Report on microeconomic analysis the effect of housing prices on household consumption

As such, people employ their resources to first satisfy these basic wants, even to the point of borrowing where the resources are found to be insufficient. According to Thangavelu (2018), in a capitalist economy, big and small decisions are made by individuals, households and businesses based on the principles of microeconomics. Economic Theories Applied Maximization of Utility and Opportunity Costs The greatest assumption in economic theory is that individuals have perfect information to enable them to maximize their satisfaction and self-interest, a concept referred to as the maximization of utility. The underlying paradigms of decision making is that individuals and households are not always rational and markets fail. It is a fact that a rational decision maker may fail to consider all the alternative uses of resources before making a choice.

The decision is further compounded by the fact that the market is supply-constrained, implying that other willing and able buyers are competing for the same houses. This brings into light the opportunity costs of getting good housing, in that to phase out the competition, one may be forced to part with more money than that originally intended. This means foregoing on other expenses such as entertainment, eating out and travelling in order to find a fitting apartment (Disney & Gathergood 2018, 467). Taking the landlord as another rational decision maker, his aim is to rent out the apartment to the highest price giver in a bid to maximize utility. In setting the rent prices, the landlord has to consider factors such as the neighborhood and the market demand for accommodation.

Access to unlimited credit enables willing individuals to buy assets, thereby increasing the prices of these assets. Lose of or limited credit to finance the buying of assets leads to the collapse of asset prices. As a result, any slight fluctuations in the availability of credit results in even greater fluctuations in asset prices, implying the concepts of price elasticity of demand. A close connection has been established between fluctuations in house prices and in credit (Thangavelu, 2018). The short-run demand for housing is determined as generally inelastic, where households have to cut down on what is least needed in the margin when faced with budget constraints. It is expected of a rational consumer to distribute this decline over their consumption periods (Kessel, Tyrefors & Vestman, 2019).

The effects of price, wealth, income and income growth changes and substitution effects are advanced to contribute to the different relationships drawn between house prices and consumption (Disney & Gathergood 2018, 458). Credit Supply and Housing The bubble in asset pries increases with a growth in credit, that is, the more that individuals and households are allowed to borrow. Economists took this theory into account by developing models with easier access to credit, which would lead to an increase in asset prices based on the concepts of speculative buying. The economic recession of 2007/2008 led to an increase of cash buying, compared to taking out credits and mortgages. Empirical Analysis Correlation begs the question of whether house prices drive borrowing or whether it is borrowing that drives house prices, making it tricky to determine the causal relationship between the two factors.

To determine this causal relationship, it is necessary to find other random reasons why house prices change other than those that influence household borrowing. The collateral effect has been identified as the main reason behind this causal relationship because a rise in house prices results in a rise in collateral as security for credit borrowing. Banks and other institutions are more willing to give credit to households who have higher collateral value, therefore this higher collateral value enables households to borrow. The ability of households to borrow depends on their income and wealth. Housing is of an indivisible nature and therefore any increases in household wealth cannot be used for other consumption purposes, and changes in prices have to be met with corresponding alterations in consumption.

The Prisoner’s Dilemma is a theory that emerged on the grounds of cooperation, after it was realized that it was quite costly for players to change strategy. This concept is used in game theory, a strategic interaction between rational decision makers. The agents in game theory have to cooperate sometimes, though they operate in competing strategies and conflicts, in order to make strategic decisions. In this case, landlords and tenants or homeowners are rational intelligent agents who must operate strategically, whether in cooperation or conflict, in order to maximize utility from their strategic decisions. w23861. National Bureau of Economic Research, 2018. Disney, Richard, and John Gathergood. "House prices, wealth effects and labor supply. " Economica 85, no. National Bureau of Economic Research, 2018. Thangavelu, Poonkulali.