External benefits in housing market

Readers Question: Could you please explain how positive externality (external benefit) lead to market failure in property industry?

A positive externality occurs when a third party benefits from the production or consumption of a good. In many cases, building the right kind of housing can have benefits to the rest of society. Therefore, the social benefit of good quality housing can be greater than the private benefit that property developers gain.

The property industry (building new homes) can have several positive externalities:

• Good quality housing helps to reduce social problems, such as drug use, crime and vandalism. Poor quality, high-density housing (e.g. 1960s tower blocks) were associated with various social problems, such as increased crime rates. This type of housing may be cheap to build, but investing in better quality housing with more features, such as gardens can create a better environment which helps to improve social welfare and strengthen local communities.
• Better public health. In extreme cases ‘slum’ housing with poor sanitation and damp surroundings can contribute to ill health. Building better housing without damp and with better sanitation can lead to improved public health which is an external benefit to society.
• Environmental standards. If houses are built with high levels of insulation, then they will help reduce the environmental costs of heating. This is an external benefit because society benefits from an improved environment related to the building of insulated housing.
• Building new houses helps to prevent a shortage of supply and resulting excess prices resulting from the squeezing of demand.
• Building new houses can also increase geographical mobility and provide benefits to local business and employers struggling to employ sufficient people.

Free market and market failure

If there are positive externalities in the housing market, then there may be social inefficiency.  For example, in a free market, the property industry may not build better quality housing to replace slums. This is because those living in slums may be unable to afford to buy the more expensive new houses. Therefore, society experiences a socially inefficient level of housing stock. In many cases (though not exclusively), it was government intervention which knocked down slum housing in Britain (throughout the early Twentieth Century) and encouraged the building of new houses.

A more modern type of positive externality is related to the environmental benefits of having minimum standards of insulation to protect against noise pollution and air pollution. In a free market, there may be little incentive to increase the building cost of a new house to improve environmental standards. Therefore, new houses would tend to get built cheaply without taking into account the external benefits of better insulation. To overcome this market failure, the government have regulations

Diagram of Positive Externality

In a free market, the equilibrium of housing is Q1 – where PMB equals PMC. The free market ignores the social marginal benefit (which includes the positive externalities.

Therefore, there is under-consumption of the socially efficient level of housing.

The red triangle shows the area of dead-weight welfare loss.

See more at positive externalities

Market Failure in UK Housing

Arguably, the UK has a significant degree of market failure in the housing market. Notably, supply is unable to keep up with demand.

The impact of this is that prices are rising faster than earnings. In areas like London and the south it is very difficult for young people to buy and/or rent.

But, this is complicated by the fact that it is often government regulation which makes it difficult to build new housing. Many want government regulation to prevent building on green-belt land because they argue building on green-belt land has a negative externality – i.e. loss of beautiful countryside and greater congestion.

Related

• Market failure in the housing market