This lesson explains Residential Investment. It is important for the 4th semester macroeconomics BBE students of Delhi University. It is relevant for other courses like BBA, Economics hons, for the graduation and post graduation level and for competitive exams like CUET Economics, IAS economics optional, Indian Economic Service and the NET JRF Economics aspirants.
Residential Investment

It includes the purchase of new housing both by people who live in it themselves and by landlords who plan to rent it to others. To keep things simple: It is assumed that all housing is owner occupied.

The Stock Equilibrium and Flow Supply
There are two parts of the model:
(i) The market for the existing stock of houses determines the equilibrium housing price.
(ii) The housing price determines the flow of residential investment.

At any point in time, the supply of houses is fixed: represented by a vertical supply curve.
The demand curve for houses slopes downward, because high prices cause people to live in smaller houses, to share residence, or sometimes even to become homeless. The price of housing adjusts to equilibrate supply and demand. This relative price of houses determines the supply of new houses.

Construction firms buy materials and hire labor to build houses and then sell the houses at the market price. Their cost depends on the overall price level P which reflects the cost of wood, bricks, plaster, etc).

The higher the relative price of housing, the greater the incentive to build houses and the more houses are built. Thus, the flow of new houses that is residential investment depends on the equilibrium price set in the market for existing houses.

This model of residential investment is similar to q theory of Business Fixed investment.

(i) According to q theory, business fixed investment depends on the market price of installed capital relative to its replacement cost, this relative price in turn depends on the relative price of housing.
(ii) According to this model of housing market, residential investment depends on the relative price of housing. The relative price of housing, in turn, depends on the demand for housing.

Hence, the relative price of housing plays much the same role for residential investment as Tobin q does for Business Fixed Investment.


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