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There has been growing concern that the Celtic Tiger’s resurgence over the last couple of years was based on property prices increases. With house prices slowing, developers may have to spend more on building to make a sale
In a recent obituary in the Economist it was said that Ralph Harris, who was the general director of the Institute of Economic Affairs—a hugely influential think tank underpinning the Thatcher revolution in the UK—wrote that the law of supply and demand was the nearest social science approached to the laws that governed the universe. He was probably not wrong. The law of supply and demand is firmly part of how we see the world. It is, therefore, not surprising that we expect that an increase in the cost of producing something will generally lead to a price increase in the market. But all markets may not work in precisely the same way and housing markets are something of an exception. This is often not appreciated sufficiently by the public generally.
Consider the following. In urban areas the supply of newly built housing is limited and is only a small percentage of the existing stock of accommodation. This has a major effect on the functioning of the market. In such a market demand for housing is primarily met from the existing stock with a very limited additional supply coming from developers. The price is, therefore, determined by demand for the existing stock which does not cost money to produce in terms of labour and materials.
This can be clearly seen in a city such as London where there is very little supply of new housing relative to the demand and the cost of construction is only a fraction of the market price of existing houses. This is similarly the case in Dublin at present where the cost of construction of a three bed semi-detached house could be about a third of the value.
Of course the difference will be found in the cost of the land.
This is where we come to an issue which is much disputed and on which there is no definitive wisdom as is the case of the law of supply and demand. Starting from the point that it is the demand for the existing stock that sets the price of houses in urban areas, it is argued that the cost of land is simply that which is left over after all the other costs of development have been deducted from the market price. The land or site for the house does not cost anything to produce in terms of labour and materials. Cost, therefore, cannot be related simply to the cost of production.
This suggests that developers approach the market for land on the basis that, given the market price of houses, the amount they can afford to pay for land will be determined by how much it costs to build profitably. Hence land is a residual and the price determined by the price of houses.
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