5 What makes house prices change?

As house prices are such a major influence on household finances, it is useful to have an understanding of how they are determined. This may help you to be able to make well-informed judgements about how prices may respond to a wide range of possible future events.

What brings about changes in house prices, for example such as those you looked at earlier in this course? The answer is largely to do with the forces of demand and supply.

Economists have a formal definition of these terms:

• ‘Demand’ means the quantity of a good or service that buyers wish to purchase over a specified period of time.
• ‘Supply’ means the quantity of a good or service that sellers wish to sell over a specified period of time.

The idea that high demand and restricted supply lead to price rises whilst slack demand and over-supply lead to price falls is a familiar and perhaps an intuitive one, whether looking at houses, oil, coffee or any other type of goods or services. Economists, however, develop this insight more formally and make use of what is known as the demand-and-supply model. A model is a device for simplifying some aspect of the real world to help our understanding. Both natural scientists and social scientists, like economists, use modelling to help them to explain complex processes and make predictions about likely outcomes. A common example of modelling is forecasting the weather.

The remainder of this section develops the model of demand and supply in the context of the housing market, and uses it to reconsider the question we asked earlier: ‘are house prices too high?’.