CHAPTER
Working with Supply
and Demand
PowerPoint Slides
Slides prepared
prepared by:
by:
PowerPoint
Andreea CHIRITESCU
CHIRITESCU
Andreea
Eastern Illinois
Illinois University
University
Eastern
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Government Intervention in Markets
• Governments
– Sometimes intervene to change the
market outcome
– Fight the market
• Prevent the price from reaching equilibrium
value
– Price ceilings
– Price floors
– Manipulate markets
• Changing the equilibrium itself
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2
Fighting the Market: Price Ceilings
• Price ceiling
– Government-imposed maximum price in a
market
• Short side of the market
– The smaller of quantity supplied and
quantity demanded at a particular price
• When QD and QS differ
– The short side of the market will prevail
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3
Fighting the Market: Price Ceilings
• Shortage
– Excess demand not eliminated by a rise in
price
– QD > Q S
• Price ceiling: creates a shortage
– Increases the time and trouble required to
buy the good
– Price decreases
– Opportunity cost may rise
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4
Figure 1
A Price Ceiling in the Market for Maple Syrup
Price per
Bottle
S
3. and increases quantity
demanded, creating a
shortage equal to the
distance between R and V.
$4.00
E
3.00
R
V
2.00
D
40,000 50,000 60,000
1. A price ceiling lower than
the equilibrium price …
Number of Bottles
of Maple Syrup
2. decreases
quantity supplied …
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5
Fighting the Market: Price Ceilings
• Black market
– A market in which goods are sold illegally
at a price above the legal ceiling
– Price: above equilibrium price
• Unintended consequences of price
ceilings
– Long lines
– Black markets
– Often higher prices
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6
Figure 2
A Price Ceiling with a Black Market
Price per
Bottle
S
3. will sell for a price
even higher than the
equilibrium price.
T
$4.00
E
3.00
V
2.00
R
D
40,000 50,000
1. With a price ceiling lower
than the equilibrium price and a
black market...
Number of Bottles
of Maple Syrup
2. the lower quantity
supplied...
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
7
Fighting the Market: Price Ceilings
• Rent control
– Price ceiling imposed in a rental housing
market
– Government-imposed maximum rents on
apartments and homes
– Purpose: to keep housing affordable
• Especially for those with low incomes
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8
Fighting the Market: Price Ceilings
• Problems with rent control
– It doesn’t target those with low incomes
• Luck
– Persistent excess demand
• Wasted time
• ‘Black market’
– Rent: higher than rent-controlled price
– Decrease in the quantity of apartments
supplied
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9
Fighting the Market: Price Floors
• Price floor
– Government-imposed minimum price in a
market
– Purpose: to help sellers
• Price floors for agricultural goods
– Price support programs
– United States Department of Agriculture
• Programs to maintain high prices for cotton,
wheat, rice, corn, tobacco, honey, milk,
cheese, butter, peanuts, sugar, dairy products
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10
Fighting the Market: Price Floors
• Surplus
– Excess supply not eliminated by a fall in
price
– QS > QD
• Price floor
– Surplus of a good
– Temptation: to sell the surplus below the
price floor
– Government: purchases the surplus
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11
Figure 3
A Price Floor in the Market for Nonfat Dry Milk
Price per
Pound
1. A price floor higher than
the equilibrium price …
3. and increases
quantity supplied.
S
K
J
$0.80
E
0.65
4. The result is a surplus
—the distance between
K and J.
D
180
2. Decreases quantity
demanded …
200 220
Millions of
Pounds
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12
Fighting the Market: Price Floors
• Government: limit any excess supplies
– Dairy market: control the production and
sale
– Government: ordered or paid farmers not
to grow crops on portions of their land
– Imposed strict limits on imports of food
from abroad
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13
Fighting the Market: Price Floors
• Critics
– Government spends too much money
buying surplus agricultural products
– Higher prices distort the public’s buying
and eating habits
– Assistance: support all farmers
• Many farmers are wealthy individuals or
powerful corporations
• More cost-effective if given directly to those
truly in need
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14
Manipulating the Market: Taxes
• Excise tax
– A tax on a specific good or service
– Can be collected from either sellers or
buyers
• Tax incidence
– The division of a tax payment between
buyers and sellers
– Determined by comparing the new (after
tax) and old (pretax) market equilibriums
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15
Manipulating the Market: Taxes
• Tax shifting
– Some/all of a tax imposed on one side of a
market
– Ends up being paid by the other side of the
market
• Excise tax on sellers
– Shifts the supply curve upward by the
amount of the tax
– Incidence: both sides of the market
• Buyers pay more and sellers receive less
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16
Figure 4
A Tax on Sellers Shifts the Supply Curve Upward
Price per
Gallon
S After Tax
A’
$3.60
3.00
S1
A
400
Millions of
Gallons per Day
After a $0.60 per gallon tax is imposed on sellers, the price at which any given quantity
would be supplied is $0.60 greater than before, so the supply curve shifts upward. For
example, before the tax, 400 million gallons would be supplied at $3 per gallon (point A);
after the tax, to get that same quantity supplied requires a price of $3.60 (point A′).
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17
Figure 5
The Effect of an Excise Tax Imposed on Sellers
Price per
Gallon
Buyers pay
this price to
sellers.
S After Tax
B
S1
$3.40
A
3.00
Sellers get this
price (after
paying tax).
2.80
D
300
400
Millions of
Gallons per Day
After a $0.60 excise tax is imposed on sellers, the market equilibrium moves from point A
to point B, with buyers paying sellers $3.40 per gallon. But sellers get only $3.40 − $0.60
= $2.80 after paying the tax. Thus, the tax causes buyers to pay $0.40 more per gallon,
and sellers to get $0.20 less than before.
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18
Manipulating the Market: Taxes
• Excise tax on buyers
– Shifts the demand curve downward by the
amount of the tax
– Tax incidence – both sides of the market
• Buyers pay more
• Sellers receive less
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19
Figure 6
A Tax on Buyers Shifts the Demand Curve Downward
Price per
Gallon
A
$3.00
A’
2.40
D1
D After Tax
400
Millions of
Gallons per Day
After a $0.60 per gallon tax is imposed on buyers, the price at which any given quantity
would be demanded is $0.60 less than before, so the demand curve shifts downward. For
example, before the tax, 400 million gallons would be demanded at $3 per gallon (point
A); after the tax, that same quantity would be demanded at a price of $2.40 (point A′).
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20
Figure 7
The Effect of an Excise Tax Imposed on Buyers
Price per
Gallon
Buyers pay
this price
(including tax).
Sellers get
this price
from buyers.
S
$3.40
A
3.00
C
2.80
D1
D After Tax
300
400
Millions of
Gallons per Day
After a $0.60 excise tax is imposed on buyers, the market equilibrium moves from point A
to point C, with buyers paying sellers $2.80 per gallon. But buyers pay a total of $2.80 +
$0.60 = $3.40 per gallon when the tax is included. Thus, the tax causes buyers to pay
$0.40 more, and sellers to get $0.20 less, just as when the tax is imposed on sellers.
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21
Manipulating the Market: Taxes
• Tax incidence
– Distribution of tax burden between buyers
and sellers
• Tax incidence vs. tax collection
– The tax incidence is the same whether the
tax is collected from buyers or sellers
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22
Manipulating the Market: Subsidies
• Subsidy
– A government payment to buyers or
sellers on each unit purchased or sold
• Medical care for the poor and elderly
• Energy-saving equipment
• Smoking-cessation programs
• College education
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23
Manipulating the Market: Subsidies
• Subsidy to buyers
– Shifts the demand curve upward by the
amount of the subsidy
– Benefits both sides of a market
• Buyers pay less
• Sellers receive more for each unit sold
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24
Figure 8
A Subsidy for Students Attending College
Price per
Year
Colleges get
this price
S
B
$31,000
A
25,000
D After Subsidy
21,000
Students pay this
price (after
deducting subsidy)
D1
4 million 4.8 million
Number of Students
Attending College
After a $10,000 subsidy is given to college students, the market equilibrium moves from point
A to point B, with students paying colleges $31,000 per year. But students pay a total of
$31,000 − $10,000 = $21,000 when their subsidy is deducted. Thus, the subsidy causes
students to pay $4,000 less per year, and it causes colleges to get $6,000 more per year.
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25
Manipulating the Market: Subsidies
• Subsidy to sellers
– Shifts the supply curve downward by the
amount of the subsidy
– Benefits both sides of a market
• Buyers pay less
• Sellers receive more for each unit sold
• Distribution of benefits from a subsidy
– Are the same, regardless of whether the
subsidy is paid to buyers or sellers
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26
Supply and Demand in Housing Markets
• Stock variable
– Measures a quantity in existence at a
moment in time
• Housing stock: number of homes that people
own at a given time
• Flow variable
– Measures a process that takes place over
a period of time
• New home construction
• New home purchases
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27
Supply and Demand in Housing Markets
• Housing markets
– Newly constructed homes and previously
owned homes are very close substitutes
• The stock approach: demand and supply
– Supply of housing: housing stock
– Demand for housing stock
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28
Supply and Demand in Housing Markets
• Supply curve for housing
– Total number of homes in a market that
are available for ownership
– Vertical line
• Housing stock at any point in time is fixed
• Number of homes that were built in the past
and still suitable for ownership
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29
Figure 9
The Supply Curve in a Housing Market
Price per
Home
Supply
Price per
Home
$200,000
$200,000
$150,000
$150,000
$100,000
$100,000
600,000
Number
of Homes
S1
600,000
S2
800,000
Number
of Homes
In panel (a), the supply curve tells us the number of homes (600,000) that exist at a
particular time. It is a vertical line because the housing stock at any time does not depend
on the price. Panel (b) shows the impact of building 200,000 new homes over the year.
The housing stock rises to 800,000 so the supply curve shifts rightward, from S1 to S2 .
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30
Supply and Demand in Housing Markets
• Shifts vs. movements along the supply
curve
– Movement along: when the price of homes
changes
– Shift: changes in the housing stock
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31
Supply and Demand in Housing Markets
• Demand curve for housing
– Total number of homes that everyone in
the market would like to own
– At each price
– Given the constraints that they face
– Slopes downward
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32
Supply and Demand in Housing Markets
• Home ownership
– An alternative to renting
• Monthly cost of owning a home
– Maintenance, property taxes, interest
• Monthly costs for prospective owners
– Foregone monthly interest
– Mortgage and interest
– Higher home prices
• Higher cost of ownership
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33
Supply and Demand in Housing Markets
• Mortgage
– Loan given to a homebuyer
– Part of the purchase price of the home
• Monthly costs for current owners
– Foregone interest
– Higher home prices
• Higher cost of ownership
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34
Supply and Demand in Housing Markets
• Ownership Costs
– Interest cost of ownership
• Both current and prospective homeowners
– This cost rises when current home prices
rise, and falls when current home prices
fall
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35
Figure 10
The Demand Curve in a Housing Market (a)
Price per
Home
A
$200,000
B
$150,000
Demand
C
$100,000
D1
300,000 600,000 900,000 Number of Homes
In panel (a), the demand curve tells us—at each price—the number of people who would
like to own homes. It slopes downward because a decrease in the average selling price of
a home lowers the ongoing interest cost of home ownership, increasing the number of
people who want to own.
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36
Figure 10
The Demand Curve in a Housing Market (b)
Price per
Home
$150,000
D1
600,000
D2
800,000
Number of Homes
In panel (b), tastes change in favor of home ownership. More people would like to own at
each price, so the demand curve shifts rightward from D1 to D2.
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37
Supply and Demand in Housing Markets
• Shift vs. movement along the demand
curve
– Movement along: change in price, other
things constant
– Shift: changes in
• Monthly cost of renting a home
• Interest rates in the economy
• Tastes for homeownership
• Average income
• Population
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38
Housing Market Equilibrium
• Equilibrium
– Intersection of demand and supply
• The equilibrium price in a housing market
– The price at which the quantity of homes
demanded and quantity supplied are equal
• Quantity of homes demanded
– Number of homes that people want to own
• Quantity of homes supplied
– Housing stock
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39
Figure 11
Equilibrium in a Housing Market
Supply
Price per
Home
A
$200,000
$150,000
B
C
$100,000
Demand
The equilibrium in this
market is at point B, where
the price of homes is
$150,000. If the price were
higher—say $200,000— the
number of homes people
want to own (300,000 at
point A) would be less than
the number in existence and
currently owned (600,000).
Owners would try to sell,
and the price would fall until
all 600,000 homes were
demanded.
300,000 600,000 900,000
Number of Homes
If the price were lower than the equilibrium price—say $100,000—the number of homes
people want to own (900,000 at point C) would be greater than the number in existence and
currently owned (600,000). People would try to buy homes, and the price would rise until only
600,000 were demanded.
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40
What Happens when Things Change
• Over time
– Supply curve shifts rightward
• As the housing stock rises (new homes are
built)
– Demand curve shifts rightward
• Population growth, rising incomes
– Market equilibrium will move rightward
• Home prices: relative shifts in the supply and
demand curves
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41
What Happens when Things Change
• Equal changes in supply and demand
– Housing stock grows at the same rate as
housing demand
– Housing prices: unchanged
– A stable housing market
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42
Figure 12
A Stable Housing Market
Price
per
Home
$150,000
S1
S2
B
E
D2
D1
600,000
610,000
Number of Homes
When the supply of homes increases at the same rate as demand for them, the equilibrium
price remains unchanged. In the figure, the rightward shift in the supply curve (from S1 to S2) is
equal to the rightward shift in the demand curve (from D1 to D2). Equilibrium moves from point B
to point E, but the price remains at $150,000.
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43
What Happens when Things Change
• Restrictions on new building
– Slow increase in supply
– Housing stock grows slower than the
demand
– Rapidly rising prices
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44
Figure 13
A Housing Market with Restricted Supply Growth
Price
per
Home
$200,000
$150,000
S1
S’2
G
F
B
D2
D1
600,000
603,000
610,000
Number of Homes
When supply is restricted, and cannot increase as fast as demand, housing prices rise. In
the figure, the rightward shift in the supply curve (from S1 to S2′) is less than the rightward
shift in the demand curve (from D1 to D2). Equilibrium moves from point B to point G, and
the price rises from $150,000 to $200,000.
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45
What Happens when Things Change
• Faster demand growth
– Due to
• Population shifts
– Sudden influx of new residents
• Rapid income growth
– Booming industry in the area
• Change in expectations about future prices
– Rapidly rising prices
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46
What Happens when Things Change
• House: an asset
– One of the most leveraged financial
investments
• Leverage
– Magnifies the impact of a price change on
the rate of return you will get from an asset
• Capital gain
– Gain to the owner of an asset
• When it is sold for a price higher than its
original purchase price
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47
What Happens when Things Change
• Capital loss
– Loss to the owner of an asset
• When it is sold for a price lower than its
original purchase price
• Faster demand growth
– The housing stock typically lags behind,
and housing prices rise
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48
Figure 14
Accelerating Demand Growth
Price per
Home
S2
S1
J
$185,000
$150,000
D’2
B
D1
600,000 610,000
Number of Homes
When demand begins to increase faster than previously, increases in supply usually lag
behind. In the figure, the rightward shift in the supply curve (from S1 to S2) is less than the
rightward shift in the demand curve (from D1 to D2'). Equilibrium moves from point B to
point J, with the price rising from $150,000 to $185,000.
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49
The Housing Boom and Bust
1997–2011
• Housing price index
– Index measure of inflation-adjusted U.S.
housing prices
• 1997 – 2006
– Housing price index almost doubled
– Bubble
• Mid-2006
– Falling housing prices
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50
Figure 15
Index of Home Prices, Adjusted for Inflation
After adjusting for price changes from general inflation, the housing boom began in 1997, and
home prices increased ever more rapidly until 2006. That marked the beginning of the housing
bust, with prices dropping dramatically for several years.
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51
The Housing Boom
• 1997-2006: accelerated demand growth
– Supply increased, but it lagged behind
– Result: a surge in housing prices
• Causes for rapidly rising demand
– Economic growth
– Low interest rates
• The Fed
• Global financial forces
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52
The Housing Boom
• Causes for rapidly rising demand
– Government policy: encouraged home
ownership
• Mortgage interest payments: deducted from
taxable income
• Increased funding available for mortgage
lending
• Higher capital gains exclusions on home sales
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53
The Housing Boom
• Causes for rapidly rising demand
– Financial innovations
• More-attractive terms for borrowers (ARM)
• Securitization: made mortgage-lending more
attractive
– Mortgage-backed securities
– Deteriorating lending standards
• Subprime loans
• Declining down-payments
– Speculation
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54
Figure 16
The Housing Boom in Las Vegas
Median
Home Price
S2003
S2006
B
$324,000
A
$179,000
D2006
D2003
Q1
Q2
Number of
Homes
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
55
The Housing Bust
• Mid-2006: a sudden drop in demand
– Oil and gasoline prices spiked
• Many new homeowners were struggling to
make ends meet
– Interest rates on a large group of
adjustable rate mortgages reset to higher
levels
– Disturbing rise in defaults
• Subprime mortgages with no down payments
– Prospect of higher default rates
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
56
The Housing Bust
• Mid-2006: a sudden drop in demand
– Interest rates on new mortgages rose
– Demand curve for housing shifted leftward
• Housing prices fell
– Speculation
• Demand curve shifted further leftward
• Housing prices fell even more rapidly
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
57
Figure 17
The Housing Bust in Las Vegas
Median
Home
Price
S2006
S2008
B
$324,000
E
$178,000
D2006
D2008
Q2
Q3
Number of
Homes
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
58
The Long Housing Slump
• End of 2008 through 2011
– The U.S. economy suffered the aftermath
of an unusually severe recession
– High unemployment and declining
incomes
• Millions of homeowners struggling to pay their
monthly mortgage bills
• More mortgage defaults
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59
The Long Housing Slump
• End of 2008 through 2011
– Financial institutions foreclosed on close to
3 million homes
• Several million additional homes had received
legal notices
• Shifted the demand curve for housing further
to the left
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60
The Long Housing Slump
• U.S. home prices stabilized a bit in 2009
and early 2010
– Making Home Affordable Program
• Incentives for banks and homeowners to
renegotiate mortgage agreements and
prevent foreclosures
– Additional tax benefits to new home
buyers
– Temporary effect at best
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61
The Long Housing Slump
• 2010
– Home prices resumed their downward
trajectory
• By mid-2011
– Average U.S. home price (adjusted for
inflation) had fallen to 40% of its peak five
years earlier
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62
Understanding Leverage
• Without leverage
– 10% higher housing prices
• 10% capital gains
– 10% lower housing prices
• 10% capital loses
• Leverage
– Magnification of gains and losses through
borrowing
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63
Understanding Leverage
• Leveraged financial investment
– Using borrowed money to buy a home
– 10% higher housing prices
• More than 10% capital gains
– 10% lower housing prices
• More than 10% capital loses
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64
Understanding Leverage
• An owner’s equity in an asset
– Difference between the asset’s value and
any unpaid debts on the asset
– Equity in Asset = Value of asset - Debt
associated with asset
• Simple leverage ratio
– Ratio of an asset’s value to the owner’s
equity in the asset
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65
Figure A.1
Leveraged Buying and Selling
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66
Understanding Leverage
• Simple leverage ratio = “Rate-of-return
multiplier”
• Rate of return on the (leveraged)
investment
– Rate of change in a home’s price
– Times the leverage ratio
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67
Understanding Leverage
• When asset prices rise
– Leverage increases your rate of return
dramatically
• When asset prices fall
– Leverage increases the chance of wiping
out your entire investment
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68