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1 PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University Working with Supply and Demand CHAPTER 1 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Government Intervention in Markets Governments –Sometimes intervene to change the market outcome –Fight the market Prevent the price from reaching equilibrium value –Price ceilings –Price floors –Manipulate markets Changing the equilibrium itself 2 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Fighting the Market: Price Ceilings Price ceiling –Government-imposed maximum price in a market Short side of the market –The smaller of quantity supplied and quantity demanded at a particular price When Q D and Q S differ –The short side of the market will prevail 3 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Fighting the Market: Price Ceilings Shortage –Excess demand not eliminated by a rise in price –Q D > Q S Price ceiling: creates a shortage –Increases the time and trouble required to buy the good –Price decreases –Opportunity cost may rise 4 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 Figure A Price Ceiling in the Market for Maple Syrup 5 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 Number of Bottles of Maple Syrup Price per Bottle $ , ,000 S D E R V , decreases quantity supplied … 3. and increases quantity demanded, creating a shortage equal to the distance between R and V. 1. A price ceiling lower than the equilibrium price …

6 Fighting the Market: Price Ceilings Black market –A market in which goods are sold illegally at a price above the legal ceiling –Price: above equilibrium price Unintended consequences of price ceilings –Long lines –Black markets –Often higher prices 6 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7 Figure A Price Ceiling with a Black Market 7 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Number of Bottles of Maple Syrup Price per Bottle 50, ,000 S D E R V the lower quantity supplied will sell for a price even higher than the equilibrium price. 1. With a price ceiling lower than the equilibrium price and a black market... T $4.00

8 Fighting the Market: Price Ceilings Rent control –Price ceiling imposed in a rental housing market –Government-imposed maximum rents on apartments and homes –Purpose: to keep housing affordable Especially for those with low incomes 8 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9 Fighting the Market: Price Ceilings Problems with rent control –It doesnt target those with low incomes Luck –Persistent excess demand Wasted time Black market –Rent: higher than rent-controlled price –Decrease in the quantity of apartments supplied 9 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10 Fighting the Market: Price Floors Price floor –Government-imposed minimum price in a market –Purpose: to help sellers Price floors for agricultural goods –Price support programs –United States Department of Agriculture Programs to maintain high prices for cotton, wheat, rice, corn, tobacco, honey, milk, cheese, butter, peanuts, sugar, dairy products 10 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11 Fighting the Market: Price Floors Surplus –Excess supply not eliminated by a fall in price –Q S > Q D Price floor –Surplus of a good –Temptation: to sell the surplus below the price floor –Government: purchases the surplus 11 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12 Figure A Price Floor in the Market for Nonfat Dry Milk 12 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Millions of Pounds Price per Pound S D E K J $ Decreases quantity demanded … 3. and increases quantity supplied. 1. A price floor higher than the equilibrium price … 4. The result is a surplus the distance between K and J.

13 Fighting the Market: Price Floors Government: limit any excess supplies –Dairy market: control the production and sale –Government: ordered or paid farmers not to grow crops on portions of their land –Imposed strict limits on imports of food from abroad 13 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

14 Fighting the Market: Price Floors Critics –Government spends too much money buying surplus agricultural products –Higher prices distort the publics buying and eating habits –Assistance: support all farmers Many farmers are wealthy individuals or powerful corporations More cost-effective if given directly to those truly in need 14 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15 Manipulating the Market: Taxes Excise tax –A tax on a specific good or service –Can be collected from either sellers or buyers Tax incidence –The division of a tax payment between buyers and sellers –Determined by comparing the new (after tax) and old (pretax) market equilibriums 15 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16 Manipulating the Market: Taxes Tax shifting –Some/all of a tax imposed on one side of a market –Ends up being paid by the other side of the market Excise tax on sellers –Shifts the supply curve upward by the amount of the tax –Incidence: both sides of the market Buyers pay more and sellers receive less 16 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17 Figure After a $0.60 per gallon tax is imposed on sellers, the price at which any given quantity would be supplied is $0.60 greater than before, so the supply curve shifts upward. For example, before the tax, 400 million gallons would be supplied at $3 per gallon (point A); after the tax, to get that same quantity supplied requires a price of $3.60 (point A). A Tax on Sellers Shifts the Supply Curve Upward 17 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Millions of Gallons per Day Price per Gallon $3.60 S After Tax S1S1 A A

18 Figure After a $0.60 excise tax is imposed on sellers, the market equilibrium moves from point A to point B, with buyers paying sellers $3.40 per gallon. But sellers get only $3.40 $0.60 = $2.80 after paying the tax. Thus, the tax causes buyers to pay $0.40 more per gallon, and sellers to get $0.20 less than before. The Effect of an Excise Tax Imposed on Sellers 18 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 Millions of Gallons per Day Price per Gallon $3.40 S After Tax S1S1 D A 300 B 2.80 Buyers pay this price to sellers. Sellers get this price (after paying tax).

19 Manipulating the Market: Taxes Excise tax on buyers –Shifts the demand curve downward by the amount of the tax –Tax incidence – both sides of the market Buyers pay more Sellers receive less 19 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20 Figure After a $0.60 per gallon tax is imposed on buyers, the price at which any given quantity would be demanded is $0.60 less than before, so the demand curve shifts downward. For example, before the tax, 400 million gallons would be demanded at $3 per gallon (point A); after the tax, that same quantity would be demanded at a price of $2.40 (point A). A Tax on Buyers Shifts the Demand Curve Downward 20 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 Millions of Gallons per Day Price per Gallon $3.00 D1D1 A D After Tax A

21 Figure After a $0.60 excise tax is imposed on buyers, the market equilibrium moves from point A to point C, with buyers paying sellers $2.80 per gallon. But buyers pay a total of $ $0.60 = $3.40 per gallon when the tax is included. Thus, the tax causes buyers to pay $0.40 more, and sellers to get $0.20 less, just as when the tax is imposed on sellers. The Effect of an Excise Tax Imposed on Buyers 21 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Millions of Gallons per Day Price per Gallon $3.40 D1D1 D After Tax S 3.00 A 400 C Buyers pay this price (including tax). Sellers get this price from buyers.

22 Manipulating the Market: Taxes Tax incidence –Distribution of tax burden between buyers and sellers Tax incidence vs. tax collection –The tax incidence is the same whether the tax is collected from buyers or sellers 22 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23 Manipulating the Market: Subsidies Subsidy –A government payment to buyers or sellers on each unit purchased or sold Medical care for the poor and elderly Energy-saving equipment Smoking-cessation programs College education 23 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24 Manipulating the Market: Subsidies Subsidy to buyers –Shifts the demand curve upward by the amount of the subsidy –Benefits both sides of a market Buyers pay less Sellers receive more for each unit sold 24 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

25 Figure After a $10,000 subsidy is given to college students, the market equilibrium moves from point A to point B, with students paying colleges $31,000 per year. But students pay a total of $31,000 $10,000 = $21,000 when their subsidy is deducted. Thus, the subsidy causes students to pay $4,000 less per year, and it causes colleges to get $6,000 more per year. A Subsidy for Students Attending College 25 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Number of Students Attending College Price per Year 21,000 4 million $31,000 S 25, million D1D1 D After Subsidy B A Colleges get this price Students pay this price (after deducting subsidy)

26 Manipulating the Market: Subsidies Subsidy to sellers –Shifts the supply curve downward by the amount of the subsidy –Benefits both sides of a market Buyers pay less Sellers receive more for each unit sold Distribution of benefits from a subsidy –Are the same, regardless of whether the subsidy is paid to buyers or sellers 26 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

27 Supply and Demand in Housing Markets Stock variable –Measures a quantity in existence at a moment in time Housing stock: number of homes that people own at a given time Flow variable –Measures a process that takes place over a period of time New home construction New home purchases 27 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

28 Supply and Demand in Housing Markets Housing markets –Newly constructed homes and previously owned homes are very close substitutes The stock approach: demand and supply –Supply of housing: housing stock –Demand for housing stock 28 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

29 Supply and Demand in Housing Markets Supply curve for housing –Total number of homes in a market that are available for ownership –Vertical line Housing stock at any point in time is fixed Number of homes that were built in the past and still suitable for ownership 29 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30 Figure In panel (a), the supply curve tells us the number of homes (600,000) that exist at a particular time. It is a vertical line because the housing stock at any time does not depend on the price. Panel (b) shows the impact of building 200,000 new homes over the year. The housing stock rises to 800,000 so the supply curve shifts rightward, from S 1 to S 2. The Supply Curve in a Housing Market 30 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 Number of Homes Price per Home Supply 600,000 $150,000 $100,000 $200,000 Number of Homes Price per Home S1S1 600,000 $150,000 $100,000 $200,000 S2S2 800,000

31 Supply and Demand in Housing Markets Shifts vs. movements along the supply curve –Movement along: when the price of homes changes –Shift: changes in the housing stock 31 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

32 Supply and Demand in Housing Markets Demand curve for housing –Total number of homes that everyone in the market would like to own –At each price –Given the constraints that they face –Slopes downward 32 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

33 Supply and Demand in Housing Markets Home ownership –An alternative to renting Monthly cost of owning a home –Maintenance, property taxes, interest Monthly costs for prospective owners –Foregone monthly interest –Mortgage and interest –Higher home prices Higher cost of ownership 33 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

34 Supply and Demand in Housing Markets Mortgage –Loan given to a homebuyer –Part of the purchase price of the home Monthly costs for current owners –Foregone interest –Higher home prices Higher cost of ownership 34 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

35 Supply and Demand in Housing Markets Ownership Costs –Interest cost of ownership Both current and prospective homeowners –This cost rises when current home prices rise, and falls when current home prices fall 35 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

36 Figure In panel (a), the demand curve tells usat each pricethe number of people who would like to own homes. It slopes downward because a decrease in the average selling price of a home lowers the ongoing interest cost of home ownership, increasing the number of people who want to own. The Demand Curve in a Housing Market (a) 36 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10 Number of Homes Price per Home $200, ,000 $150,000 $100, , ,000 Demand D1D1 A B C

37 Figure In panel (b), tastes change in favor of home ownership. More people would like to own at each price, so the demand curve shifts rightward from D 1 to D 2. The Demand Curve in a Housing Market (b) 37 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10 Number of Homes Price per Home 600, ,000 D1D1 $150,000 D2D2

38 Supply and Demand in Housing Markets Shift vs. movement along the demand curve –Movement along: change in price, other things constant –Shift: changes in Monthly cost of renting a home Interest rates in the economy Tastes for homeownership Average income Population 38 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

39 Housing Market Equilibrium Equilibrium –Intersection of demand and supply The equilibrium price in a housing market –The price at which the quantity of homes demanded and quantity supplied are equal Quantity of homes demanded –Number of homes that people want to own Quantity of homes supplied –Housing stock 39 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

40 Figure If the price were lower than the equilibrium pricesay $100,000the number of homes people want to own (900,000 at point C) would be greater than the number in existence and currently owned (600,000). People would try to buy homes, and the price would rise until only 600,000 were demanded. Equilibrium in a Housing Market 40 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11 Number of Homes Price per Home $200,000 Demand A $150,000 $100, , ,000 C Supply 600,000 B The equilibrium in this market is at point B, where the price of homes is $150,000. If the price were highersay $200,000 the number of homes people want to own (300,000 at point A) would be less than the number in existence and currently owned (600,000). Owners would try to sell, and the price would fall until all 600,000 homes were demanded.

41 What Happens when Things Change Over time –Supply curve shifts rightward As the housing stock rises (new homes are built) –Demand curve shifts rightward Population growth, rising incomes –Market equilibrium will move rightward Home prices: relative shifts in the supply and demand curves 41 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

42 What Happens when Things Change Equal changes in supply and demand –Housing stock grows at the same rate as housing demand –Housing prices: unchanged –A stable housing market 42 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

43 Figure When the supply of homes increases at the same rate as demand for them, the equilibrium price remains unchanged. In the figure, the rightward shift in the supply curve (from S 1 to S 2 ) is equal to the rightward shift in the demand curve (from D 1 to D 2 ). Equilibrium moves from point B to point E, but the price remains at $150,000. A Stable Housing Market 43 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12 Number of Homes Price per Home D1D1 $150,000 S1S1 600,000 B S2S2 610,000 D2D2 E

44 What Happens when Things Change Restrictions on new building –Slow increase in supply –Housing stock grows slower than the demand –Rapidly rising prices 44 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

45 Figure When supply is restricted, and cannot increase as fast as demand, housing prices rise. In the figure, the rightward shift in the supply curve (from S 1 to S 2 ) is less than the rightward shift in the demand curve (from D 1 to D 2 ). Equilibrium moves from point B to point G, and the price rises from $150,000 to $200,000. A Housing Market with Restricted Supply Growth 45 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13 Number of Homes Price per Home D1D1 $150,000 S1S1 600,000 B S2S2 603,000 D2D2 F $200,000 G 610,000

46 What Happens when Things Change Faster demand growth –Due to Population shifts –Sudden influx of new residents Rapid income growth –Booming industry in the area Change in expectations about future prices –Rapidly rising prices 46 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

47 What Happens when Things Change House: an asset –One of the most leveraged financial investments Leverage –Magnifies the impact of a price change on the rate of return you will get from an asset Capital gain –Gain to the owner of an asset When it is sold for a price higher than its original purchase price 47 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

48 What Happens when Things Change Capital loss –Loss to the owner of an asset When it is sold for a price lower than its original purchase price Faster demand growth –The housing stock typically lags behind, and housing prices rise 48 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

49 Figure When demand begins to increase faster than previously, increases in supply usually lag behind. In the figure, the rightward shift in the supply curve (from S 1 to S 2 ) is less than the rightward shift in the demand curve (from D 1 to D 2 '). Equilibrium moves from point B to point J, with the price rising from $150,000 to $185,000. Accelerating Demand Growth 49 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14 Number of Homes Price per Home D1D1 $150,000 S1S1 600,000 B S2S2 610,000 D2D2 J $185,000

50 The Housing Boom and Bust 1997–2011 Housing price index –Index measure of inflation-adjusted U.S. housing prices 1997 – 2006 –Housing price index almost doubled –Bubble Mid-2006 –Falling housing prices 50 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

51 Figure After adjusting for price changes from general inflation, the housing boom began in 1997, and home prices increased ever more rapidly until That marked the beginning of the housing bust, with prices dropping dramatically for several years. Index of Home Prices, Adjusted for Inflation 51 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15

52 The Housing Boom : accelerated demand growth –Supply increased, but it lagged behind –Result: a surge in housing prices Causes for rapidly rising demand –Economic growth –Low interest rates The Fed Global financial forces 52 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

53 The Housing Boom Causes for rapidly rising demand –Government policy: encouraged home ownership Mortgage interest payments: deducted from taxable income Increased funding available for mortgage lending Higher capital gains exclusions on home sales 53 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

54 The Housing Boom Causes for rapidly rising demand –Financial innovations More-attractive terms for borrowers (ARM) Securitization: made mortgage-lending more attractive –Mortgage-backed securities –Deteriorating lending standards Subprime loans Declining down-payments –Speculation 54 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

55 Figure The Housing Boom in Las Vegas 55 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16 Number of Homes Median Home Price D 2003 $179,000 S 2003 Q1Q1 A S 2006 Q2Q2 D 2006 B $324,000

56 The Housing Bust Mid-2006: a sudden drop in demand –Oil and gasoline prices spiked Many new homeowners were struggling to make ends meet –Interest rates on a large group of adjustable rate mortgages reset to higher levels –Disturbing rise in defaults Subprime mortgages with no down payments –Prospect of higher default rates 56 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

57 The Housing Bust Mid-2006: a sudden drop in demand –Interest rates on new mortgages rose –Demand curve for housing shifted leftward Housing prices fell –Speculation Demand curve shifted further leftward Housing prices fell even more rapidly 57 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

58 Figure The Housing Bust in Las Vegas 58 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17 Number of Homes Median Home Price D 2008 $178,000 S 2006 Q2Q2 S 2008 Q3Q3 D 2006 B $324,000 E

59 The Long Housing Slump End of 2008 through 2011 –The U.S. economy suffered the aftermath of an unusually severe recession –High unemployment and declining incomes Millions of homeowners struggling to pay their monthly mortgage bills More mortgage defaults 59 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

60 The Long Housing Slump End of 2008 through 2011 –Financial institutions foreclosed on close to 3 million homes Several million additional homes had received legal notices Shifted the demand curve for housing further to the left 60 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

61 The Long Housing Slump U.S. home prices stabilized a bit in 2009 and early 2010 –Making Home Affordable Program Incentives for banks and homeowners to renegotiate mortgage agreements and prevent foreclosures –Additional tax benefits to new home buyers –Temporary effect at best 61 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

62 The Long Housing Slump 2010 –Home prices resumed their downward trajectory By mid-2011 –Average U.S. home price (adjusted for inflation) had fallen to 40% of its peak five years earlier 62 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

63 Understanding Leverage Without leverage –10% higher housing prices 10% capital gains –10% lower housing prices 10% capital loses Leverage –Magnification of gains and losses through borrowing 63 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

64 Understanding Leverage Leveraged financial investment –Using borrowed money to buy a home –10% higher housing prices More than 10% capital gains –10% lower housing prices More than 10% capital loses 64 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

65 Understanding Leverage An owners equity in an asset –Difference between the assets value and any unpaid debts on the asset –Equity in Asset = Value of asset - Debt associated with asset Simple leverage ratio –Ratio of an assets value to the owners equity in the asset 65 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

66 Figure Leveraged Buying and Selling 66 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. A.1

67 Understanding Leverage Simple leverage ratio = Rate-of-return multiplier Rate of return on the (leveraged) investment –Rate of change in a homes price –Times the leverage ratio 67 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

68 Understanding Leverage When asset prices rise –Leverage increases your rate of return dramatically When asset prices fall –Leverage increases the chance of wiping out your entire investment 68 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.


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