When is a Market Not a Market?

An article published by Bloomberg news on July 21st presents a good case study of why we, as economists, are always careful in how we define markets and market prices. Click here for article.

A competitive market is one that has many buyers and many sellers for a particular homogeneous product, all of whom have the same set of information. In most places, the housing market approximates a competitive market. The interaction of the buyers and sellers in this market determines the equilibrium price, the price that we would normally see, and the quantity sold. Changes in the determinants of either supply or demand will cause the equilibrium price to change.

One thing that can lead to a change in both demand and supply is the expectations of future prices. If prices are expected to fall, supply will increase as owners try to sell before the price does fall, and demand will decrease as potential buyers wait for prices to actually fall. An increase in supply and a simultaneous decrease in demand will cause prices to fall. The widely held belief that prices will fall is sufficient to make prices actually fall.

When supply and demand move slowly, transactions will occur and new prices will be determined. However, when there is a dramatic change in either supply or demand, market participants may not be able to agree on an exchange price. This appears to be what is happening in Dubai. The pre-credit crisis boom saw a large increase in the number of homes being built and a large number of new buyers. As credit collapsed and the global economy faltered, housing prices began to fall. Foreign owners of Dubai real estate found that the value of their holdings had fallen below the amount of the outstanding mortgages and they defaulted. Banks naturally foreclosed and became property owners.

There are now so many sellers and so few buyers, that a competitive market no longer exists. No one is sure what the equilibrium value of real estate is. Later this year, the banks will be in position to auction off the foreclosed properties, and at that time, a new equilibrium price may be determined. Credit Suisse estimates that the price of real estate my fall by 20% as a result of the auction process. (On top of the 50% drop that has already occurred)

A forthcoming article from Boston based economists John Y. Campbell, Stefano Giglio, and Parag Pathak suggests that the average drop in real estate values due to foreclosure in Massachusetts is 27%. Click here for article

When the auction process begins and if they can do it without minimum required bids market participants may begin to get a sense of the fair value of their holdings and the Dubai housing market may once again be a market.