A q-theory for the housing market

The well known q-theory aims to explain the connection between investment and stock market prices. Higher stock market­ prices cause higher investment as new investment is valued equally high on the markets and firms are trying to maximize shareholder value that is to stay their stock market price. A similar story can be plotted for the housing market: we may call it a q-theory for the housing market. Housing investment is much more volatile than total investment in the economy. The reason is simply that most of the housing stock is fixed and it takes some time to construct new houses. This phenomenon causes housing prices to be quite volatile as an increase in demand can only be offset by a price increase in the short run (housing supply is fixed in the short run).

The supply side of the housing market operates as follows:

where π is the profit of firms, p_H the market price of houses, I_H housing investment, p the price for construction costs of housing, and X the factors of production. In short, those are the profits of the construction sector.

Maximizing profits by taking the first derivative with respect to housing investment yields the following:

Without paying too much attention to the elasticity β and the constant k we can see why the idea is labeled as a q-theory for the housing market. The ratio of housing prices and the price of constructing new houses determines investment in the housing market. If the current price for houses is high, construction companies will build more houses as they can sell them with a higher profit. This is quite intuitive and such price mechanisms are found in many areas of a market economy.

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