.

1. IvyPanda. "House Price Mosaic: Demand Elasticity in the Market." July 26, 2022. https://ivypanda.com/essays/house-price-mosaic-article-analysis/.


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