Saturday, 25 July 2015

Be careful with producer surplus, because housing is different

One of the most important concepts I teach in ECON100 and ECON110 is the concept of economic welfare. In the simplest terms economic welfare is made up of the net benefits that sellers get from selling a product (the producer surplus), and the net benefits the consumers receive from buying the product (the consumer surplus). Producer surplus is the difference between the price that producers receive for selling the product, and what the product costs them to produce. The consumer surplus is the difference between the maximum amount the consumer is willing to pay for the product, and the price they actually pay. Since it is made up of the benefits to sellers and the benefits to buyers, economic welfare therefore demonstrates the overall benefits that arise from the operation of a market.

Which all sounds fairly simple, but sometimes it isn't quite so easy to apply these concepts. Take owner-occupied housing for instance. In the New Zealand Herald on Wednesday, former Act Party leader Jamie Whyte writes:
To see why banning foreign buyers is a bad policy, start with the benefit to New Zealanders that occurs when one Kiwi buys a house from another Kiwi. Suppose Kiwi John buys a house from Kiwi Jane for $800,000.
John must value the house at least a little more than $800,000, otherwise he would have been unwilling to pay this much for it. Suppose the maximum he would have paid is $810,000.
Then he benefits $10,000, this being the difference between the $800,000 he paid and the value of the house to him. (Economists call the difference between what someone is willing to pay and what they actually pay the "consumer's surplus".)
Similarly, Jane must have valued her house at less than $800,000, otherwise she would not have been willing to accept this amount. Suppose she would have sold it for no less than $790,000. Then she benefits $10,000 from the sale.
So, the total benefit of the transaction to Kiwis is $20,000, split evenly between the buyer and the seller.
Now suppose instead that a foreigner, Fritz, had out-bid Kiwi John. To do this, he must have paid at least $810,001 since, by hypothesis, John was willing to spend up to $810,000. What is the benefit to New Zealanders in this case?
John is where he started, still with his $800,000 and without Jane's house. He gets no benefit from the sale of Jane's house to Fritz. But Jane's benefit has risen from $10,000 to at least $20,001. Which means the total benefit to New Zealanders has increased by at least $1. (In reality, the net gain will usually be in the thousands.)
There is a problem with the scenario above, in the calculation of Jane's producer surplus. If Jane is a owner-occupier and she sells her house, she then has the money from selling her house but has nowhere to live. She either has to buy a new house, rent, or live in her car or under a bridge. Let's ignore the latter three options for the moment.

Given Jane was willing to sell her house for no less than $790,000, that suggests that she can get a new replacement home for that cost. That's why she would be $10,000 better off (her consumer surplus), since she still has a home and has $10,000 left over in her bank account.

However, once Fritz is operating in the market, houses are now more expensive. He has increased the price of Jane's house by $10,001. If other houses had increased by less than $10,001, Fritz would prefer to buy one of those other houses. So, all houses must have increased in price by $10,001, including the house that Jane is intending to buy. So even though Jane might get $810,001 from Fritz for her house, to find somewhere new to live is now going to cost Jane $800,001 instead of $790,000. So, Jane's producer surplus is still $10,000, regardless of whether the purchaser is John or Fritz. Essentially, this is just a convoluted explanation of why buying and selling in the same market doesn't make you any better off on average, irrespective of prices.

Another way of thinking about this is in terms of the 'real value' of the economy. In this simple example, there is one house irrespective of whether that house is being transferred from Jane to John, or Jane to Fritz. Adding Fritz into the pool of potential buyers doesn't increase the total amount of real value in the economy (which is still just one house being sold), so in net terms having Fritz involved can't enrich Jane.

So, a government concerned about maximising benefits for New Zealanders should prefer the house transfer from Jane to John ($20,000 economic welfare = $10,000 consumer surplus for John + $10,000 producer surplus for Jane) over the house transfer from Jane to Fritz ($10,000 economic welfare for New Zealanders, since Fritz's consumer surplus doesn't count). Unless Fritz is moving to New Zealand perhaps?

Of course, if Jane is a property developer and not the homeowner, then things are different. Since she doesn't have to replace the house with another (or face living in her car), then the producer surplus doesn't change regardless of whether she sells to John or to Fritz. In this case, presumably the $790,000 minimum she is willing to accept for the house represents her costs of building (and financing, etc.). In this case the sale to Fritz does increase economic welfare by an additional $10,001 (or more). In terms of real value, because Jane built and sold a new house, it does increase the real value of the economy (by one new house).

Which I guess suggests that we should be in favour of following a similar policy setting to Australia, where foreigners can buy newly-constructed houses, but not existing homes?

More from my blog on Auckland housing:

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