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Fooled by Search: Housing Prices, Turnover and Bubbles

  • Brian Petereson

    ()

    (Indiana University Bloomington)

Theory predicts that the effects of search frictions on house prices from temporary movements in demand should be temporary, while the data suggests it is permanent. The latter implies that movements in demand coupled with search frictions create higher volatility in prices than theory would predict, amplifying price changes, leading to bubbles and depressions. To generate permanent price changes from temporary demand shocks, a textbook search model is combined with a behavioral assumption where house buyers and sellers ignore the effects of search frictions on past prices. The estimated model implies that over half of the real price growth from the housing bubble starting in 1998 is due to the behavioral assumption where households are ‘Fooled by Search.’ When trend growth of prices is removed, the behavioral assumption explains almost three-fourths of the housing bubble. The estimated model also provides several other results. (1) There is a large inefficiency in the search process of the housing market: buyers have very little bargaining power relative to their impact on creating sales, i.e. the Hosios condition is not met by an order of magnitude. (2) There is evidence of a rise in the fundamental value of houses from 1998 to 2005 that mirrors the loose monetary policy under the Greenspan Federal Reserve. (3) Analysis of the boom and bust of the housing market from 1975 to 1982 suggests that buyers who are choosing to not enter the housing market are rational. Using the last observation to make a back of the envelope projection for the current crisis, turnover will have to fall to its 1982 level and remain there until 2011 before a recovery can begin, driving house prices down to their real levels of 2002-2003

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File URL: http://www.iub.edu/~caepr/RePEc/PDF/2009/CAEPR2009-004.pdf
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Paper provided by Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington in its series Caepr Working Papers with number 2009-004.

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Length: 41 pages
Date of creation: Feb 2009
Date of revision:
Handle: RePEc:inu:caeprp:2009-004
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