Question:
Homes are very durable and often last for decades. Consider the real estate market in Cleveland.
Let’s say in 2026:
- Cleveland has 250,000 existing homes, all of which were built before the year 2000.
- Homes never shrink.
- No new homes have been built in Cleveland in the last 26 years.
- The minimum cost to build a new home in Cleveland is $200,000, and the construction industry has constant returns to scale.
(a) Using a standard supply and demand graph, draw Cleveland’s aggregate housing supply curve in 2026. Be sure to clearly label any important prices and amounts.
(b) Suppose the demand for housing in Cleveland increases. Using your diagram, explain how this affects the price and value of houses.
(c) Suppose the demand for housing in Cleveland decreases. Using your diagram, explain how this affects the price and value of houses.
(d) Do increases and decreases in housing demand have equal effects on housing prices and housing prices in Cleveland? Explain your answer using your supply curve.
Solution:
According to the question, the real estate market in Cleveland is characterized by two important factors. First, there is an existing stock of 250,000 houses that were all built before 2000 and are not shrinking. Second, new homes can be built at a fixed cost of $200,000. These two facts—firmness and ongoing construction costs—determine the shape of the supply curve and, in turn, how the market responds to changes in demand.
Start by offering.
Because homes are not shrinking, the existing stock of 250,000 homes is fixed. For any price below $200,000, no new homes will be built. Builders can experience losses if they try to build at those prices. Because of this, the total number of housing units offered is limited to 250,000 units. In a standard supply and demand diagram, this corresponds to a vertical supply curve for 250,000 homes for all prices under $200,000.
Now imagine what happens to the $200,000. At this price, builders are only willing to build new homes. Because the construction industry exhibits infinite returns to scale, the marginal cost of building an additional home is always $200,000 regardless of how many homes are built. This means that once the price reaches $200,000, builders are willing to offer any additional amount of homes at that price. Graphically, the supply curve becomes horizontal at $200,000 for prices greater than 250,000 houses.
Taken together, the supply curve has a kink. It is vertical for 250,000 homes up to $200,000 and horizontal for $200,000 beyond that point.
With the supply curve in place, consider how the market responds to changes in demand.
Suppose demand increases. Initially, equilibrium lies on the vertical part of the supply curve. Because the number of houses is stable at 250,000 houses, the increase in demand raises the price of houses without changing the price. Buyers compete for existing stock, driving up prices.
As demand continues to increase, the price eventually reaches $200,000. At that time, new construction becomes profitable. Builders enter the market and start providing more housing. A further increase in demand does not raise the price above $200,000. Instead, they increase the number of houses through new construction. The price remains pegged at $200,000, while the value is increasing.
Importantly, this process changes the supply curve itself over time. When new homes are built, the total number of homes increases. What used to be a straight housing supply curve of 250,000 homes shifts to the right—say, 260,000 or 275,000 homes—indicating a greater number of available homes. In this sense, past increases in demand leave a lasting imprint on the market by increasing the housing stock. The vertical part of the supply curve is not fixed forever; it extends outwards as new homes are added.
Now consider a decrease in demand.
When demand falls, equilibrium remains on the vertical side of the supply curve. The existing housing stock—which may now be larger because of previous construction—doesn’t change. There is no way to reduce the number of houses due to low demand. Homes are not destroyed, and no one can “build” them. As a result, all adjustments are made in prices. A decrease in demand leads to a lower appraisal price, while the value of homes remains unchanged in the existing stock.
This highlights the asymmetry. Increased demand drives up prices and ultimately creates new construction, which expands the housing stock and shifts the supply curve outward. A drop in demand, however, does not reverse this process. Housing stock is not shrinking. Instead, prices drop to clear the market.
This asymmetry has important real-world implications. In cities that experience a steady decline in demand—due to declining population, layoffs, or changing economic conditions—housing stock remains as demand weakens. The result is a persistent oversupply at existing prices, which manifests itself as falling home values, rising vacancy rates, and empty homes. In extreme cases, this can contribute to urban blight, as buildings are abandoned or poorly maintained because their market value falls below the cost of maintaining them.
The main limitation is simple: houses can be added, but they cannot be easily removed. When demand rises, prices eventually begin to build, increasing the housing stock and shifting supply out. When demand falls, those adjustment limits disappear—price is pegged to existing stock, so prices do all the work. The result is an inherent asymmetry: upward demand shocks translate into both higher prices and more housing, while downward shocks translate primarily into lower prices. This is not just for housing. In any durable goods market, past production decisions force current adjustments, and those constraints determine how prices and quantities respond.
