Download Chapter 2 Economic Theories and Measurements

Chapter 2
Economic Theories and
Measurements
I. Economists
A. Adam Smith (1723 – 1790)

Adam Smith is the father of modern capitalist theories

LAISSEZ-FAIRE (“Let people do as they please”) is a
governmental policy allowing an economy to grow without
government interference or direction

The “invisible hand”

Smith never proved his doctrine, but enumerated
countless cases of governmental follies. He understood
how markets worked and established the foundation of
the supply and demand theory.
B. Thomas Malthus (1766 – 1834)

The Malthusian theory was set forth by Thomas Malthus in
An Essay on the Principle of Population

Malthus believed that population growth was bound to
reduce worker wages

Population increases would mean higher rents and prices,
thus resulting in a lower standard of living
C. John Maynard Keynes
(1883- 1946)

Keynes believed an economy reaches a balance
at less than full employment

Keynesian economics advocated governmental
intervention in the economy to fight unemployment
and inflation

Keynes is considered the founder of modern
“macroeconomics,” which is the study of the entire
economic system as a whole, rather than its
individual parts
D. Milton Friedman (1912 – 2006)
 Nobel
prize winner and influential member of the School of
Economics at the University of Chicago
 Friedman
was associated with MONETARISM, which is
the belief that we need a careful and steady increase in
the money supply and that by increasing the money
supply we increase production
E. Ben Bernanke (1955 - )
 Chairperson
of the Federal Reserve
 Bernanke
wrote extensively on the causes of the
Great Depression
 He
believes that the Federal Reserve was largely
responsible for the depression by reducing the
money supply and has stated that it won’t happen
again
II. Economic
Systems
Economic Systems

The major economic systems used today in the
Western world are:

CAPITALISM which is when the majority of decisions
are made by private individuals demanding land,
goods, or services in competitive markets

SOCIALISM which occurs when the government
makes the majority of decisions
A. Capitalism

Capitalist markets answer the questions:

What?

How?

For Whom?
1. Basic Principles of Pure Capitalism

Private Property

Private Enterprise

Competitive Markets

Profit Motive

Laissez-Faire
2. Mixed Capitalism

The U.S. is a “mixed economy” in which both public
(government) and private (individual) institutions
exercise economic control
3. How Capitalism Works

A CAPITALIST SOCIETY exercises private control over
production and distribution through individuals working
for individual gain

Sources of production under capitalism are:

Land
Labor
Capital
Management

ENTREPRENEUR



=
=
=
=
Rent
Wages
Interest
Profit
B. Socialism

Under Socialism, major industries are owned by the
government

Karl Marx is the father of socialism
1. Karl Marx (1818-1883)

Marx believed that economic change was possible only
through revolution

Under socialism, private ownership of the means of
production is replaced by state ownership

Socialism requires a COMMAND ECONOMY rather than a
MARKET ECONOMY
III. Land and the
Real Estate Market
A. The Broker in the
Marketplace

Informed buyers and sellers make for a narrower range
of sales prices

Boards of Realtors® provide a Multiple Listing Service
(MLS)

Real estate agents stabilize local markets by providing
information about current selling prices as part of their
service
B. The Internet and the Real
Estate Marketplace

The Internet is a significant real estate marketing tool

It provides for a marketplace with informed buyers and
sellers

More than 87% of buyers used the Internet to shop for
a home according to the National Association of
Realtors®

Seller Internet Services
IV. Types of
Competition
A. Perfect Competition

PERFECT COMPETITION is an economic situation in
which no single seller or buyer can influence prices

Real estate does NOT fit into the perfect competition
category because the product is NOT homogeneous
B. Imperfect Competition

IMPERFECT COMPETITION is an economic situation in
which many sellers and buyers have some degree of
control over prices
1. Oligopoly

The market is controlled by a small number of
firms such that the production and pricing of one
will affect all.
 DUOPOLY
2. Monopoly

In a monopoly there is NO competition to act as a curb
against higher prices and excess profits

A MONOPOLY occurs where there is only one producer in
a market
3. Monopsony

A MONOPSONY is a market situation in which there is only
one buyer

The right of governmental agents to acquire property
through eminent domain is an example of monopsony
4. Oligopsony

OLIGOPSONY is a market situation in which there are only
a few buyers
V. Understanding
Value
A. Highest and Best Use

The HIGHEST AND BEST USE of land is that use which
will provide the greatest net value
B. Value

There are 4 forces influencing value of land:





Physical
Social
Economic
Political
Values are NOT static
C. Price

Price is NOT necessarily the same as value

A PRICE is the amount obtained when an item or service is
actually sold

EQUILIBRIUM PRICE
D. Rent

RENT is the economic return from use of land or
improvements

TENANT CONCESSIONS
E. Profit

PROFIT is a return beyond the value of the land, labor,
material, and management that goes into a project

Without profit as a motivation, decisions would be based on
non-economic considerations

Unearned Profit
VI. Economic
Measurements
Economic Measurements

There are a great number of indicators used to measure
the health of our economy in general

By studying changes in these indicators, economists
attempt to predict future economic changes
A. Governmental Agencies

A number of government agencies provide
information on measures of our national economy
1.
Federal Reserve
2.
Bureau of Economic Analysis
3.
Energy Information Administration
4.
Bureau of Labor Statistics
5.
U.S. Census Bureau
B. SMSAs

The Standard Metropolitan Statistical Areas consists
of at least 50,000 people

There are about 286 SMSAs in the U.S.
C. Indexes and Statistics
17.
Consumer Leverage Ratio
18.
Big Mac Index
19.
Misery Index
Prime Rate
20.
Bankruptcies
5.
Retail Sales
21.
Poverty Rate
6.
Stock Market Indexes
22.
Capital Expenditure
7.
Wholesale Price Index
23.
Help Wanted Advertising
8.
Consumer Price Index (CPI)
24.
Unemployment
9.
Balance of Trade
25.
Inventories
10.
Personal Income
26.
Collection Account Billings
11.
Median Household Income
27.
Unused Plant Capacity
12.
Savings
28.
Machine Tool Orders
13.
Consumer Credit
29.
Fiberboard Orders
14.
Federal Deficit
30.
Ratio of Corporate Debt to Corporate Inventory
15.
National Debt
31.
National Defense Spending
16.
Currency Valuation
32.
Vendor Performance
33.
Property Value Indexes
1.
Gross Domestic Product (GDP)
2.
M¹
3.
M²
4.
D. Leading and Lagging
Indicators

LEADING INDICATORS indicate changes in the
economy that should or will happen while LAGGING
INDICATORS show us what has happened in the
economy
1. Composite Index
(Lagging Indicators)
Average duration of unemployment
Ratio of manufacturer and trade inventories to sales
Change in labor costs per unit
Average prime rate
Commercial and industrial loans
Ratio of consumer installment credit to personal income
Change in consumer price index
2. Leading Indicators
Average weekly hours
Average weekly claims for unemployment
New orders for consumer goods and services
Vendor performance
Contracts and orders for plants and equipment
Building permits
Change in unfilled orders of durable goods
Changes in the price of sensitive materials
Stock prices
Money supply
Index of consumer expectations
E. Real Estate Oriented
Indicators

Some of the tools listed below are used to measure the
local real estate economy in your area:
Housing Affordability Index
2. Median Multiple
3. Housing Opportunity Index (HOI)
4. Occupancy Rate
5. Vacancy Rate
6. New Building Permits
7. Home Resales
8. Time to Sell
9. Rental Growth Rate
10.Mortgage Default Rate and Foreclosures
1.
VII. Real Estate
Bubble and the
Economic Bubble
Real Estate Bubble ?

A bubble occurs when investors put so much demand on a
product that the price is driven up beyond any rational
explanation of value

A bubble bursts when a great many owners try to unload
the product and realize their gain, only to discover that
there are fewer buyers than sellers at the high prices

Some sellers begin to panic and will sell at any price, which
threatens the entire market.
VIII. The Bubble
Burst
Burst Bubble

In 2006, we began to see a moderate drop in prices in
some real estate markets

By 2010, almost every area in the nation has experienced a
sharp decline in real estate values

Many factors played a role in the rapid escalation of real
estate prices and the subsequent fall in values
A. Exuberance

EXUBERANCE is the belief that values can only go up and
no matter what you paid, someone will pay more

This is often referred to as the Bigger Fool Theory
B. Speculators

Speculators entered the market in droves and developers
were willing to sell to speculators who planned to resell at a
profit

Speculators purchased multiple units in hopes of flipping for
a profit

FLIPPING is a purchase and a quick resale of a property

When speculators became net sellers rather than net
buyers, the lessening demand affected the entire real
estate marketplace
C. Developers

Because of demand, there was a rush to complete new
housing units

Builder demand led to shortages and higher prices of many
materials

Developers raised prices with each new phase of a
development

Developers encouraged speculators to purchase multiple
units

As the market softened, developers found themselves in
competition with the speculators to sell units
D. New Loan Products

Loan originators pushed products that lowered and even
eliminated down payment requirements for buyers

Many buyers were encouraged to take loan products with
escalating payments in the belief that loans could be
refinanced later

When buyers have no equity in a property, they are less
likely to maintain it and more likely to default on their loan
E. Subprime Loans

When Freddie Mac or Fannie Mae will not purchase a loan
because the borrower either has poor credit or has
insufficient income, it is considered a SUBPRIME LOAN

Because a market developed for subprime loans, lenders
rushed to make them

In many cases they were considered, PREATORY
LENDING in that loans were made without regard as to the
likelihood of the borrower being able to make the payments
F. Refinancing

Because loan originators could readily resale loans, home
owners were encouraged to refinance and spend the
money

Homes were regarded as piggy banks

When real estate values declined, many owners discovered
that their homes were upside down…they owned more than
their home was worth
G. Optimistic Appraisals

The 1989 FIRREA requires licensing and certification for
appraisers in federally related transactions

Unfortunately, appraisal standards did not protect lenders
from appraisals where the lenders encouraged higher
valuations

In many areas, over 95% of appraisals were at or more
than the sales price
H. Stock Market Drop

While the stock market drop in 2008 did not cause the real
estate market to collapse, it has been a factor in further
depressing values.

Investors felt less secure because of the drop in value of
their holdings

Because the stock market is based more on expectations
of the future than what is happening right now…the stock
market is expected by many economists to rebound prior to
a general economic recovery
I. Spike in Oil Prices

From 2007 to 2008, oil prices went from $50 a barrel to
$140 a barrel before falling back

Higher gas prices made it difficult for many prospective
buyers to be able to afford a new home
K. Rising Unemployment

Most households have to rely on two incomes to qualify for
a home loan

The loss of one income results in prospective buyers no
longer being in the marketplace
IX. Recession 2007
Recession 2007

According to the National Bureau of Economics Research,
December 2007 was the beginning of the worst recession
we have seen since the collapse of the stock market in
1929

Many economists underestimated the depth of the
recession thinking it would be “short and shallow”

There are a number of factors that worked together to bring
on this recession in our economy
A. Change From Production to
Service Economy

Some economists believe that the loss of much of our
heavy industrial base has had a negative effect on our
overall economy and affects the length and severity of the
recession

Loss of manufacturing jobs means loss of high paid jobs
that are often replace by lower paid service positions

Loss of production means greater imports and a negative
balance of trade
B. Collapse in Home Prices

The collapse in the housing market resulted in the
following:


Loss of Jobs
Less Commodity Demand
C. Commercial Real Estate
Market

Rising vacancies in office, retail, and industrial properties
has resulted in a slow down in development

REIT’s showed significant decline in value in 2007 and
2008
D. Deregulation and Bank
Failure

The Graham-Leach Bliley Act of 1999 removed barriers
between traditional banks, investment banks, and insurance
companies

In 2004, the SEC released the major investment bankers from
the net capitalization rule that had required that they maintain
reserves which minimized risk

Banks failed

Other casualties:





Lehman Brothers
AIG
Merrill Lynch sold to B of A
Washington Mutual
Wachovia sold to Citigroup
Security Pacific
bank
 PFF Bank and
Trust
 Downey Savings
and Loan

E. Mortgage-Backed
Securities

Packages of loans were collateralized and sold as
mortgage-back securities

They had high yields and lots of ready buyers

Many were equal to “junk bonds” based on subprime loans

The losses suffered by investors made them cautious and
lenders reluctant to make loans both of which had serious
negative affect on our economy
F. Shadow Banking

Hedge funds and investment banks are relatively free of
government regulation

Mortgage-backed security transactions led to the failure of
some hedge funds and a number of investment banks as
the value of their securities began to evaporate
G. Tight Credit

Lenders tightened credit to consumers and businesses as
the recession set it

Excess of greed changed to excess of caution

Without credit, the auto industry stumbled

Businesses that were doing well, could not borrow on their
accounts receivable or inventory

Without credit, the recession continued
C. Private Action

Some lenders took action to keep loans performing and
avoid foreclosures

Wells Fargo took over $107 billion in option adjustable rate
mortgages when it rescued Wachovia

Wells Fargo has rewritten loans at low interest rates for terms of 6 – 10
years

Wells Fargo has also significantly reduced balances on loans
X. Economic
Stimulus 2008
2008 Stimulus

In an effort to turn the economy around, the government
under both Presidents Bush and Obama realized that
action was necessary

The belief was that we could NOT afford to wait for the
economy to correct itself
A. President George W. Bush


$168 Billion Economic Stimulus Act of 2008

Tax rebates, for low to moderate income taxpayers, to encourage consumer spending

Tax incentives to stimulate business investments

Raise loan limits that could be purchased by Fannie Mae and Freddie Mac
$700 Billion Financial Reserve to Bail Out Financial
Institutions

No restrictions were put on “how” to use the bailout money resulting in AIG paying for
executive junkets and bonuses
B. President Barack H.
Obama

$787 Billion American Recovery and Reinvestment Act
of 2009

Purpose was to preserve and create jobs, invest in infrastructure,
provide assistance to unemployed, and tax relief

MAKING HOMES AFFORDABLE PLAN
CASH FOR CLUNKERS
FIRST TIME HOME BUYER CREDIT



Helping Families Save Their Home Act of 2009

$750 Billion Bank Rescue Plan
Chapter Summary


Early Economists

◦
◦
◦
◦
Economic Systems
◦ Capitalism
◦ Socialism


Gov’t Agencies
Indexes and Statistics
Leading/Lagging Indicators
Real Estate Oriented Indicators

Real Estate/Economic
Bubble

The Bubble Burst
◦ Perfect
◦ Imperfect

Recession 2007
Understanding Value

Economic Stimulus
Land and the Real
Estate Market
◦ The Broker
◦ The Internet

Economic Measurements
Types of Competition
◦ 2008 to present