Impact of weak substitution between owning and renting a dwelling on housing market

Abstract

According to economic theory, an economically rational market agent searching for permanent housing in a particular stage in his/her life cycle should base his/her tenure considerations also by comparing rent to the user costs of homeownership, and among flats with otherwise identical housing services and security will select the cheaper of two alternative tenures. Economic theory perceives rental and owner-occupied housing as ‘communicating vessels’—a change in conditions in one necessarily entails changes in the other. This is called the ‘substitution effect’ and represents an important balancing mechanism in the housing market. Our hypothesis is that if the substitution between rental and owner-occupied housing in particular culture/society is weak, then the demand for owner-occupied housing becomes more income-elastic than vice versa. Consequently, in the case of a weak substitution effect, changes in house prices will closely mimic changes in household incomes, while in the case of a strong substitution effect this relationship will be much weaker. We confirmed our hypothesis by employing both a theoretical model and an empirical analysis of price data. If we assume poor responsiveness of housing supply, the main implication of our findings is that in societies with weak substitution effect between owning and renting we can expect higher house-price volatility and thus a higher chance of price bubbles appearing.