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By Ravinder Kumar, UG Student, IIT Kharagpur
Introduction
Housing is a big part of people’s lives and a big part of an urban area, but it is also unique among
consumer goods in other respects. Housing is potentially very durable. A useful life for a house
routinely is 70 years, and many last far longer than that. With careful maintenance and periodic
modernization, a well-built house can last indefinitely. But misuse and lack of maintenance can also
shorten the life of a house. The high degree of durability means that the market for housing is
dominated by existing housing units. New construction adds, at most, about 2% to the nation’s
existing stock of housing in a year, although the housing stock grows more rapidly in urban areas
with high growth rates.
Housing is also immovable. When one selects a particular housing unit, a choice of residential
location has been made as well. The neighbourhood surrounding the house contains neighbours,
schools, and many other things that people care about. The analysis of the market for housing in an
urban area cannot be divorced from neighbourhood factors. Also, houses and apartment are very
complicated commodities that contain numerous features that have value for the consumer. The
housing market is a market that is characterized by complicated, highly durable units, each of which
is located in a neighbourhood with many attributes. This statement makes it sound as if each
housing unit is unique, and there is considerable truth in that thought. However, it is also true that
the housing market functions. Every day houses and apartment buildings are bought and sold, and
housing units are rented. Rest of the report examines how the actors in the housing market simplify
things so that transactions can be made on a routine basis? In this report I have tried to understand
the working of housing market in urban areas. First two sections explain the hedonic housing model
and then a professional approach to calculate the value of a housing unit is discussed. Next section
discusses the theory of housing demand which is followed by a list of variables which generally affect
the housing prices. The filtering model of the housing market is presented in next section and after
that the problem of affordable housing and gentrification, and the housing in developing countries is
discussed in ending sections.
What is Housing?
Any study of housing begins with the definition of what housing is. The literature is organized around
two definitions. At one end of the spectrum, Richard Muth (1969) defined housing as a bundle of
services that is produced by stocks of housing capital and land, and defined the price of housing as
the expenditure needed to purchase a standardized quantity of those services. In effect, Muth
collapsed housing to a uni-dimensional service. At the other end of this spectrum is the idea from
Lancaster (1966) and Rosen (1974) that housing is fundamentally a multidimensional product.
Households value goods according to their characteristics, and market demands and supplies of
characteristics determine the particular bundles bought and sold at any given place and time. These
two somewhat opposing models might be called the House of Lancaster/Rosen and the House of
Muth. The House of Muth has many uses, and is the basis for conventional studies of the income and
price elasticities of demand for housing as well as studies of supply elasticity, population density
patterns, and patterns of land-use intensity. The house of Lancaster/Rosen has led to literally
hundreds of statistical studies of house values and a revolution in the methods used by real estate
appraisers and tax assessors. Let us further consider the House of Lancaster/Rosen.
An appraiser of residential property has data on hundreds of sales. This database can be used to
estimate a statistical model of house prices. He knows the attributes, locations, and selling prices of
many properties. He might also have data on the important features of the neighbourhood in which
each house is located. All of this information can then be used to estimate an equation that can be
used to predict the price of a subject house.
The statistical model of house prices estimated using such a database is called a hedonic model, a
term derived from the word hedonism, which is the idea that one should pursue pleasure. The idea
is that a house consists of numerous components that add to one’s pleasure, and that each of these
components has a price. The market price of the house is the sum of the market prices of its
components. Consider a very simple model of house value in which the components are the size of
the house (interior square feet), the size of the lot (exterior square feet), and the proximity to
employment. The market value of houses (V) can be specified as a linear equation
V = a
0
+ a
1
F + a
2
L + a
3
x + e,
where F is the number of square feet of interior space, L the number of square feet of exterior
space, x the distance to employment, and e is a random error term. The coefficient a
1
is the market
value of an additional square foot of interior space, a
2
the market value of a square foot of exterior
space, and a
3
the reduction in value that is associated with greater distance from employment. The
random error term reflects the fact that the three variables do not completely account for variations
in the value of houses. Each house in the database has its own individual error term, which is a
collection of other influences on value that are not included in the equation.
We can use the multiple regression to estimate the foregoing linear model of house prices. If we
want to appraise a house with 1500 square feet of interior space on a lot that is 50 by 100 feet and
located five miles from the work place, we can estimate its market value V* as
V* = a
0
+ a
1
(1500) + a
2
(5000) + a
3
(5)
Appraisers are not permitted to perform appraisals in this manner. They must follow a procedure
called sales comparison approach. However, hedonic models are useful tools for appraiser because
they indicate the market value of particular attributes. For example, suppose that the subject
property and the comparable properties used for appraisal purposes differ in the amount of interior
space they provide. The estimated coefficient a
1
tells you the magnitude of the adjustment to the
price of the comparable property that is needed in the standard appraisal. Another use of hedonic
models is for property tax assessment. The task of the municipal tax assessor is to determine an
assessed value for every house in the municipality. Many assessors estimate a hedonic model based
on a sample of houses and then use it to “predict” the market value of all the houses in the
municipality. Assessed value is then based on this predicted market value.
Scores of hedonic studies of house prices have been published in academic and professional
journals. All of them include a fairly standard list of variables. Most hedonic studies of house prices
use an exponential function rather than a linear function of the form
V = exp(a
0
+ a
1
F + ... + a
n
X + e),
where exp(...) means that the base of the natural logarithm is taken to the power shown in
parentheses. The natural log of the price is then the dependent variable in a linear hedonic model of
the form
ln V = a
0
+ a
1
F + ... + a
n
X + e
This log-linear equation usually fits the data better than does the conventional linear equation in
which V is the dependent variable. The coefficients in the log-linear model (a
1
to a
n
) indicate the
percentage change in V associated with a change in the independent variable.
The Hedonic Housing Model
As mentioned in the previous section, the hedonic model is used to recover the implicit price of a
multi-faceted good. How much does an additional bedroom add to the sales price of a house? Do
higher average student test scores increase the value of homes within the school district? Do higher
crime rates reduce house prices? This section describes briefly how the economics of housing
market is explained by the Hedonic Model.
In the hedonic model of housing, households are assumed to receive utility from each of the many
characteristics that comprise a house. Housing producers attempt to build homes that reflect the
tastes of consumers. It is costly to add square footage, another room, or more elaborated design
components to a house. The basic insight of the hedonic model is that the marginal price of a
characteristic – the additional charge for one more unit – can be estimated by regressing the sales
price of a home on its characteristics. In equilibrium, the marginal price is equal to the household’s
marginal willingness to pay for an additional unit. The marginal price is also equal to the marginal
cost of the good on the part of producers.
Although the theoretical model appears quite complicated, it can be simplified by focusing on the
choice of a single housing characteristic. A home includes basic characteristics of the structure, e.g.,
square footage, the number of stories, room size, and so on. It also includes characteristics of the
location, such as school quality and crime rates. Holding all these factors constant, let us focus on
the choice of the quality of the design, which we assume can be simplified down to a single measure.
Homes can be built with expensive hardwood floors, marble countertops, and outdoor landscaping,
all of which add to the amount of the composite good “housing” as well as the price. For simplicity,
we will treat all of these components together as though they are a single good called “design
quality.”
Figure 1 shows the household’s bid function for this good. It shows the maximum amount that a
household will pay for the level of design quality indicated on the horizontal axis, holding other
factors constant. This maximum bid increases at a decreasing rate with the quality of the design.
Initial amounts – a better kitchen design, some grass in the yard – add a lot to the amount
households will pay for the house. But eventually this levels off as we move into the “luxury” range.
The position of the bid curve for an individual housing characteristic depends on the level of utility
received by the households. Higher levels of utility are associated with higher design quality and
lower house prices. Two bid curves are shown in Figure 1, representing “high” and “low” levels of
utility. As indicated by the arrow, utility rises as we move toward lower bid curves.

Figure 1 Figure 2 Figure 3
A high-quality design comes at a cost. Producers will be willing to install luxurious design
components, but only if they are compensated for the installation cost. Figure 2 show the offer
curves for a representative producer. The offer curve shows combinations of house price and design
quality that lead to the same level of profit for the producer. The offer curves are assumed to
increase at an increasing rate with the level of design quality because additional increments to
quality become more and more expensive to add to a home. Producers find it less costly to build
homes with lower quality, and they earn higher profit when houses prices are high. Thus, as
indicated by the arrow in Figure 2, higher profit levels are associated with higher offer curves.
Figure 3 shows an equilibrium combination of bid and offer curves. Given the level of the bid curves,
producers have reached the highest offer curve – the highest level of profit – that they can attain.
Similarly, households have reached the highest level of utility they can attain given the location of
the offer curve. Of course, there are many other combinations of bid and offer curves that also are
consistent with equilibrium in the housing market. But all equilibrium combinations will end up with
the bid curve for households being tangent to the offer curve for firms.
If Figure 3 were the full story, the hedonic housing model would not be particularly useful or
interesting. The hedonic model becomes interesting once we recognize that households differ in
their tastes for housing characteristics and that producers may differ in their cost structure. Figure 4
presents two different types of households. To understand this diagram, start from point A, the
intersection of the two curves. The households represented by the dotted line will pay more for an
additional unit of design quality than households represented by the solid line. Similarly, the bids
drop off more sharply for dotted-line households when design quality is reduced below Q
1
. The
households represented by the dotted bid curve clearly value design quality more than the solid-line
households. In general, steeper bid curves imply that households value the housing characteristic
more highly in the sense that they will pay more for an additional increment of the good.
Figure 5 shows the offer curves for two firms that differ in their cost structures. Again if we start
from the point labelled A, the firm represented by the solid line requires more compensation for
increasing the design quality beyond Q
1
, where the additional compensation comes in the form of a
higher house price. Similarly, if the firm represented by the solid line were to reduce design quality
below Q
1
, it would have reduced the housing price and still come out with the same level of profit.
Thus, the firm represented by the solid line is the high-cost producer: it requires a greater addition
to the price of housing to compensate it for having to add more design quality.

Figure 4 Figure 5 Figure 6
Now if we match our high and low cost producers to the high and low demand households, we
would expect households who place a high value on design quality to seek out housing producers
who are able to provide that level of design quality relatively inexpensively. And firms that find it
costly to produce high levels of design quality will offer discounts for lower quality levels that attract
low-demand households. This outcome is exactly what is predicted by the model. Figure 6
represents an equilibrium outcome. The two dotted lines – high-demand households and low-cost
firms – are matched in equilibrium with a high level of design quality. The two solid lines – low-
demand households and high-cost firms – are in a match with low design quality. High design quality
comes at a price: high-demand prices pay P
2
for Q
2
units. But the price paid by each household is
significantly lower than what they would have to pay to get the same level of design quality from the
other type of producer. This matching process is an important prediction of the hedonic model.
We can extend Figure 6 to include a wide variety of household and producer types. The set of
tangencies between bid and offer curves forms a set of equilibrium price-quantity combinations. The
curve that connects these tangencies is called the “hedonic price function.” Figure 7 shows a hedonic
price function that is consistent with the matching equilibrium of Figure 6. The hedonic function
shows that the price of housing rises with design quality. The slope of the hedonic price function is a
direct result of two main assumptions that
1) consumers are willing to pay more for high levels of design quality, and
2) producers find it costly to produce higher-quality houses.
An important feature of the hedonic price function shown in Figure 7 is that it is not linear. In this
case, the hedonic price function increases at a decreasing rate with the level of design quality. This
implies that it costs less per unit of design quality to have a high-quality home than a home with a
lower level of design quality. A nonlinear pricing structure is one of the predictions of hedonic
theory.
The matching process is important to keep in mind when interpreting the results of hedonic models.
At Q
1
, the slope of the hedonic price function is equal to the slope of the low-demand households’
bid function and the high-cost firms’ offer function. Thus, this marginal price represents the marginal
willingness to pay for another unit of design quality on the part of low-demand households. It also
represents the marginal cost of production for high-cost firms. It does not represent the marginal
willingness to pay on the part of high-demand households or the marginal cost to low-cost firms. To
see this, look at the slopes at Q
1
for the high-demand bid curve and the low-cost offer curves (the
dotted lines). At Q
1
, the marginal willingness to pay for another unit is higher for high-demand
households than it is for low-income households, and the marginal cost for low-cost firms is lower
than for high-cost firms. Thus, the marginal price implied by the hedonic price function is the right
measure of marginal willingness to pay and marginal cost only for those households and firms who
have chosen that quality level.

Figure 7 Figure 8
The matching process has important implications for cost-benefit analyses of housing policies.
Suppose the local government decides to adopt stringent building codes that effectively require a
minimum level of design quality. Coincidentally, suppose this minimum design quality is given by Q
2

in Figures 6 and 7. Armed with estimates of the hedonic price function, we may think that the value
of this high level of design quality is the difference between P
2
and P
1
for households who are living
in low-quality homes. After all, the hedonic price function implies that households are willing to pay
P
2
-P
1
to increase design quality from Q
1
to Q
2
. However, low-demand households are only willing to
pay P
3
for this increase in design quality. If they are forced to consume Q
2
units, they will have to pay
P
2
, and this higher price will leave them at a lower level of utility than they had before. In a
competitive hedonic market, this type of quality regulation will actually make low-demand
households worse off even though they end up living in higher-quality homes.
The housing characteristic which has been analyzed to this point, design quality, is representative of
any characteristic that is added to a house by producers. Other variables – school quality, crime,
access to employment opportunities – are part of the location and cannot be varied readily by the
producer. The hedonic model is simplified somewhat when the supply of the characteristic is fixed
because we need only consider the households’ bid functions. Considering the case of school quality,
housing producers do not directly choose the quality of the schools in a neighbourhood. But many
studies show that school quality is capitalized into house price because people will bid more for
homes in neighbourhoods with good schools.
To simplify the diagrams, assume that we have two types of households. The first household type
places a higher value on school quality than the second type. The bid functions for the two
households are shown in Figure 8. The trick to analyzing the shape of the equilibrium price function
is that the household type that bids more for a home is the one who buys it. Thus, homes in
neighbourhoods with low school quality, Q<Q
1
, are occupied by low-demand households –
households with a relatively low demand for school quality. Homes in neighbourhoods with Q>Q
1

are occupied by high-demand households. The hedonic price function is the upper envelope of the
two bid function, i.e., the bold line segments in Figure 8. At each point along this function, the
marginal price of housing is equal to the household’s marginal willingness to pay.
Appraisal of Residential Real Estate
This section describes briefly how the value of a house in the real estate market is determined. The
task of estimating the market value of a property is done by a professional appraisal. In this task, it is
assumed that the property is being sold by a “normal” seller to a “normal” buyer under “normal”
market conditions. The professional appraiser has extensive training and, if the appraisal is done
properly, makes use of procedures that are actually quite scientific. The appraisal process for a
residential property is very standardized; in fact the appraiser fills out a standard form that meets
the requirements of government agencies. The standard appraisal of a house is based primarily on a
sales comparison approach that is supplemented by two other methods, called the income
capitalization and the cost-less-depreciation methods.
The income capitalization method is similar to the method used for commercial properties, except
that a market rent for the house must be estimated from rental market data.
The cost-less-depreciation method begins with the cost of reproducing the structure today. Standard
sources on constructions costs are used to determine this cost, and then allowances are made for
the depreciation of the structure’s value. An estimate of the value of the land is added on.
But here the focus will be on the sales comparison approach because this is the method that all
parties to the transaction primarily rely upon.
The formal, professional appraisal process requires that three actual sales of comparable properties
be used. Detailed data on the subject property and the three “comparables” are gathered, and use
of the data is described below and in Table 1. The basic idea in appraisal is to adjust the actual selling
price of the comparable property as close as identical to the subject property as is possible. After the
price of the comparable property has been adjusted, the adjusted selling price is an estimate of the
market value of the subject property. The critical step is the selection of comparable properties so
that the adjustments to their selling prices do not have to be very large and, therefore, less subject
to error. In the example in Table 1 three comparables have been selected that are located close to
the house in question and are very nearly the same.
The sequence of adjustment to the selling prices that appraiser follow is shown in Table 1. The first
adjustment that must be considered is called “conditions of sale.” The sale of a comparable property
may not be a conventional arm’s length transaction. For example, transactions involving members of
the same family may not really be a fair market price. We should select only comparables that are
straightforward arm’s length sales. The next adjustment is made to account for the effect of any
special financing arrangements. For example, suppose that the seller loans some of the purchase
price to the buyer at an interest rate that is below the rate that prevails in the market. This sort of
concession will tend to boost the selling price of the house, so the effect on the price of financing
concession must be subtracted from the actual selling price, as is done for comparable #3. The idea
is to estimate the market value of the subject property under normal selling conditions. The third
possible adjustment is for the date of sale of the comparable property. If the comparable was sold
six months ago and it is known that prices are increasing over time, then the price must be adjusted
upward by a percentage to reflect the price increase. This prices adjustment should be based, if
possible, on data for the immediate neighbourhood of the comparable property. Price trends can be
quite different in different parts of the same urban area. At this point we have an estimate of the
price of the comparable property if it were to be sold today under normal selling conditions. If we
assume that prices are rising by 3% per year, then comparables #1 and #2 are adjusted upward by
3% and 1.5%, respectively.
Table 1. The Sales Comparison Approach to Appraisal
Comparable
Sales
Subject
Property
#1 #2 #3
Sale Price $125,000 $130,000 $140,000
Square Feet 1,500 1,600 1,600 1,500
Price per sq. ft. $83.33 $81.25 $87.50
Adjustments for
Conditions of sale none none
Financing concessions none none -1000(reduced
payment, yr 1)

Date of sale +3,750 (1 year
ago)
+1,950 (6
months ago)
none
Location none none none
Site/View none none none
Design none none none
Quality of construction none +5,000 (frame) none (brick) brick
Age +3125(10 years) +1,300 (5 years) none (3 years) 3 years
Condition none none none excellent
Rooms none none none 3BR
Bathrooms +1,500 (a bath) none none 1.5
Heating/cooling none none none Gas/AC
Garage/carport none none none garage
Porch, patio, pool none none none porch
Fireplaces +1,500 (none) none none one
Total Adjustment 9,875 125 -9,750
Indicated Value of Subject 134,875 130,125 130,250

The next task is to adjust the price of the comparable property to match the subject property. The
first adjustment that must be made is for location. If the comparable and subject properties are
located in the same immediate neighbourhood, no location adjustment is needed. However, if the
comparable property is located in a different neighbourhood, then a location adjustment should be
made. The location adjustment is made by finding two actual sales – one near the subject property
and one near the comparable property. The difference in their sales prices is computed in
percentage terms, and that percentage is used to adjust the price of the comparable property. One
should try for comparable properties that are all in the same neighbourhood as the subject property.
Now, the adjustment for the actual physical characteristics of the comparable and subject properties
is left. Table 1 lists the factors that are taken into account. Again, we should find comparables that
are very similar to the subject property on these features. An adjustment must be made if the
comparable and subject properties are not identical on a feature. For example, suppose that the
comparable is ten years older than the subject property. If it is known that houses in the market in
question decline in value as they age by 0.5% per year, then the price of the comparable must be
increased by 5% because it is the older property. We can have this knowledge through previous
comparisons of value that have been made. As another example, suppose that the subject property
does not have central air conditioning, but that the comparable property does have this feature.
From previous comparisons, an appraiser will know that central air conditioning adds about 12%
(say) to the value of houses of this type. This means that the sales price of the comparable must be
reduced by 12% to make it match the subject property. The adjustment in Table 1 include an
adjustment for a half Bath (comparable #1 does not have one), gross living area (comparables #2 and
#3 have 100 square feet more than the subject property), and a fireplace (comparable #1 does not
have one). The sum of all of the adjustment is computed, and indicated value of the subject property
is shown at the bottom of the table.
The final step in the sales comparison approach is to use the sample of three “indicated values” to
estimate the market value of the subject property. The usual approach is to compute the mean of
the three indicated values, which in Table 1 results in an estimated value of $131,750. However,
there are times when more weight might be put on one of the comparable properties. For example,
if the comparable property is the house directly across the street from the subject property, then
substantially more weight should be placed on this indicated value. However, an appraiser must not
put 100% of the weight on the comparable from across the street because that would men relying
on a sample of one. The vagaries of negotiating a sale price may have made this sale somewhat
unusual in a way that has not been measured. The other two comparables provide additional
information that should be used.
The Theory of Housing Demand
The basic theory of demand for housing is based on the theory of the consumer. Consumers make
choices based on their preferences and the budget constraints they face. In other words, consumers
maximize utility subject to the budget constraint. We assume that consumers have preferences for
housing and other goods. The budget constraint in housing demand is stated as
Y = g + Ph,
where Y is income for the time period in question, g is the amount spent on other goods, P is the
price of housing services, and h is the quantity of housing services consumed. The price of housing
services includes the cost of operating a unit of housing and the cost of the capital embodied in the
dwelling. Operating costs include both direct operating expenses such as fuel for heating as well as
maintenance and depreciation expenses. The cost of capital is the return to the land and the capital
that has been invested. The demand for housing is written
h = h(Y, P, X)
Here X represents various household characteristics that determine preferences for housing such as
age, household size, household composition, and so on. Studies of demand for a consumer good
concentrate on the income elasticity of demand and the price elasticity of demand. Income elasticity
of demand is the percentage change in quantity of housing divided by the percentage change in
income:
(∆h/h)/(∆Y/Y) = (∆h/∆Y)(Y/h), and
the price elasticity of demand is
(∆h/h)/(∆p/p) = (∆h/∆p)(p/h)
Studies of the demand for housing face two challenges.
1. As noted above, it is agreed that the relevant income concept for many households is
permanent income – not current income. Some renters adjust housing consumption (i.e.,
move) frequently, but most households make housing decisions that set consumption for
some years – and base those decisions on an income level that is assumed to apply for
several years. Studies of housing demand should therefore be based on a measure for
permanent income.
2. Neither the price of a unit of housing services nor the quantity of housing services consumed
is observable. Expenditures on housing, Ph, can be observed.
It turns out that the income elasticity of demand can be estimated using the available data on
housing expenditures and (permanent) income. The income elasticity of demand and the elasticity of
expenditures with respect to income are the same number. To see this, write housing expenditures
as:
Ph = Ph(Y, P, X), so
(∆Ph/∆Y) = P(∆h/∆Y)
Next, converting both sides into elasticities by multiplying by (Y/Ph), or
(∆Ph/h)/(Y/Ph) = P(∆h/∆Y)(Y/Ph)= (∆h/∆Y)(Y/h)
Empirical studies of income elasticity of demand generally show that this elasticity is less than 1;
expenditures increase less than proportionately with income. For example, a study by Green and
Malpezzi (2003) based on the 1993 American Housing Survey shows that households in the bottom
10% of the income distribution spent 50% of income on housing, households in the middle 20% of
the income distribution spent 23% of income on housing, and households in the top 10% of the
income distribution spent only 10% of income on housing.
A similar strategy can be used to study the price elasticity of demand for housing. It turns out that
the elasticity of housing expenditures with respect to a change in price equals 1 plus the price
elasticity of demand. To see this write the change in housing expenditures as the price of housing
changes:
∆(Ph)/∆P = ∆[Ph(Y, P, X)]/∆P = P(∆h/∆P) + h
This can be rewritten as
h[1 + (∆h/∆P)(P/h)] = h(1 + e),
where e is the price elasticity of demand. The elasticity of housing expenditures with respect to a
change in price (denoted E) is written
E = (∆Ph/∆P)(P/Ph) = h(1 + e)(P/Ph) = 1 + e
The price elasticity is e = E – 1. This result eliminates the need to measure the quantity of housing,
but an empirical study still needs a measure of the price of housing services in order to estimate E.
For example, some studies of renters use rent per square foot as the price of housing services. This
may not be a bad assumption, but clearly the “quantity” of housing services also depends upon
many other features of the unit such as age, number of bathrooms, quality of heating and plumbing,
air conditioning, and so on. Other studies construct a hypothetical unit price of housing services
from estimates of the cost of the various components of price - operating expenses cost of capital,
and tax treatment. A survey of empirical studies of housing demand by Whitehead (1999) finds that
the price elasticity of demand generally is inelastic (i.e., smaller than 1 in absolute magnitude), but
varies depending upon tenure (own versus rent) demographic group, and income level.
Housing Prices
The price of a house reflects the attributes of the house and lot and the characteristics of the
neighbourhood in which the house is located. The price is established through the process of
negotiation between buyer and seller, but there is no sale unless the buyer makes a bid. Buyers base
their bids on many factors and the purpose of this section is to discuss the neighbourhood
characteristics that influence bids.
What neighbourhood factors have been found to influence the selling price of a house? Obviously
the following list is not complete, but its length gives some idea of how many variables seem to
matter to people. These variables have been found to have a statistically significant impact on the
selling price of houses in at least one study:
1. Quality of local school (positive effect)
2. Crime rate in area (negative effect)
3. Property tax rate (negative effect)
4. Neighbourhood income, size of houses in neighbourhood, etc. (positive effect)
5. Air pollution (negative effect)
6. Airport noise (negative effect)
7. Proximity to contaminated areas (negative effect)
8. Proximity to a park (positive effect)
9. Industrial noise (negative effect)
10. Heavy traffic on street (negative effect)
11. Location in a floodplain (negative effect)
12. Distance to employment (negative effect)
13. Distance to shopping (negative effect)
14. Rating of the quality of houses next door and on the block (positive effect)
15. Within walking distance of public transit or commuter rail station (positive effect)
16. Adjacent to rail line, highway, or transit line (negative effect)
This is a pretty bewildering list of variables. Each variable makes sense individually, but how can a
person possibly take all of these factors in to account in formulating a bid for a house, or for that
matter, in doing an empirical study of house values?
Also the housing prices are not only determined by the variety of housing units but also by the
variety of households that demand those housing units. This section also introduces the idea that
different types of households may make different bids for the same property. Not everyone places
the same value on a given bundle of attributes and neighbourhood characteristics. The household
with the highest bid occupies the property. If there are systematic differences in the bids made by
different types of households, there will be clustering of households of particular types. Hedonic
model discussed previously is not efficient since it does not take into account the variety of
households that demand housing units. Next section discusses the filtering model to grasp the
working of housing market in a more efficient manner.
The Filtering Model of the Housing Market
The filtering model of the housing market has been devised to take both types – households and
housing units – into account. The presentation of the model will begin by ignoring location and
neighbourhood characteristics. This assumption is relaxed later. As a beginning, suppose that all
housing units can be arrayed in a hierarchy from best to worst. The array goes from the fanciest
mansion to the run-down, single-room apartment. Further suppose that households are arrayed in
order of the amount of housing that they demand. Households with higher incomes demand more
housing, so the order of the household in the array will be strongly correlated with income. The
housing market assigns each household to a housing unit and determines prices for the various
units. Now let us simplify the picture by grouping the households and their assigned housing unites
according to the quality level of the housing unit. For concreteness, suppose that the housing units
are grouped into the top, middle, and bottom thirds. We now have set up a model with markets for
three general types of housing units: high-quality units, medium-quality units, and low-quality units.
These three markets are interrelated because they are markets for goods that are, to some degree,
substitutes.
The basic three-market model is depicted in Figure 1. The initial demand functions for high-,
medium-, and low-quality units are denoted D
H
, D
M
, and D
L
. The supply of high-quality units initially
is H, and M units of medium-quality units are supplied. These supplies are fixed (for the moment),
and it is assumed that there are no vacant units in these two markets. The number of low-quality
units in the market is L, but the short-run supply cure is S
L
, to reflect the fact that the number of
units actually offered in the market depends on the housing rent. Given the market demands, the
initial equilibrium housing rents are R
H
, R
M
, and R
L
. In addition, the number of vacant units of low-
quality housing is L – Q
L
.
Figure1

The model in figure 1 has many uses. Perhaps the standard exercise is to introduce an increase in the
supply of high-quality units. This supply increase may occur due to a reduction in the cost of building
these units. The increase in the supply of high-quality units is shown in Figure 2 as a shift from H to
H*. Given the demand for high-quality units has not changed, the housing rent must decline from R
to R* so that the additional units will be occupied by the households who occupy medium-quality
units. Since high- and medium-quality units are substitutes, the demand curve for medium-quality
units shifts to the left by the increase in high-quality units. The decline in rent in high-quality units
must be enough to shift D
M
to D
M
*. Some households who occupy low-quality units move into the
vacated medium-quality units. Housing rents in medium-quality units fall to R
M
*. Finally, housing
rents in low-quality units fall to R
L
*, and there is an increase in the number of vacant low-quality
units equal to the increase in high-quality units.
Figure2

In a nutshell what has happened is that increase in high-quality units has set off a series of changes
in which all housing rents declined and some households “filtered” up in the quality hierarchy. Also
the number of households who moved up in quality is equal to two times the original increase in
high-quality units. But this process has hiccups too. For one thing, the process is initiated by an
increase in supply of high-quality units relative to demand. The filtering process will not occur if new
construction at the top end only matches the growth in high-income households. Furthermore, the
results are altered if the number of households can expand in response to lower housing rents.
Suppose that some of the households who live in medium-quality units can split into two
households. One of these households moves into a vacant high-quality unit and the other
households stays put. This can mean that the demand for medium-quality units does not decline at
all, and the housing rent for these units does not decline. No occupants of low-quality units move up
in quality. This is an extreme example, but the creation of new households from the same
population tends to choke off the filtering process.
Next consider the market for low-quality units. The housing rent has declined and the vacancy rate
has increased. The suppliers of low-quality housing may not react immediately to these changes but
eventually they will because a high vacancy rate will mean that some units will be vacant for lengths
of time that are too great to make them economically feasible. A unit is no longer economically
feasible if the housing rents cannot cover the variable costs of operating the unit as housing. This is
the usual decision to shut down a business. Clearly, units will be withdrawn from the housing stock.
If there is a good alternative use for the land under the unit, the owner will demolish the housing
and convert to another use, such as commercial, parking lot, and so on. The withdrawal of units from
the low-quality stock will shift supply to the left (to L* and S
L
*) and cause housing rents to rise at this
end of the market. This reduction in supply and increase in housing rents can be a good thing
because they ensure that the remaining low-quality units are now economically feasible. But the
occupants of low-quality housing must pay the higher housing rents.
One more feature of housing needs to be added to the model. Housing is durable, but it is not
infinitely durable. Some households move up in housing quality, but the units that they occupy may
not remain at the original quality level. Medium-quality units eventually may become low-quality
units, and high-quality units can become units of medium quality. The improvement in housing
quality generated by the filtering mechanism may well not be permanent. Indeed, the rent paid for
both high- and medium-quality units have declined. These declines in rents will probably lead
landlords to cut back on maintenance expenditures, which will eventually lead to a decline in the
quality of some units. Some high-quality units will be turned into medium-quality units, and some
medium-quality units will be turned into low-quality units. The entire housing market may eventually
return to the original price and quantity for each level of quality.
So far the model has generated reductions in the stock of low-quality housing by demolition, but a
drive around older central cities demonstrates that many units are removed from the stock simply
by being abandoned. The owner walks away from the building and leaves no forwarding address for
the property tax collector and the building inspector. Abandonment can be a good choice for the
owner. The abandonment of a property results from two things:
x the housing rents cannot cover variable costs,
x and the value of the land is zero or less. (Demolition costs make the value of the land less
than zero.)
Given that the value of land in some inner-city areas has collapsed virtually to zero, abandonment
can be expected to result from increases in the supply of high- or medium-quality housing.
Abandonment may be a good decision for the owner, but it is often a disastrous decision for society.
Abandoned units cost something to demolish, and usually the municipal government must pay the
cost. Before the demolition can be accomplished, the abandoned unit can be a source of negative
external effects in its neighbourhood. Abandoned units hurt the appearance of a neighbourhood,
are fire hazards, and can be places of criminal activity. Abandoned units are red flags that say the
neighbourhood is in trouble. It appears that abandonment can beget more abandonment as many
factors interact to reduce the quality of the neighbourhood further unless the city government can
keep on top of the problem with timely demolition. Central cities sometimes have lost the race
against abandonment, but in some cases the city is its own worst enemy. A study by White (1986)
showed that the most important factor in housing abandonment in New York City during the late
1970s was a high property tax bill compared to the rents the building can earn. The property tax bills
loomed large as a percentage of rent because the city had failed to adjust assessed values downward
as rents declined. Landlords were pushed over the edge by high property tax bills.
Now let us put location into the filtering model. The fact is that in all the metropolitan cities, most of
the newer and high-quality housing is in the suburbs, and most of the low-quality housing is the old
housing located in the inner city. Mieszkowski and Mills (1993) argue that the filtering model
provides a primary reason for the movement of population to the suburbs and for the concentration
of low-income households in central cities. They call the model the natural evolution theory. The
construction of the expressways in the 1950s and 1960s in USA, coupled with federal policies that
encouraged new construction and homeownership, opened the floodgates for movement of (mostly
white) middle-class people to the suburbs. Rising real incomes, at least up to the 1970s, stimulated
new construction as well. In this kind of housing market in the suburbs, the filtering mechanism
worked and neighbourhood after neighbourhood was relinquished to the growing minority
populations. The old minority neighbourhoods increasingly became areas of abandonment. If we
examine the data on census tracts in Bangalore for past forty or fifty years we may see evidence of
the filtering process at work. We can also find out how has the demography of the Bangalore
changed over these 40 years.
Affordable Housing and Gentrification
The issues of affordable housing and gentrification are much on the minds of the public, public
officials, and economists. In this section I have reviewed the current research and try to home in on
the most important problems. I find that the problem of the affordability of housing is confined
mainly to low-income renter in urban areas and that, in some places; gentrification has contributed
to the increase in housing costs experienced by this group.
Quigley and Raphael (2004) provide a clear overview of the issue of housing affordability in USA
during the 1990s. Their first finding is that, for the two-thirds of households that own the home,
there was no evidence that the annual cost of housing increased in the 1990s. However, this
changed during the housing price bubble of the 2000s. The basic point is that mortgage interest
rates were low and stable during the 1990s. However, rates of home ownership are low for
nonelderly, low-income households. For example, Quigley and Raphael (2004, p. 193) show that only
32% of low-income (in the bottom 20%) households with a household head aged 35 to 44 own the
home. This can be compared to a 66% homeownership rate (as it happens, the overall national
average) for all households in this age group.
The Quigley-Raphael (2004) study of rental housing shows the following:
x In 2000 the poor renter household spent, on average, 64% of income on housing and 77% of
the renter poor devoted more than 30% of their income to housing. The poor represent
about 12% of all households.
x Renter households in the lowest 20% of the income distribution experienced a large increase
in the ratio of rent to income – from 0.47 in 1960 to 0.53 in 1980 to 0.55 in 2000. The
proportion of this group that spent more than 30% of income on rent increased from 62% in
1960 to 69% in 1980 to 79% in 2000.
Quigley and Raphael (2004) showed that this decrease in affordability in the 1980s and 1990s can be
attributed almost entirely to increases in rents rather than decreases in income of the low-income
population. Some of the increase in rents can be attributed to increases in the quality of rental
housing. Rental units are larger and very few lack plumbing facilities or adequate electricity or
heating. The increase in quality can partly be attributed to government restrictions – building codes
and housing codes that mandate standards. It is possible that low-income households would have
chosen housing units of lower quality than required by the building and housing codes imposed by
local governments. In the extreme case, some households choose to be homeless.
While some of the increase in rents stems from increases from quality, it is also true that rents
increased after adjusting for quality. The trend in rents depends upon factors that influence the
overall supply of rental housing. The filtering model discussed above implies that rents for housing at
the bottom of the housing supply continuum depend upon the quantity of new, higher-quality units
supplied. Any factor that reduces the rate of housing construction is implicated; growth controls,
land-use and zoning regulations, generous provisions for open space, and stringent building codes. It
is ironic that the people who are concerned about housing affordability are also in favour of growth
controls and strong land-use regulation. Making rental housing more affordable will depend upon
increasing housing supply and increasing the income of poor households.
Does gentrification contribute to the problem of housing affordability? Vigdor (2002) has considered
this question at length. Gentrification is defined as private residential and commercial development
(usually in central city) that includes the movement into the neighbourhood of households with
larger incomes than the current residents. Vigdor’s detailed study of Boston shows that
gentrification as defined does not necessarily mean that poor households suffer a decline in living
standards. In Vigdor’s view gentrification is a result of broader trends that affect the poor rather
than a direct cause of any change in the well being of the poor. As we know, housing in urban areas
has become less affordable for the poor over time, and this trend has numerous underlying
economic causes. Gentrification is a symptom of the broader trends in the urban economy.
Furthermore, gentrification tends to increase the tax base of the central city and might therefore
lead to improvements in public services. Gentrification might increase employment opportunities in
the central city and reduce the concentration of poverty as well. Vigdor (2002) finds no evidence
that low-income households move out of their housing units. He finds that poor households are
more likely to leave poverty than to be displaced from the housing units by higher-income
households. But low-income households in Boston generally have experienced reductions in housing
affordability without compensating changes in public services or neighbourhood quality. In essence,
Vigdor (2002) has found that there is a general problem of housing affordability among the low-
income renters in Boston. This finding matches the conclusion of Quigley-Raphael (2004) study of
entire nation.

Housing in Developing Countries
This section deals with the housing markets in developing countries based upon the survey of the
topic by Malpezzi (1999). Malpezzi’s basic point is that the behaviour of households and firms in the
housing market is similar from country to country, but that institutions and constraints (e.g.,
incomes) vary a great deal.
The importance of property rights is emphasized by Malpezzi and he notes that legal systems are in
flux in many developing countries. He emphasizes the rights of owners of poverty, but also points
out that the rights of landlords and tenants must be well defined. Rights must be set out in contracts
that are the outcome of a competitive market process, and there must be clear remedies for the
violation of agreements by either party. In Malpezzi’s view (1999), “Property rights profoundly affect
not only the efficiency of the housing market; they also profoundly affect other social goals or
questions such as the distribution of wealth and income.” Another critical expect of institutions is
the nature of land-use regulations – the body of customs, laws, and regulations that govern land use
and buildings. These include zoning laws, building and housing codes, deed restrictions,
environmental laws, and so on. It is fair to say that both mainstream and conservative housing
economists think that housing is provided most efficiently by private suppliers who operate within a
system of competitive markets with well defined real property rights and reasonable land-use
regulations.
Another article by Annez and Wheaton (1984) explored basic economic relationships between
economic development and housing in a cross section of countries. They began by pointing out that
a large number of low-income households in developing countries consume housing that is below a
socially desirable standard. “Informal” housing, such as the favelas in Brazil, is of such poor quality
that it is not counted as part of the official housing stock. Another concern is that, because the price
of housing rises as economic development proceeds, the net effect of economic development may
be little or no improvement in housing. These concerns lead governments to institute programs that
provide funds for low interest loans for private housing and to build subsidized housing directly.
Annez and Wheaton (1984) were motivated by the lack of long-run studies of the housing sector that
address these concerns.
Annez and Wheaton (1984) used a particularly clever technique to measure the importance of
informal housing. Informal housing is not recorded in the official data on housing production – data
on building permits and housing starts. However, the number of informal housing units that serve as
permanent shelter is enumerated in the census of population. They assembled data for 1960 to 1970
for 24 countries on the recorded production of housing units and on the change in the total number
of housing units (including informal housing). Their findings for the ratio of recorded production to
change in number of housing units for some developing countries are as follows:




Country Ratio of Recorded Production to Change in Housing Stock
Chile 0.56
Colombia 0.36
Costa Rica 0.52
Egypt 0.28
Panama 0.40
Philippines 0.14
Syria 0.72
Venezuela 0.23

If all housing units that were constructed over the decade have been recorded, then this ration
should be greater than 1.0 because some units are removed from the stock because they have
reached the end of their useful lives. However, the ratio was well below 1.0 for these 8 countries in
the 1960s and below 0.50 for 5 of them. This is evidence that a large fraction of the additional
housing units was of the “informal” type.
De Soto (2000) estimated that 85% of urban dwellings in the developing countries of the world are
of the informal type. He estimated that these 329 million dwellings, which housed about 1.6 billion
people, were worth a total of 6.7 trillion dollars in 1997. The value of these dwellings is a primary
source of capital that de Soto believes needs to be “unlocked” to facilitate economic development.
In contrast, the ratio of recorded production to the change in the stock for developed countries was
close to or exceeded 1.0. The results for some of those countries are:
Country Ratio of Recorded Production to Change in Housing Stock
Australia 0.85
Canada 0.93
France 1.24
Germany (West) 1.92
Japan 1.02
United Kingdom 1.98
United States 1.61

Australia and Canada are two nations that still had “frontier” areas at that time, so it is likely that
some construction of housing went unrecorded in the official data.
Annez and Wheaton (1984) hypothesized that the change in the housing stock is driven by
demographic factors (not housing prices and income), and that price and income determine the size
and quality of the units. Their econometric results show that the change in the housing stock (as
recorded by successive censuses) is a positive function of the change in population and a negative
function of the change in average household size – and does not depend upon GNP per household,
cost of construction of the recorded units, provision of loans, or construction of public housing. This
last result suggests that public housing simply replaces housing units that would exist anyway.
Presumably public housing is constructed at a higher level of quality than informal housing. As
expected, the ratio of recorded production to change in the housing stock was found to be strongly
positively correlated with GNP per household, but it was not found to be related to construction cost
of recorded units. Furthermore, the average size (square/footage) of the recorded units that were
constructed depended on GNP per household (Positive sign) and cost of construction per square
foot. The estimated income elasticity of unit size is 0.51 and the estimated price (cost) elasticity of
unit size is – 0.45. These are reasonable estimates of demand elsasticities for housing. They also
found that provision of loans (measured as the ration of loan to value) increased unit size. Lastly,
they found that the cost per square foot increased with GNP per household, and that this elasticity is
0.57. These empirical results imply that, if GNP per household increases by 1%, then unit size for
recorded units will increase by 0.41-(0.45)(0.57) = 0.15%. The basic conclusion is that, as economic
development proceeds, housing quality improves because fewer new units are of the “informal”
type, but that unit size of recorded units does not increase by a large amount. While there can be
supply bottlenecks in the short run, the supply of recorded (i.e., at a socially desirable level) housing
responds to economic development in the long run. This again leads to the proposition that housing
is best supplied by the private market, supported by clear real property rights and reasonable
regulations.
Annez and Wheaton (1984) did not examine the regulatory framework and its impact on the housing
market. This issue is important, and has been the topic of studies by Malpezzi (1999) and others.
One study by Malpezzi and Mayo (1997) compared housing supply elasticities in Malaysia and South
Korea (countries with highly restrictive regulations regarding land use, redevelopment, and finance)
with Thailand and the U.S. (countries with liberal regulatory environments). They examined the
changes in the relative asset prices of housing as these economies experience growth, and found
that housing supply was essentially perfectly elastic in Thailand and the U.S. and very low (virtually
zero) in Malaysia and South Korea. The data on housing asset prices pertains to recorded housing
transactions, so the rising prices observed in Malaysia and South Korea do not pertain to the
informal housing stock, which presumably responded to population growth as expected. In essence,
the study by Malpezzi and Mayo (1997) shows that a restrictive regulatory environment means that
the formal recorded housing supply is restricted – so that housing quality improvements are
inhibited as economic development proceeds. Another restrictive technique is to limit access to
basic public services. A recent study by Feler and Henderson (2009) finds that localities in Brazil
withhold access to public services to discourage migration to the urban area. Their study focuses on
provision of access to water provided by the public sector to the areas of informal housing.
References
Annez, Philipp, and William Wheaton, 1984, “Economic Development and the Housing Sector: A
Cross-National Model,” Economic Development and Cultural Change, Vol. 32, pp. 749-766.
Downes, Thomas A., and Jeffrey E. Zabel, 2002, “The Impact of School Prices on Housing Prices:
Chicago 1987-1991,” Journal of Urban Economics, Vol. 52, pp. 1-25.
Feler, Leo, and Vernon Henderson, 2009, “Exclusionary Policies in Urban Development: Under-
Servicing Migrant Households in Brazilian Cities,” working paper, Brown University.
Green, Richard, and Stephen Malpezzi, 2003, A Primer on Housing Markets and Housing Policy,
Washington, DC: The Urban Institute Press.
Lancaster, Kelvin, 1966, “A New Approach to Consumer Theory,” Journal of Political Economy, Vol.
74, pp. 132-157.
Malpezzi, Stephen, 1999, “Economic Analysis of Housing Markets in Developing and Transition
Economies,” in P. Cheshire and E. Mills, eds., Handbook of Regional and Urban Economics, Vol. 3,
Amsterdam: North Holland.
Quigley, John, and Steven Raphael, 2004, “Is Housing Affordable? Why Isn’t It More Affordable?”
Journal of Economic Perspectives, Vol. 18, pp. 191-214.
Rosen, Sherwin, 1974, “Hedonic Price and Implicit Markets: Product Differentiation in Pure
Competition,” Journal of Political Economy, Vol. 82, pp. 34-55.
Sheppard, Stephen, 1999, “Hedonic Analysis of Housing Markets,” in Paul Cheshire and Edwin Mills,
eds., Handbook of Regional and Urban Economics, Vol. 3, Amsterdam: North Holland.
Soto, Hernando de, 2000, The Mystery of Capital, New York: Basic Books.
Vigdor, Jacob, 2002, “Does Gentrification Harm the Poor?” Brookings-Wharton Papers on Urban
Affairs, Vol. 3, pp. 133-160.
Whitehad, Christine, 1999, “Urban Housing Markets: Theory and Policy,” in P. Cheshire and E. Mills,
eds., Handbook of Regional and Urban Economics, Vol. 3, Amsterdam: North Holland.

patterns, and patterns of land-use intensity. The house of Lancaster/Rosen has led to literally hundreds of statistical studies of house values and a revolution in the methods used by real estate appraisers and tax assessors. Let us further consider the House of Lancaster/Rosen. An appraiser of residential property has data on hundreds of sales. This database can be used to estimate a statistical model of house prices. He knows the attributes, locations, and selling prices of many properties. He might also have data on the important features of the neighbourhood in which each house is located. All of this information can then be used to estimate an equation that can be used to predict the price of a subject house. The statistical model of house prices estimated using such a database is called a hedonic model, a term derived from the word hedonism, which is the idea that one should pursue pleasure. The idea is that a house consists of numerous components that add to one’s pleasure, and that each of these components has a price. The market price of the house is the sum of the market prices of its components. Consider a very simple model of house value in which the components are the size of the house (interior square feet), the size of the lot (exterior square feet), and the proximity to employment. The market value of houses (V) can be specified as a linear equation V = a0 + a1F + a2L + a3x + e, where F is the number of square feet of interior space, L the number of square feet of exterior space, x the distance to employment, and e is a random error term. The coefficient a1 is the market value of an additional square foot of interior space, a2 the market value of a square foot of exterior space, and a3 the reduction in value that is associated with greater distance from employment. The random error term reflects the fact that the three variables do not completely account for variations in the value of houses. Each house in the database has its own individual error term, which is a collection of other influences on value that are not included in the equation. We can use the multiple regression to estimate the foregoing linear model of house prices. If we want to appraise a house with 1500 square feet of interior space on a lot that is 50 by 100 feet and located five miles from the work place, we can estimate its market value V* as V* = a0 + a1(1500) + a2(5000) + a3(5) Appraisers are not permitted to perform appraisals in this manner. They must follow a procedure called sales comparison approach. However, hedonic models are useful tools for appraiser because they indicate the market value of particular attributes. For example, suppose that the subject property and the comparable properties used for appraisal purposes differ in the amount of interior space they provide. The estimated coefficient a1 tells you the magnitude of the adjustment to the price of the comparable property that is needed in the standard appraisal. Another use of hedonic models is for property tax assessment. The task of the municipal tax assessor is to determine an assessed value for every house in the municipality. Many assessors estimate a hedonic model based on a sample of houses and then use it to “predict” the market value of all the houses in the municipality. Assessed value is then based on this predicted market value. Scores of hedonic studies of house prices have been published in academic and professional journals. All of them include a fairly standard list of variables. Most hedonic studies of house prices use an exponential function rather than a linear function of the form

or more elaborated design components to a house. Although the theoretical model appears quite complicated... It shows the maximum amount that a household will pay for the level of design quality indicated on the horizontal axis.. The coefficients in the log-linear model (a1 to an) indicate the percentage change in V associated with a change in the independent variable.” Figure 1 shows the household’s bid function for this good. Housing producers attempt to build homes that reflect the tastes of consumers. room size. it can be simplified by focusing on the choice of a single housing characteristic. The marginal price is also equal to the marginal cost of the good on the part of producers. Initial amounts – a better kitchen design. Holding all these factors constant. square footage. The position of the bid curve for an individual housing characteristic depends on the level of utility received by the households. holding other factors constant. such as school quality and crime rates. As indicated by the arrow. The Hedonic Housing Model As mentioned in the previous section. e.. . It also includes characteristics of the location. This maximum bid increases at a decreasing rate with the quality of the design. Two bid curves are shown in Figure 1. representing “high” and “low” levels of utility. which we assume can be simplified down to a single measure. The natural log of the price is then the dependent variable in a linear hedonic model of the form ln V = a0 + a1F + . The basic insight of the hedonic model is that the marginal price of a characteristic – the additional charge for one more unit – can be estimated by regressing the sales price of a home on its characteristics. Higher levels of utility are associated with higher design quality and lower house prices.. the marginal price is equal to the household’s marginal willingness to pay for an additional unit. A home includes basic characteristics of the structure. It is costly to add square footage. another room. we will treat all of these components together as though they are a single good called “design quality. where exp(. In equilibrium. all of which add to the amount of the composite good “housing” as well as the price.g. + anX + e This log-linear equation usually fits the data better than does the conventional linear equation in which V is the dependent variable. utility rises as we move toward lower bid curves. marble countertops. In the hedonic model of housing. For simplicity. the hedonic model is used to recover the implicit price of a multi-faceted good. But eventually this levels off as we move into the “luxury” range. households are assumed to receive utility from each of the many characteristics that comprise a house. + anX + e). How much does an additional bedroom add to the sales price of a house? Do higher average student test scores increase the value of homes within the school district? Do higher crime rates reduce house prices? This section describes briefly how the economics of housing market is explained by the Hedonic Model.. let us focus on the choice of the quality of the design. and outdoor landscaping. some grass in the yard – add a lot to the amount households will pay for the house.) means that the base of the natural logarithm is taken to the power shown in parentheses.. Homes can be built with expensive hardwood floors. and so on.V = exp(a0 + a1F + . the number of stories.

the bids drop off more sharply for dotted-line households when design quality is reduced below Q1. households have reached the highest level of utility they can attain given the location of the offer curve. Figure 3 shows an equilibrium combination of bid and offer curves. Of course. If Figure 3 were the full story. Figure 4 presents two different types of households. The households represented by the dotted line will pay more for an additional unit of design quality than households represented by the solid line. In general. start from point A.Figure 1 Figure 2 Figure 3 A high-quality design comes at a cost. Given the level of the bid curves. Producers will be willing to install luxurious design components. and they earn higher profit when houses prices are high. Again if we start from the point labelled A. Producers find it less costly to build homes with lower quality. higher profit levels are associated with higher offer curves. Thus. the firm represented by the solid line requires more compensation for increasing the design quality beyond Q1. but only if they are compensated for the installation cost. as indicated by the arrow in Figure 2. . To understand this diagram. the hedonic housing model would not be particularly useful or interesting. Similarly. the firm represented by the solid line is the high-cost producer: it requires a greater addition to the price of housing to compensate it for having to add more design quality. the intersection of the two curves. But all equilibrium combinations will end up with the bid curve for households being tangent to the offer curve for firms. Figure 5 shows the offer curves for two firms that differ in their cost structures. Thus. Similarly. there are many other combinations of bid and offer curves that also are consistent with equilibrium in the housing market. if the firm represented by the solid line were to reduce design quality below Q1. Figure 2 show the offer curves for a representative producer. producers have reached the highest offer curve – the highest level of profit – that they can attain. The offer curve shows combinations of house price and design quality that lead to the same level of profit for the producer. The households represented by the dotted bid curve clearly value design quality more than the solid-line households. it would have reduced the housing price and still come out with the same level of profit. The hedonic model becomes interesting once we recognize that households differ in their tastes for housing characteristics and that producers may differ in their cost structure. steeper bid curves imply that households value the housing characteristic more highly in the sense that they will pay more for an additional increment of the good. The offer curves are assumed to increase at an increasing rate with the level of design quality because additional increments to quality become more and more expensive to add to a home. where the additional compensation comes in the form of a higher house price. Similarly.

this marginal price represents the marginal willingness to pay for another unit of design quality on the part of low-demand households.” Figure 7 shows a hedonic price function that is consistent with the matching equilibrium of Figure 6. High design quality comes at a price: high-demand prices pay P2 for Q2 units. To see this. The slope of the hedonic price function is a direct result of two main assumptions that 1) consumers are willing to pay more for high levels of design quality. In this case. This outcome is exactly what is predicted by the model. The two solid lines – lowdemand households and high-cost firms – are in a match with low design quality. An important feature of the hedonic price function shown in Figure 7 is that it is not linear. Figure 6 represents an equilibrium outcome. The hedonic function shows that the price of housing rises with design quality.Figure 4 Figure 5 Figure 6 Now if we match our high and low cost producers to the high and low demand households. The curve that connects these tangencies is called the “hedonic price function. And firms that find it costly to produce high levels of design quality will offer discounts for lower quality levels that attract low-demand households. Thus. The set of tangencies between bid and offer curves forms a set of equilibrium price-quantity combinations. the slope of the hedonic price function is equal to the slope of the low-demand households’ bid function and the high-cost firms’ offer function. This implies that it costs less per unit of design quality to have a high-quality home than a home with a lower level of design quality. and 2) producers find it costly to produce higher-quality houses. A nonlinear pricing structure is one of the predictions of hedonic theory. At Q1. The two dotted lines – high-demand households and low-cost firms – are matched in equilibrium with a high level of design quality. We can extend Figure 6 to include a wide variety of household and producer types. This matching process is an important prediction of the hedonic model. It also represents the marginal cost of production for high-cost firms. look at the slopes at Q1 for the high-demand bid curve and the low-cost offer curves (the . The matching process is important to keep in mind when interpreting the results of hedonic models. we would expect households who place a high value on design quality to seek out housing producers who are able to provide that level of design quality relatively inexpensively. It does not represent the marginal willingness to pay on the part of high-demand households or the marginal cost to low-cost firms. the hedonic price function increases at a decreasing rate with the level of design quality. But the price paid by each household is significantly lower than what they would have to pay to get the same level of design quality from the other type of producer.

The hedonic model is simplified somewhat when the supply of the characteristic is fixed because we need only consider the households’ bid functions. the marginal price implied by the hedonic price function is the right measure of marginal willingness to pay and marginal cost only for those households and firms who have chosen that quality level. Considering the case of school quality. are occupied by low-demand households – households with a relatively low demand for school quality. homes in neighbourhoods with low school quality. low-demand households are only willing to pay P3 for this increase in design quality. we may think that the value of this high level of design quality is the difference between P2 and P1 for households who are living in low-quality homes. and this higher price will leave them at a lower level of utility than they had before. they will have to pay P2. access to employment opportunities – are part of the location and cannot be varied readily by the producer. design quality. But many studies show that school quality is capitalized into house price because people will bid more for homes in neighbourhoods with good schools. At Q1. assume that we have two types of households. In a competitive hedonic market. Other variables – school quality. Homes in neighbourhoods with Q>Q1 . The bid functions for the two households are shown in Figure 8. Q<Q1. the marginal willingness to pay for another unit is higher for high-demand households than it is for low-income households. The trick to analyzing the shape of the equilibrium price function is that the household type that bids more for a home is the one who buys it. Armed with estimates of the hedonic price function. The first household type places a higher value on school quality than the second type. Thus. Suppose the local government decides to adopt stringent building codes that effectively require a minimum level of design quality. and the marginal cost for low-cost firms is lower than for high-cost firms. the hedonic price function implies that households are willing to pay P2-P1 to increase design quality from Q1 to Q2. To simplify the diagrams. is representative of any characteristic that is added to a house by producers. crime. After all. Thus. If they are forced to consume Q2 units.dotted lines). this type of quality regulation will actually make low-demand households worse off even though they end up living in higher-quality homes. housing producers do not directly choose the quality of the schools in a neighbourhood. However. The housing characteristic which has been analyzed to this point. Figure 7 Figure 8 The matching process has important implications for cost-benefit analyses of housing policies. suppose this minimum design quality is given by Q2 in Figures 6 and 7. Coincidentally.

The next adjustment is made to account for the effect of any special financing arrangements. At each point along this function.e. In the example in Table 1 three comparables have been selected that are located close to the house in question and are very nearly the same. the marginal price of housing is equal to the household’s marginal willingness to pay. An estimate of the value of the land is added on. We should select only comparables that are straightforward arm’s length sales. The formal. If the comparable was sold . For example. But here the focus will be on the sales comparison approach because this is the method that all parties to the transaction primarily rely upon. makes use of procedures that are actually quite scientific. The sequence of adjustment to the selling prices that appraiser follow is shown in Table 1. except that a market rent for the house must be estimated from rental market data. the bold line segments in Figure 8. as is done for comparable #3. The standard appraisal of a house is based primarily on a sales comparison approach that is supplemented by two other methods. The cost-less-depreciation method begins with the cost of reproducing the structure today. The critical step is the selection of comparable properties so that the adjustments to their selling prices do not have to be very large and. In this task. The income capitalization method is similar to the method used for commercial properties. The task of estimating the market value of a property is done by a professional appraisal. called the income capitalization and the cost-less-depreciation methods. suppose that the seller loans some of the purchase price to the buyer at an interest rate that is below the rate that prevails in the market. The appraisal process for a residential property is very standardized. Standard sources on constructions costs are used to determine this cost. it is assumed that the property is being sold by a “normal” seller to a “normal” buyer under “normal” market conditions. in fact the appraiser fills out a standard form that meets the requirements of government agencies. Detailed data on the subject property and the three “comparables” are gathered. For example. The basic idea in appraisal is to adjust the actual selling price of the comparable property as close as identical to the subject property as is possible. The first adjustment that must be considered is called “conditions of sale. The hedonic price function is the upper envelope of the two bid function. and use of the data is described below and in Table 1.” The sale of a comparable property may not be a conventional arm’s length transaction. therefore. The third possible adjustment is for the date of sale of the comparable property. the adjusted selling price is an estimate of the market value of the subject property. The idea is to estimate the market value of the subject property under normal selling conditions. so the effect on the price of financing concession must be subtracted from the actual selling price. less subject to error. professional appraisal process requires that three actual sales of comparable properties be used. transactions involving members of the same family may not really be a fair market price. and then allowances are made for the depreciation of the structure’s value. Appraisal of Residential Real Estate This section describes briefly how the value of a house in the real estate market is determined. i..are occupied by high-demand households. After the price of the comparable property has been adjusted. The professional appraiser has extensive training and. if the appraisal is done properly. This sort of concession will tend to boost the selling price of the house.

5%.750 (1 year ago) Location none Site/View none Design none Quality of construction none Age +3125(10 years) Condition none Rooms none Bathrooms +1. Price trends can be quite different in different parts of the same urban area. Now.875 -1000(reduced payment.000 1.500 $83.500 (none) Total Adjustment 9. Again.000 (frame) +1. One should try for comparable properties that are all in the same neighbourhood as the subject property. the adjustment for the actual physical characteristics of the comparable and subject properties is left.125 Subject Property #3 $140. then comparables #1 and #2 are adjusted upward by 3% and 1.875 Indicated Value of Subject 134. The Sales Comparison Approach to Appraisal Comparable Sales #2 $130.000 1.33 none none 1.50 Sale Price Square Feet Price per sq. The first adjustment that must be made is for location. If the comparable and subject properties are located in the same immediate neighbourhood. and that percentage is used to adjust the price of the comparable property. then a location adjustment should be made.300 (5 years) none none none none none none none 125 130. The difference in their sales prices is computed in percentage terms.750 130. yr 1) none none none none none (brick) none (3 years) none none none none none none none -9. if the comparable property is located in a different neighbourhood. The location adjustment is made by finding two actual sales – one near the subject property and one near the comparable property. Table 1 lists the factors that are taken into account. This prices adjustment should be based.000 1. we should find comparables that . no location adjustment is needed. Table 1. respectively. patio. pool none Fireplaces +1.250 brick 3 years excellent 3BR 1. on data for the immediate neighbourhood of the comparable property.500 (a bath) Heating/cooling none Garage/carport none Porch. Adjustments for Conditions of sale Financing concessions Date of sale #1 $125.5 Gas/AC garage porch one The next task is to adjust the price of the comparable property to match the subject property. then the price must be adjusted upward by a percentage to reflect the price increase. However.six months ago and it is known that prices are increasing over time.600 $81.600 $87. ft. if possible.950 (6 months ago) none none none +5.500 +3. At this point we have an estimate of the price of the comparable property if it were to be sold today under normal selling conditions. If we assume that prices are rising by 3% per year.25 none none +1.

The other two comparables provide additional information that should be used. P is the price of housing services. household composition. If it is known that houses in the market in question decline in value as they age by 0. The budget constraint in housing demand is stated as Y = g + Ph. household size. suppose that the comparable is ten years older than the subject property. Income elasticity . Studies of demand for a consumer good concentrate on the income elasticity of demand and the price elasticity of demand.750. The Theory of Housing Demand The basic theory of demand for housing is based on the theory of the consumer. The vagaries of negotiating a sale price may have made this sale somewhat unusual in a way that has not been measured. and h is the quantity of housing services consumed. The demand for housing is written h = h(Y. We can have this knowledge through previous comparisons of value that have been made. An adjustment must be made if the comparable and subject properties are not identical on a feature. As another example. there are times when more weight might be put on one of the comparable properties. where Y is income for the time period in question. We assume that consumers have preferences for housing and other goods. For example. and indicated value of the subject property is shown at the bottom of the table. The final step in the sales comparison approach is to use the sample of three “indicated values” to estimate the market value of the subject property. The cost of capital is the return to the land and the capital that has been invested. X) Here X represents various household characteristics that determine preferences for housing such as age. Operating costs include both direct operating expenses such as fuel for heating as well as maintenance and depreciation expenses. then substantially more weight should be placed on this indicated value. and a fireplace (comparable #1 does not have one). gross living area (comparables #2 and #3 have 100 square feet more than the subject property). However. From previous comparisons. The adjustment in Table 1 include an adjustment for a half Bath (comparable #1 does not have one). Consumers make choices based on their preferences and the budget constraints they face. suppose that the subject property does not have central air conditioning. which in Table 1 results in an estimated value of $131. and so on. an appraiser will know that central air conditioning adds about 12% (say) to the value of houses of this type. For example. The price of housing services includes the cost of operating a unit of housing and the cost of the capital embodied in the dwelling. The usual approach is to compute the mean of the three indicated values. However.are very similar to the subject property on these features. The sum of all of the adjustment is computed. P. This means that the sales price of the comparable must be reduced by 12% to make it match the subject property. then the price of the comparable must be increased by 5% because it is the older property. but that the comparable property does have this feature. if the comparable property is the house directly across the street from the subject property. consumers maximize utility subject to the budget constraint. g is the amount spent on other goods.5% per year. In other words. an appraiser must not put 100% of the weight on the comparable from across the street because that would men relying on a sample of one.

move) frequently. expenditures increase less than proportionately with income. so (∆Ph/∆Y) = P(∆h/∆Y) Next. X)]/∆P = P(∆h/∆P) + h This can be rewritten as h[1 + (∆h/∆P)(P/h)] = h(1 + e).of demand is the percentage change in quantity of housing divided by the percentage change in income: (∆h/h)/(∆Y/Y) = (∆h/∆Y)(Y/h). It turns out that the income elasticity of demand can be estimated using the available data on housing expenditures and (permanent) income. or (∆Ph/h)/(Y/Ph) = P(∆h/∆Y)(Y/Ph)= (∆h/∆Y)(Y/h) Empirical studies of income elasticity of demand generally show that this elasticity is less than 1. converting both sides into elasticities by multiplying by (Y/Ph). 2. households in the middle 20% of the income distribution spent 23% of income on housing. a study by Green and Malpezzi (2003) based on the 1993 American Housing Survey shows that households in the bottom 10% of the income distribution spent 50% of income on housing. To see this write the change in housing expenditures as the price of housing changes: ∆(Ph)/∆P = ∆[Ph(Y. P. Ph. A similar strategy can be used to study the price elasticity of demand for housing. . Expenditures on housing. but most households make housing decisions that set consumption for some years – and base those decisions on an income level that is assumed to apply for several years. Neither the price of a unit of housing services nor the quantity of housing services consumed is observable. P.e. As noted above. Studies of housing demand should therefore be based on a measure for permanent income. Some renters adjust housing consumption (i. To see this. write housing expenditures as: Ph = Ph(Y. and the price elasticity of demand is (∆h/h)/(∆p/p) = (∆h/∆p)(p/h) Studies of the demand for housing face two challenges.. For example. X). 1. and households in the top 10% of the income distribution spent only 10% of income on housing. It turns out that the elasticity of housing expenditures with respect to a change in price equals 1 plus the price elasticity of demand. The income elasticity of demand and the elasticity of expenditures with respect to income are the same number. it is agreed that the relevant income concept for many households is permanent income – not current income. can be observed.

air conditioning. These variables have been found to have a statistically significant impact on the selling price of houses in at least one study: 1. but there is no sale unless the buyer makes a bid. but clearly the “quantity” of housing services also depends upon many other features of the unit such as age. For example. or transit line (negative effect) . and tax treatment. number of bathrooms. highway. 11. and income level.. but varies depending upon tenure (own versus rent) demographic group. 4. A survey of empirical studies of housing demand by Whitehead (1999) finds that the price elasticity of demand generally is inelastic (i. This may not be a bad assumption. smaller than 1 in absolute magnitude). Other studies construct a hypothetical unit price of housing services from estimates of the cost of the various components of price . some studies of renters use rent per square foot as the price of housing services. 2. 6. Housing Prices The price of a house reflects the attributes of the house and lot and the characteristics of the neighbourhood in which the house is located. quality of heating and plumbing. and so on. 15. 3. The price is established through the process of negotiation between buyer and seller. This result eliminates the need to measure the quantity of housing. 5. Buyers base their bids on many factors and the purpose of this section is to discuss the neighbourhood characteristics that influence bids. 7.operating expenses cost of capital. 10. 16. but its length gives some idea of how many variables seem to matter to people.where e is the price elasticity of demand. but an empirical study still needs a measure of the price of housing services in order to estimate E. The elasticity of housing expenditures with respect to a change in price (denoted E) is written E = (∆Ph/∆P)(P/Ph) = h(1 + e)(P/Ph) = 1 + e The price elasticity is e = E – 1. etc. 14. 9. size of houses in neighbourhood.e. 8. 13. Quality of local school (positive effect) Crime rate in area (negative effect) Property tax rate (negative effect) Neighbourhood income. (positive effect) Air pollution (negative effect) Airport noise (negative effect) Proximity to contaminated areas (negative effect) Proximity to a park (positive effect) Industrial noise (negative effect) Heavy traffic on street (negative effect) Location in a floodplain (negative effect) Distance to employment (negative effect) Distance to shopping (negative effect) Rating of the quality of houses next door and on the block (positive effect) Within walking distance of public transit or commuter rail station (positive effect) Adjacent to rail line. What neighbourhood factors have been found to influence the selling price of a house? Obviously the following list is not complete. 12.

and RL. Households with higher incomes demand more housing. The presentation of the model will begin by ignoring location and neighbourhood characteristics. In addition. This assumption is relaxed later. and bottom thirds. Given the market demands. medium-quality units. so the order of the household in the array will be strongly correlated with income. Not everyone places the same value on a given bundle of attributes and neighbourhood characteristics. The household with the highest bid occupies the property. The housing market assigns each household to a housing unit and determines prices for the various units. to some degree. or for that matter. there will be clustering of households of particular types. As a beginning.This is a pretty bewildering list of variables. Next section discusses the filtering model to grasp the working of housing market in a more efficient manner. and M units of medium-quality units are supplied. The array goes from the fanciest mansion to the run-down. DM. Hedonic model discussed previously is not efficient since it does not take into account the variety of households that demand housing units. These supplies are fixed (for the moment). the initial equilibrium housing rents are RH. and it is assumed that there are no vacant units in these two markets. suppose that the housing units are grouped into the top. The supply of high-quality units initially is H. This section also introduces the idea that different types of households may make different bids for the same property. and low-quality units. RM. and low-quality units are denoted DH. If there are systematic differences in the bids made by different types of households. We now have set up a model with markets for three general types of housing units: high-quality units. in doing an empirical study of house values? Also the housing prices are not only determined by the variety of housing units but also by the variety of households that demand those housing units. Now let us simplify the picture by grouping the households and their assigned housing unites according to the quality level of the housing unit. and DL. The Filtering Model of the Housing Market The filtering model of the housing market has been devised to take both types – households and housing units – into account. Further suppose that households are arrayed in order of the amount of housing that they demand. The number of low-quality units in the market is L. These three markets are interrelated because they are markets for goods that are. For concreteness. medium-. The basic three-market model is depicted in Figure 1. to reflect the fact that the number of units actually offered in the market depends on the housing rent. . substitutes. the number of vacant units of lowquality housing is L – QL. Each variable makes sense individually. single-room apartment. suppose that all housing units can be arrayed in a hierarchy from best to worst. but how can a person possibly take all of these factors in to account in formulating a bid for a house. middle. The initial demand functions for high-. but the short-run supply cure is SL.

Since high.Figure1 The model in figure 1 has many uses. The filtering process will not occur if new construction at the top end only matches the growth in high-income households. Housing rents in medium-quality units fall to RM*. For one thing. the process is initiated by an increase in supply of high-quality units relative to demand. Figure2 In a nutshell what has happened is that increase in high-quality units has set off a series of changes in which all housing rents declined and some households “filtered” up in the quality hierarchy. This supply increase may occur due to a reduction in the cost of building these units. Some households who occupy low-quality units move into the vacated medium-quality units. Perhaps the standard exercise is to introduce an increase in the supply of high-quality units. The increase in the supply of high-quality units is shown in Figure 2 as a shift from H to H*. Also the number of households who moved up in quality is equal to two times the original increase in high-quality units. The decline in rent in high-quality units must be enough to shift DM to DM*. the housing rent must decline from R to R* so that the additional units will be occupied by the households who occupy medium-quality units. One of these households moves into a vacant high-quality unit and the other . and there is an increase in the number of vacant low-quality units equal to the increase in high-quality units. Given the demand for high-quality units has not changed. But this process has hiccups too. the results are altered if the number of households can expand in response to lower housing rents. Suppose that some of the households who live in medium-quality units can split into two households.and medium-quality units are substitutes. Furthermore. housing rents in low-quality units fall to RL*. Finally. the demand curve for medium-quality units shifts to the left by the increase in high-quality units.

but the creation of new households from the same population tends to choke off the filtering process. Abandonment may be a good decision for the owner. Clearly. but it is not infinitely durable.or medium-quality housing. are fire hazards. But the occupants of low-quality housing must pay the higher housing rents. Abandoned units are red flags that say the . the abandoned unit can be a source of negative external effects in its neighbourhood. This is the usual decision to shut down a business.) Given that the value of land in some inner-city areas has collapsed virtually to zero. and some medium-quality units will be turned into low-quality units. which will eventually lead to a decline in the quality of some units. No occupants of low-quality units move up in quality. (Demolition costs make the value of the land less than zero. Abandonment can be a good choice for the owner. One more feature of housing needs to be added to the model. abandonment can be expected to result from increases in the supply of high. the rent paid for both high. and so on. but it is often a disastrous decision for society. and the value of the land is zero or less. Abandoned units cost something to demolish. This can mean that the demand for medium-quality units does not decline at all. This reduction in supply and increase in housing rents can be a good thing because they ensure that the remaining low-quality units are now economically feasible. The withdrawal of units from the low-quality stock will shift supply to the left (to L* and SL*) and cause housing rents to rise at this end of the market. Housing is durable. The suppliers of low-quality housing may not react immediately to these changes but eventually they will because a high vacancy rate will mean that some units will be vacant for lengths of time that are too great to make them economically feasible. Medium-quality units eventually may become low-quality units. Abandoned units hurt the appearance of a neighbourhood. A unit is no longer economically feasible if the housing rents cannot cover the variable costs of operating the unit as housing. The abandonment of a property results from two things: x x the housing rents cannot cover variable costs. This is an extreme example. Before the demolition can be accomplished. units will be withdrawn from the housing stock. Next consider the market for low-quality units. If there is a good alternative use for the land under the unit. So far the model has generated reductions in the stock of low-quality housing by demolition. The owner walks away from the building and leaves no forwarding address for the property tax collector and the building inspector. parking lot. and the housing rent for these units does not decline. The improvement in housing quality generated by the filtering mechanism may well not be permanent. and can be places of criminal activity. These declines in rents will probably lead landlords to cut back on maintenance expenditures. The entire housing market may eventually return to the original price and quantity for each level of quality. but the units that they occupy may not remain at the original quality level. The housing rent has declined and the vacancy rate has increased. the owner will demolish the housing and convert to another use.households stays put. Some high-quality units will be turned into medium-quality units. Some households move up in housing quality. and high-quality units can become units of medium quality. such as commercial. but a drive around older central cities demonstrates that many units are removed from the stock simply by being abandoned. and usually the municipal government must pay the cost.and medium-quality units have declined. Indeed.

64% of income on housing and 77% of the renter poor devoted more than 30% of their income to housing. Now let us put location into the filtering model. rates of home ownership are low for nonelderly. It appears that abandonment can beget more abandonment as many factors interact to reduce the quality of the neighbourhood further unless the city government can keep on top of the problem with timely demolition. Quigley and Raphael (2004. Landlords were pushed over the edge by high property tax bills. They call the model the natural evolution theory.neighbourhood is in trouble. opened the floodgates for movement of (mostly white) middle-class people to the suburbs. We can also find out how has the demography of the Bangalore changed over these 40 years. Quigley and Raphael (2004) provide a clear overview of the issue of housing affordability in USA during the 1990s. The property tax bills loomed large as a percentage of rent because the city had failed to adjust assessed values downward as rents declined. If we examine the data on census tracts in Bangalore for past forty or fifty years we may see evidence of the filtering process at work. there was no evidence that the annual cost of housing increased in the 1990s. 193) show that only 32% of low-income (in the bottom 20%) households with a household head aged 35 to 44 own the home. However. the filtering mechanism worked and neighbourhood after neighbourhood was relinquished to the growing minority populations. in some places. public officials. and most of the low-quality housing is the old housing located in the inner city. but in some cases the city is its own worst enemy. Their first finding is that. However. In this section I have reviewed the current research and try to home in on the most important problems. . The Quigley-Raphael (2004) study of rental housing shows the following: x In 2000 the poor renter household spent. I find that the problem of the affordability of housing is confined mainly to low-income renter in urban areas and that. This can be compared to a 66% homeownership rate (as it happens. coupled with federal policies that encouraged new construction and homeownership. The basic point is that mortgage interest rates were low and stable during the 1990s. the overall national average) for all households in this age group. most of the newer and high-quality housing is in the suburbs. Affordable Housing and Gentrification The issues of affordable housing and gentrification are much on the minds of the public. gentrification has contributed to the increase in housing costs experienced by this group. In this kind of housing market in the suburbs. The construction of the expressways in the 1950s and 1960s in USA. at least up to the 1970s. A study by White (1986) showed that the most important factor in housing abandonment in New York City during the late 1970s was a high property tax bill compared to the rents the building can earn. The poor represent about 12% of all households. this changed during the housing price bubble of the 2000s. Rising real incomes. For example. Mieszkowski and Mills (1993) argue that the filtering model provides a primary reason for the movement of population to the suburbs and for the concentration of low-income households in central cities. The fact is that in all the metropolitan cities. low-income households. The old minority neighbourhoods increasingly became areas of abandonment. for the two-thirds of households that own the home. on average. stimulated new construction as well. and economists. p. Central cities sometimes have lost the race against abandonment.

But low-income households in Boston generally have experienced reductions in housing affordability without compensating changes in public services or neighbourhood quality. . In the extreme case. Gentrification is a symptom of the broader trends in the urban economy. Rental units are larger and very few lack plumbing facilities or adequate electricity or heating. In Vigdor’s view gentrification is a result of broader trends that affect the poor rather than a direct cause of any change in the well being of the poor. Gentrification is defined as private residential and commercial development (usually in central city) that includes the movement into the neighbourhood of households with larger incomes than the current residents. Does gentrification contribute to the problem of housing affordability? Vigdor (2002) has considered this question at length. Vigdor (2002) finds no evidence that low-income households move out of their housing units. It is ironic that the people who are concerned about housing affordability are also in favour of growth controls and strong land-use regulation. Some of the increase in rents can be attributed to increases in the quality of rental housing. land-use and zoning regulations. Making rental housing more affordable will depend upon increasing housing supply and increasing the income of poor households. and stringent building codes. higher-quality units supplied.53 in 1980 to 0. Vigdor’s detailed study of Boston shows that gentrification as defined does not necessarily mean that poor households suffer a decline in living standards. gentrification tends to increase the tax base of the central city and might therefore lead to improvements in public services. Vigdor (2002) has found that there is a general problem of housing affordability among the lowincome renters in Boston.x Renter households in the lowest 20% of the income distribution experienced a large increase in the ratio of rent to income – from 0. generous provisions for open space. and this trend has numerous underlying economic causes. This finding matches the conclusion of Quigley-Raphael (2004) study of entire nation. He finds that poor households are more likely to leave poverty than to be displaced from the housing units by higher-income households. The trend in rents depends upon factors that influence the overall supply of rental housing.55 in 2000. While some of the increase in rents stems from increases from quality. The increase in quality can partly be attributed to government restrictions – building codes and housing codes that mandate standards. As we know.47 in 1960 to 0. Gentrification might increase employment opportunities in the central city and reduce the concentration of poverty as well. Furthermore. It is possible that low-income households would have chosen housing units of lower quality than required by the building and housing codes imposed by local governments. The filtering model discussed above implies that rents for housing at the bottom of the housing supply continuum depend upon the quantity of new. housing in urban areas has become less affordable for the poor over time. growth controls. it is also true that rents increased after adjusting for quality. Quigley and Raphael (2004) showed that this decrease in affordability in the 1980s and 1990s can be attributed almost entirely to increases in rents rather than decreases in income of the low-income population. Any factor that reduces the rate of housing construction is implicated. In essence. some households choose to be homeless. The proportion of this group that spent more than 30% of income on rent increased from 62% in 1960 to 69% in 1980 to 79% in 2000.

incomes) vary a great deal. but that institutions and constraints (e. They assembled data for 1960 to 1970 for 24 countries on the recorded production of housing units and on the change in the total number of housing units (including informal housing). “Informal” housing. is of such poor quality that it is not counted as part of the official housing stock. These concerns lead governments to institute programs that provide funds for low interest loans for private housing and to build subsidized housing directly. and regulations that govern land use and buildings. These include zoning laws. The importance of property rights is emphasized by Malpezzi and he notes that legal systems are in flux in many developing countries. Rights must be set out in contracts that are the outcome of a competitive market process. building and housing codes. because the price of housing rises as economic development proceeds. Annez and Wheaton (1984) were motivated by the lack of long-run studies of the housing sector that address these concerns. laws. They began by pointing out that a large number of low-income households in developing countries consume housing that is below a socially desirable standard. environmental laws. “Property rights profoundly affect not only the efficiency of the housing market. they also profoundly affect other social goals or questions such as the distribution of wealth and income. Another concern is that. However. In Malpezzi’s view (1999). such as the favelas in Brazil. It is fair to say that both mainstream and conservative housing economists think that housing is provided most efficiently by private suppliers who operate within a system of competitive markets with well defined real property rights and reasonable land-use regulations.” Another critical expect of institutions is the nature of land-use regulations – the body of customs. the number of informal housing units that serve as permanent shelter is enumerated in the census of population. and there must be clear remedies for the violation of agreements by either party. the net effect of economic development may be little or no improvement in housing. Their findings for the ratio of recorded production to change in number of housing units for some developing countries are as follows: .Housing in Developing Countries This section deals with the housing markets in developing countries based upon the survey of the topic by Malpezzi (1999). He emphasizes the rights of owners of poverty. and so on. deed restrictions. but also points out that the rights of landlords and tenants must be well defined.g. Another article by Annez and Wheaton (1984) explored basic economic relationships between economic development and housing in a cross section of countries. Informal housing is not recorded in the official data on housing production – data on building permits and housing starts. Malpezzi’s basic point is that the behaviour of households and firms in the housing market is similar from country to country.. Annez and Wheaton (1984) used a particularly clever technique to measure the importance of informal housing.

24 Germany (West) 1. De Soto (2000) estimated that 85% of urban dwellings in the developing countries of the world are of the informal type. or construction of public housing.6 billion people.7 trillion dollars in 1997. In contrast.0 because some units are removed from the stock because they have reached the end of their useful lives.0 for these 8 countries in the 1960s and below 0.52 Egypt 0. The results for some of those countries are: Country Ratio of Recorded Production to Change in Housing Stock Australia 0. The value of these dwellings is a primary source of capital that de Soto believes needs to be “unlocked” to facilitate economic development.02 United Kingdom 1. so it is likely that some construction of housing went unrecorded in the official data. As expected.23 If all housing units that were constructed over the decade have been recorded. Annez and Wheaton (1984) hypothesized that the change in the housing stock is driven by demographic factors (not housing prices and income).72 Venezuela 0. but it was not found to be related to construction cost of recorded units.92 Japan 1. Furthermore. Presumably public housing is constructed at a higher level of quality than informal housing. the average size (square/footage) of the recorded units that were .85 Canada 0.61 Australia and Canada are two nations that still had “frontier” areas at that time.28 Panama 0.50 for 5 of them. and that price and income determine the size and quality of the units.0. However. This last result suggests that public housing simply replaces housing units that would exist anyway. then this ration should be greater than 1. the ratio was well below 1. cost of construction of the recorded units. were worth a total of 6. Their econometric results show that the change in the housing stock (as recorded by successive censuses) is a positive function of the change in population and a negative function of the change in average household size – and does not depend upon GNP per household. He estimated that these 329 million dwellings. provision of loans. the ratio of recorded production to the change in the stock for developed countries was close to or exceeded 1. the ratio of recorded production to change in the housing stock was found to be strongly positively correlated with GNP per household.40 Philippines 0. This is evidence that a large fraction of the additional housing units was of the “informal” type.56 Colombia 0. which housed about 1.98 United States 1.14 Syria 0.93 France 1.36 Costa Rica 0.Country Ratio of Recorded Production to Change in Housing Stock Chile 0.

1966. They also found that provision of loans (measured as the ration of loan to value) increased unit size. supported by clear real property rights and reasonable regulations. Downes. at a socially desirable level) housing responds to economic development in the long run. the study by Malpezzi and Mayo (1997) shows that a restrictive regulatory environment means that the formal recorded housing supply is restricted – so that housing quality improvements are inhibited as economic development proceeds. The basic conclusion is that.” working paper. “Exclusionary Policies in Urban Development: UnderServicing Migrant Households in Brazilian Cities. The data on housing asset prices pertains to recorded housing transactions. pp. redevelopment. “A New Approach to Consumer Theory. DC: The Urban Institute Press. if GNP per household increases by 1%. 2003. 2009. Brown University. they found that the cost per square foot increased with GNP per household.57) = 0. Another restrictive technique is to limit access to basic public services. and has been the topic of studies by Malpezzi (1999) and others.S. A recent study by Feler and Henderson (2009) finds that localities in Brazil withhold access to public services to discourage migration to the urban area. Feler. They examined the changes in the relative asset prices of housing as these economies experience growth. Washington. housing quality improves because fewer new units are of the “informal” type.. the supply of recorded (i. “Economic Development and the Housing Sector: A Cross-National Model. 1984. Green. Vol. and finance) with Thailand and the U. References Annez. 74.” Economic Development and Cultural Change. These empirical results imply that. Kelvin. A Primer on Housing Markets and Housing Policy. While there can be supply bottlenecks in the short run. .45)(0. 132-157. 52. and William Wheaton..constructed depended on GNP per household (Positive sign) and cost of construction per square foot. Leo. Vol. 32.45. Richard. pp. and found that housing supply was essentially perfectly elastic in Thailand and the U. pp.” Journal of Urban Economics. and Vernon Henderson. (countries with liberal regulatory environments). 2002.51 and the estimated price (cost) elasticity of unit size is – 0.S. but that unit size of recorded units does not increase by a large amount.15%.41-(0. Annez and Wheaton (1984) did not examine the regulatory framework and its impact on the housing market. This issue is important.e. One study by Malpezzi and Mayo (1997) compared housing supply elasticities in Malaysia and South Korea (countries with highly restrictive regulations regarding land use. which presumably responded to population growth as expected.57. Their study focuses on provision of access to water provided by the public sector to the areas of informal housing. and very low (virtually zero) in Malaysia and South Korea. Lastly. The estimated income elasticity of unit size is 0. Lancaster. Zabel. 749-766. and Stephen Malpezzi. and that this elasticity is 0. then unit size for recorded units will increase by 0.” Journal of Political Economy. This again leads to the proposition that housing is best supplied by the private market. Vol. and Jeffrey E. so the rising prices observed in Malaysia and South Korea do not pertain to the informal housing stock. Thomas A. In essence. “The Impact of School Prices on Housing Prices: Chicago 1987-1991. Philipp. These are reasonable estimates of demand elsasticities for housing. as economic development proceeds. 1-25.

1999. Vol. Sherwin. “Does Gentrification Harm the Poor?” Brookings-Wharton Papers on Urban Affairs. Christine. “Hedonic Analysis of Housing Markets. . Cheshire and E. 1974. eds. Vigdor. “Is Housing Affordable? Why Isn’t It More Affordable?” Journal of Economic Perspectives. Vol.” Journal of Political Economy.” in P. Whitehad. Handbook of Regional and Urban Economics. New York: Basic Books. Stephen. Cheshire and E. Stephen. Sheppard. Soto. 2002. 1999. 82. Amsterdam: North Holland. 3. pp. 18.” in P. 3. 3. Amsterdam: North Holland.” in Paul Cheshire and Edwin Mills. 34-55. Mills. pp. Vol.Malpezzi. “Hedonic Price and Implicit Markets: Product Differentiation in Pure Competition. pp. 133-160. 2004.. eds. and Steven Raphael.. eds. 2000. Vol. “Economic Analysis of Housing Markets in Developing and Transition Economies. Handbook of Regional and Urban Economics. Vol. The Mystery of Capital. “Urban Housing Markets: Theory and Policy.. Vol. John. Hernando de. 191-214. 3. Handbook of Regional and Urban Economics. Mills. Quigley. Jacob. Amsterdam: North Holland. 1999. Rosen.

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