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Housing Market Crash

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Housing Market Crash

Surely you have been in a situation where you wanted to buy something but it was out of stock. Unfortunately, this doesn’t just happen with everyday goods like clothes and food. It also happens with houses. This explanation will discuss why certain items are allocated inefficiently and we will look at the specific case of the housing market crash.

Housing Market Crash UK

To understand the housing market crash in the UK in 2008, we need to review what market failure is. An item being out of stock isn't a coincidence. In economics, this is known as market failure.

Market failure happens when the market fails to allocate resources efficiently.

There are many different types of market failure. The three we will briefly summarise in this article are:

Don't wait and read our Market Failure explanation.

Externalities

Externalities occur when the free market fails to take into account the effects of a decision on third parties.

An externality is the cost or benefit (to a third party) from the production or consumption of a good or service.

Externalities can be either positive or negative and can impact a single individual or society as a whole.

First, let's look at two examples.

Negative externalities

Negative externalities occur when the social costs are greater than the private costs. The costs to the third parties are greater than the private costs and it results in a loss of social welfare.

The pollution from cars is an example of a negative externality. It costs the consumer to buy a car. This is their private cost. But the pollution from the car is a large social cost. The pollution, congestion, and even the risk of an accident can affect third parties.

Positive externalities

Positive externalities occur when the social benefits are greater than the private benefits. As third parties benefit greatly from positive externalities, it should result in a gain of social welfare. However, in the free market there is underprovision or underconsumption of these goods and thus a loss in social welfare.

Education is a good example of a positive externality. The individual benefits from gaining more skills and increasing their productivity, but society benefits as a whole from the increase in productivity and a more skilled workforce.

These two concepts are explained further in the Externalities explanation. If you are struggling to understand, we suggest that you read that explanation and practice with the flashcards, before continuing with this one.

Public goods

Similar to positive externalities, public goods are underprovided by the free market despite benefiting society as a whole.

Public goods are goods or services that are available to all members of society.

For a good to be classified as a public good, it must meet two characteristics:

  1. Non-rivalrous.
  2. Non-excludable.

Non-rivalrous means that if one person uses the good, it doesn't stop another person from using it.

Non-excludable means that an individual cannot be stopped from accessing the good.

Street lamps are a good example of a public good. Walking under a street lamp doesn't reduce the light for others and you can't prevent someone else from using the street lamp.

Another example of a public good is the internet. Everyone can access a website and it doesn't reduce the amount available to others (Assuming that these websites are free to access).

Public goods are explained in more depth in the Public Goods explanation. Sharpen your understanding of public goods with that explanation and the provided flashcards before reading this one.

Merit and demerit goods

Merit and demerit goods are linked to positive and negative externalities.

Merit goods are goods deemed to be more beneficial to consumers than they realise.

There is an information gap that causes consumers to not fully understand the benefits of these goods. Merit goods generate a positive externality in consumption but tend to be under-consumed or produced.

Education and exercise are examples of merit goods. Consumers may not understand the long term benefits of education and exercise. Consuming more education tends to result in higher incomes and consuming more exercise tends to lead to a better quality of life and less burden on the healthcare system.

On the other hand, demerit goods generate a negative externality in consumption and tend to be over-consumed.

Demerit goods are goods deemed to be more harmful to consumers than they realise.

There is imperfect information that causes consumers not to fully understand the harmful effects of consuming these goods.

Cigarettes and alcohol are examples of demerit goods. Consumers may not fully understand the long term damaging effects of consuming cigarettes and alcohol and make the irrational decision to overconsume these goods.

Read our Merit and Demerit Goods explanation for more information on this topic.

Source of numerous housing market failures

Now that we have considered some of the different types of markets, we can focus on market failure in the housing market. The housing market can fail due to numerous reasons. Some of these sources of housing market crash are in the figure below.

Housing Market Failure, Causes of Housing Market Failure, StudySmarterFigure 2. Causes of market failure in the housing market, Alanna Odagbu, created with Flaticon - StudySmarter.

In this explanation, we will focus on three of these reasons in more depth: housing costs, geographic immobility, and environmental factors.

Housing costs

Since 2000, UK house prices have risen faster than incomes. In March 2021, the average house price is 65 times more than the average house price in 1970. But comparing incomes with the same years, the average income is only 35.8 times higher.1

Additionally, house prices are rising faster than inflation. Stagnating incomes and low inflation coupled with higher house prices make it difficult to buy homes, especially for first-time buyers.

With an increased demand for homes and rising prices, supply should increase. However, it is difficult to increase supply due to limited land and planning restrictions.

Environmental factors

With the climate change crisis, many governments are rushing to protect green space. Thus, they have implemented many restrictions on building houses in these areas.

Therefore, with less space to build and the rising demand for houses, the lack of houses will lead to a price increase due to limited supply. It also exacerbates the problem of homelessness and affordable housing.

Check out our explanations of 'Demand' and 'Supply' to learn more.

Geographical immobility

It’s no surprise that London has the highest house prices in the UK. Because of that many workers struggle to find suitable and affordable accommodation in the city.

The lack of affordable accommodation leads to other problems such as a shortage of skilled workers in areas of expensive housing.

Housing Market Failure Example: London StudySmarterThe city of London has a rising housing problem, Pixabay.

In London, many hospitals are experiencing a shortage of workers, partly due to the housing market.

Housing Market Crash of 2008

Housing market crash of 2008 is the most well-known example of market failure in the housing market.

The 2008 financial crisis began with relaxed regulations in the housing market. This allowed for those with poor or no credit history, to get loans and mortgages. These were known as subprime mortgages.

A subprime mortgage is a loan given to consumers with poor credit scores. Such consumers wouldn’t qualify for conventional loans and mortgages. This is important and quite significant because people with poor or no credit history are more likely to default on a loan.

Banks made enormous amounts of profit through selling complex financial products. Some of these complex financial products include mortgage-backed securities (MBS), credit default swaps (CDS), and adjustable-rate mortgages.

Mortgage-backed securities and credit default swaps

Mortgage-backed securities (MBS) had a large impact on the property market.

MBS are bonds secured by a home and other real estate loans. The investor who buys an MBS is lending money to individuals to buy a home. MBS turn a bank into an intermediary between the homebuyer and an investment firm.

A bank can grant mortgages to its consumers and sell them at a discount when an MBS is included. It benefits the bank and they lose nothing even if the homebuyer defaults. They were very popular because everyone benefited when everyone was doing their part.

You can read more about MBS in the '2008 Financial Crisis' article.

Credit default swaps (CDS) work hand in hand with subprime mortgages.

They allowed investors, who sold subprime mortgages, to ‘swap’ their risk with another lender. This meant that if a lender of subprime mortgages was worried that a consumer would default, they could use CDS to swap that risk. It is similar to insurance. However, it was unregulated and there was no requirement on the amount of money needed in reserves.

The unregulated housing market allowed investors and banks to take up large risks to increase their profits.

Rising house prices and the amount of risk financial institutions were taking up, led to the infamous financial crisis.

Financial markets and housing markets globally were all impacted. Some countries' financial and housing markets still haven't fully recovered today.

Impacts of the 2008 Financial Crisis on the housing market

In the UK, average house prices fell by 20% after the crisis. It took around six years for house prices to return back to pre-crisis levels, and arguably some areas in the UK still haven’t recovered.2

After the crisis, homebuilding significantly declined. With a rising population and the housing market slowly returning back to normal, the lack of supply and the increase in demand created a new problem in the housing market. More individuals are looking for homes that are limited in supply and have high prices.

Affordable housing: a crisis in the making?

Housing in the UK wasn't always unaffordable. In the 1970s, almost ⅓ of houses across the country were affordable social housing. The average house price was £4,057.3

Under the Thatcher government, the ‘Housing Act of 1980’ was introduced. This caused the number of council homes to decrease. While social housing was decreasing, the financial sector started to be more deregulated, allowing mortgages to become widely available.

From the early 1990s, the housing supply became a problem. There were few restrictions on who could buy mortgages, so many were still demanding houses. However, there weren't enough houses being built. With a limited supply of houses and growing demand, house prices were rising.

This housing boom continued into the 2000s and by 2008 the bubble burst. During the crisis, the number of houses being built significantly dropped. Around 2013, the UK’s population was growing and this meant more demand for houses.

In an attempt to make houses more affordable, the government introduced the ‘Help to Buy’ scheme. This scheme was designed to help first-time buyers.

The Help to Buy scheme

The Help to Buy scheme is a programme introduced by the UK Government to help first-time home buyers.

The aim of this scheme is to help first-time buyers onto the property ladder by facilitating the purchase of new-build. It also had the intention of meeting the high demand for houses by building new houses in the housing market.

The government gives first-time buyers an equity loan to help them build a new home. They must have a deposit of at least 5% of the purchase price. Buyers can borrow 20% (40% in London) of the purchase price and it is interest-free for five years.4 The maximum purchase price for a Help to Buy property depends on what region of England you live in.

However, since the introduction of this scheme, house prices have increased by 38% while wages have stagnated.5 Although the scheme had well intentions, it has led to many struggling to find an affordable home.

Around 2018–19, Theresa May got rid of the council cap, which was a cap on the amount councils can borrow to build homes. The aim was to increase council housing which provides affordable homes for individuals.

Housing Market Crash 2022: Housing Market Crash Predictions

Even despite the 2020 Covid-19 pandemic, UK house prices rose, eventually building up to a possible housing market crash in 2022. Primarily, this was due to the stamp duty holiday which caused a rush to buy houses. The global rising prices in 2022 are likely to exacerbate things further.

The UK has a history of rising house prices, increasing demand for houses, and a limited supply of housing. Years of selling off social housing, low-interest rates, and high rents make it very difficult for first-time buyers to save and get on the property ladder.

Trying to make housing affordable in the UK isn’t a lost cause, but it will require a lot of policies and improvements.

Housing Market Crash - Key takeaways

  • Market failure happens when the market fails to allocate resources efficiently.
  • Externalities occur when the free market fails to take into account the effects of a decision on third parties.
  • Externalities can either be positive or negative and can impact a single individual or society as a whole.
  • Public goods are goods or services that are available to all members of society.
  • Merit goods are goods deemed to be more beneficial to consumers than they realise and demerit goods are goods deemed to be more harmful to consumers than they realise.
  • The 2008 financial crisis is an example of market failure in the housing market.
  • Affordable housing in the UK is the main problem in the housing market. If it doesn't improve, it could result in market failure.

Sources

1. Ammy Borrett, ‘How UK houses have soared ahead of average wages’, The New Statesman, 2021.

2. ‘How 2020’s property market compares to the 2008 house price crash’, What Mortgage, 2020.

3. Lydia McMullan, Hilary Osborne, Garry Blight and Pamela Duncan, ‘UK housing crisis: how did owning a home become unaffordable?’, The Guardian, 2021.

4. ‘Own your home’, HM Government, 2022, https://www.ownyourhome.gov.uk/scheme/help-to-buy-2021-2023/

5. Laurie Macfarlane, ‘Extending help-to-buy will only make the housing crisis worse’, The Guardian, 2020.

Frequently Asked Questions about Housing Market Crash

Rising housing costs, geographical immobilities, environmental factors, the instability of house prices and homelessness are some examples of market failure within the housing market.

Housing is a positive externality. Good housing benefits third parties as it can reduce social problems such as homelessness and crime. It also prevents shortgages of supply, increases geographic mobility and reduces environmental costs like heating.

The lending of subprime mortgages increases the amount of risk financial institutions took on in the housing market. An unregulated housing market, a large uptake of risk and an unsustainable boom within the housing market created a bubble that burst, causing the housing market to crash.

Market failure is when the market fails to allocate resources efficiently. Market failure within housing can include unaffordable housing, homelessness and unstable house prices.

Yes, housing market failure is a market failure.

The subprime mortgage crisis

Financial markets and housing markets globally would all be impacted.

There are prospects for the housing market crash to occur in 2022, but there are some factors at play that could reverse that.

Final Housing Market Crash Quiz

Question

Define market failure.

Show answer

Answer

Market failure happens when the market fails to allocate resources efficiently.


Show question

Question

Define externality.

Show answer

Answer

Externality is the cost or benefit (to a third party) from the production or consumption of a good or service.

Show question

Question

What do negative externalities mean? (In terms of social and private costs).

Show answer

Answer

It means that the social costs are greater than the private costs.

Show question

Question

What do positive externalities mean? (In terms of social and private benefits)

Show answer

Answer

It means that the social benefits are greater than the private benefits.

Show question

Question

Define public goods.

Show answer

Answer

Public goods are goods or services that are available to all members of society.

Show question

Question

What two characteristics must a good/service meet to be classified as a public good?

Show answer

Answer

Non-rivalrous and non-excludable.


Show question

Question

Define non-rivalrous.

Show answer

Answer

Non-rivalrous means that if one person uses the good, it doesn't stop another person from using it.

Show question

Question

Define non-excludable.

Show answer

Answer

Non-excludable means that an individual cannot be stopped from accessing the good.

Show question

Question

Define merit goods.

Show answer

Answer

Merit goods are goods deemed to be more beneficial to consumers than they realise.

Show question

Question

Define demerit goods.

Show answer

Answer

Demerit goods are goods deemed to be more harmful to consumers than they realise.

Show question

Question

Give some reasons why market failure occurs in the housing market.

Show answer

Answer

The housing market can failure due to the following reasons:

Housing costs 

Geographical immobilities

Environmental factors

Instability of house prices

Homelessness

Shortage of homes


Show question

Question

Explain how the housing market failed in 2008.

Show answer

Answer

The unregulated housing market allowed investors, and banks to take up large risks to increase profits. Along with the boom in house prices, it created an unsustainable bubble that burst, causing the housing market to crash.

Show question

Question

Explain how cars are an example of a negative externality. 

Show answer

Answer

It costs the consumer to buy a car. But the pollution from the car is a large social cost. The pollution, congestion and even the risk of an accident can affect third parties. In this example the social costs of pollution, and congestion is greater than the private costs of buying a car.


Show question

Question

Explain how education is an example of a positive externality.

Show answer

Answer

The individual benefits from gaining more skills and increasing their productivity, but society benefits as a whole from the increase in productivity and a more skilled workforce. The social benefits for a more skilled workforce and higher productivity is greater than the private benefits of being a skilled individual.


Show question

Question

Why are goods that benefit consumers tend to be under provided or under consumed in the free market?

Show answer

Answer

Goods/services that benefit consumers in the free market are under produced/consumed because there is little or no profit incentive to produce the good. Information gaps can also cause a consumer to under consume a good/service that is beneficial to them.

Show question

Question

Explain how street lamps are an example of a public good.

Show answer

Answer

Walking under a street lamp doesn't reduce the light for others and you can't prevent someone else from using the street lamp.


Because it is non-excludable and non-rivalrous, street lamps are a public good.


Show question

Question

Explain how alcohol is an example of a demerit good.

Show answer

Answer

Due to imperfect information, consumers may not fully understand the long term damaging effects of consuming alcohol and make the irrational decision to over consume this good.


Show question

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