Stimulus

Economic Decision to Purchase a New House We use Economics Theory knowingly or unknowingly in our day to day decision making. Our action is guided by the knowledge we possess. If we buy something, we take decision based on relevant economics theories either consciously or unconsciously. When we take decision whether to buy a new house or not, first thing which comes to our mind is price. Because of heavy investment involved, deciding to purchase a new house is very important decision for anyone. Demand of house is price elastic. It follows law of demand. If price of the house is lower, there will be more demand for houses and vice-versa. Also, since demand of house is price elastic, it is influenced by the consumer income. If consumer income is high, price of houses will be high and if consumer’s income is low, price of houses will be lower. First thing which we analyze while buying a house is the benefits from it. As buying a house requires to spend huge money, buyer has to think from where he will arrange the money. Even if money can be arranged, what is the cost of the funding. Can this money be used somewhere else and earn more benefit' This alternate investment may give direct benefit (for example if invested in stock) or long term indirect benefit (for example if invested in children’s education). What benefits buyer can expect are – saving of rent, if house is purchased closer to place where buyer works then saving in terms of transportation cost and price appreciation of the house. There are some intangible benefits also, like feelings of owning a house, having freedom to decorate house and make it environment friendly etc. Buyer needs to analyze the alternatives where buyer can put money and see if it is more beneficial to buy a house. In Economics, this is called “Opportunity Cost”. Opportunity cost is whatever must be given up to obtain some item. (Mankiw, 2004) If buyer is buying a house, he is foregoing the opportunity to put money in alternative which would generate some return for the buyer. The benefit from buying a house should exceed the opportunity cost. If buyer buys house as investment, buyer is diversifying his portfolio by adding one more asset class in his portfolio. Investing in real estate is an example of Vertical Diversification. Diversification helps the investor mitigate risk. Vertical diversification spreads investor’s money between different types of assets. Cash, government bonds, corporate bonds, property and shares can each be expected to behave slightly differently, and so potentially produce different returns, as circumstances change. (Monevator.com, 2009) Another Principle of Economics which guides in decision making is Marginal Benefit and Marginal Cost. Buying a hosue makes sense only if Marginal benefit from owning the house exceeds Marginal cost. Marginal benefits include saving of rent, saving of transportation cost and other savings as a result of owning the house and tax benefit . Marginal cost is the interest payment made on the loan for purchasing the house and loss of interest income on the savings which buyer puts in buying the house. Total Marginal benefits should be higher than total Marginal cost. Marginal benefits and Marginal costs depend on the locality where house is purchased, amenities available in the housing complex (eg. Gym, swimming pool etc which results in savings and hence higher marginal benefit), price of the house (higher the price of house, higher the marginal cost) etc. Buyer’s income can turn the benefits in the favor of buyer. If buyer has higher income, he will choose a house which would give higher marginal benefit. On the other hand, for a buyer having lower income, choice is limited. The state of economy affects marginal benefits and marginal costs associated with purchasing a new house. If economy is strong, consumer’s income would be higher. As in strong economy consumer can expect that his income will also grow with the growth of GDP, consumer can have more disposable income. In strong economy buyer’s purchasing power will be higher. Buyer can spend more money on buying house and can still have money to cover his other expenses and maintain lifestyle. However, if economy is weak and going through recession or slowdown, consumer income will be lower. With lower income, consumers will have to spend higher portion of their income for necessary things like food, clothes, petrol etc. In such case, consumer’s disposable income will also be lower. Moreover, in weak economy unemployment rate is also higher and consumers will prefer to save money for uncertain future than buy a house. In weak economy, marginal cost of buying a house will exceed the marginal benefits from owing a house and so there will be very few buyers of new house. The state of economy is influenced by domestic and international trade. Domestic economy is made up of components such as government spending, consumer’s spending, trade and investment. Any change in any of these components affect the economy. For example, if government spending increases, it has expansionary effect on economy. On the other hand, if government spending decreases, it has contractionary effect on the economy. The monetary policy is also a factor which influences the economy. If money supply in system is increased (by lowering discount rate, lowering discount rate or buying bonds ), it has expansionary effect on economy. On the other hand, if money supply is reduced in system, it has contractionary effect on economy. (Mankiw, 2009) International trade affects balance of trade of a country. Balance of trade of a country is export minus import. If export exceeds import, balance of trade is favorable for a country. Higher international trade helps the GDP to grow as domestic companies have access to larger market and they can produce more. A favorable balance of trade helps the economy grow faster. If economy is growing, there will be more jobs, higher consumer income and higher consumer spending which will increase GDP even further. International trade can affect housing industry directly also. If industry can import construction material cheaper, cost of building house would come down and it will become affordable for larger section of consumer resulting in higher demand for houses. If I decide to buy a house, it will be based on my current income, location of house, price of house, my expectation of future income, prospects of capital appreciation of house, general condition of economy (if economy is strong, I would expect higher income in future and capital appreciation of house) and alternative avenues of investment. If situation changes, I may take a different decision. A buyer would buy a house only if marginal benefit from house is greater than marginal cost. If buyer is afraid that his income will go down in future due to recession/slow down or he may lose job, he will not purchase a house. Also, if price of house is coming down, there will not be capital appreciation (in fact there will be loss) and I will not buy a house. Another factor which will influence my decision is inflation adjusted return from investment in stocks and bonds. If stocks and bonds generate high inflation adjusted return, opportunity cost in buying a house will be very high and I would prefer to invest in alternative avenue and earn higher return. My decision will also be influenced by the possibility of natural disaster, terrorist attack in hat locality and possibility of war. Also, if situation changes and the place becomes unhealthy (for example if some chemical factory is coming up in that area), I would prefer to not to move there and not to buy a house. Whether to buy a house or not depends on so many factors and as factor changes, buyer’s decision would change. World economy is going through recession and many countries are facing sovereign default risk. Consumer’s are less optimistic about the future and have chosen to scrimp and save so as to last through the recession. Therefore, this has resulted in a decline in demand for houses (Tapper & Travers, 2009). As demand has declined, price of houses has also declined. As situation improves, there will be more buyers in the market and there will be more demand for houses. Since buying a house requires substantial outlay, a buyer will analyze several factors before considering buying a house. References Mankiw N. G.(2009). "Principles of Macroeconomics". 5th Edition. Publisher: South-Western Mankiw N. G.(2004). "Principles of Microeconomics". 3rd Edition. Publisher: South-Western No Author. (2009). “Portfolio Diversification”. Retrieved on June 26th, 2010. From: http://monevator.com/2009/02/26/portfolio-diversification/ Tapper, J., & Travers, K. (2009). “President Obama Predicts Unemployment Will Hit 10% This Year”. Retrieved on June 26th, 2010. From: http://blogs.abcnews.com/politicalpunch/2009/06/president-obama-predicts-unemployment-will-hit-10-this-year.html