The Welcome Mat Is NOT Out: Why Housing Costs So Much

There's a mystery in the rise of urban housing prices. Since the 1970s the cost of housing has risen much faster than economics can explain. That is, we assume that the cost of a new house equals the price of land and construction plus builder's profit. But in the past three decades or so, it's clear that there's a fourth element that's pushing up housing costs. What could it be? You guessed it, it's the government.

First, a short course in economics. Prices rise for all kinds of reasons, from sudden scarcities in raw materials to bizarre fads (think Beanie Babies). But over time, competition moderates these swings. How? Because if something surges in price, others will rush in to supply it — and reap the high profits, at least temporarily. This economic model works in everything from laptop computers to blue jeans. Prices go up, suppliers come in, prices go down.

Everything, that is, but urban housing. As a recent paper by three economists, Edward L. Glaeser and Raven E. Saks of Harvard and Joseph Gyourko of the University of Pennsylvania, explained, housing used to follow the normal economic model. "Even in the most expensive metropolitan areas," they wrote, "(the cost of the) structure appears to have represented almost all of the cost of housing in 1970 and earlier years." But by 2000, they continued, "there were 27 metropolitan areas in which structure (costs) could account for no more than 60 percent of total house value." Something new was pushing up the cost of housing — something that the usual economic counterweight (more builders rushing in to take advantage of high prices) could not overcome. 

Was it a spike in construction costs? No, building costs have declined slightly over the period. A surge in population in some cities? Well, that could temporarily run up housing prices, but fast-growing cities attract builders, so supply and demand should catch up at some point. Here's a clue: We're not building nearly as many new houses as we were in the past. In the 1950s, 40 percent of houses in large metro areas were 10 years old or newer. By 2000, only 14 percent were — and in high-cost places like New York, San Francisco and Los Angeles the percentage was much lower. 

So what's the answer? Government restrictions on new construction. Simply put, cities aren't granting as many building permits or making as many zoning changes as the housing market demands. Why? The authors look at various explanations (restrictive court rulings, changes in housing quality, perhaps even a decline in builders' ability to bribe local officials) but the one that seems most plausible: Neighborhood associations are demanding that governments restrict new housing. And why would they do that? The authors don't speculate, but it could be as simple as a desire by existing homeowners to make sure their housing values keep rising. 

Whatever the reason, the paper is an important insight into urban sprawl. Sprawl isn't the work merely of grasping suburbs. Cities, too, have had a hand in pushing people outward by not permitting enough housing construction to keep prices affordable. Posted 9/1/2005

Postscript: Since we wrote this, research on restrictive local policies and housing costs has grown deeper and even more persuasive and is now becoming part of the urban affordability debate.