What May Eventually Limit Rising House Prices? Evidence from Engel Elasticities and Budget Shares of Housing

Abstract

Rising house prices lead to questions of sustainability, since mortgages must be financed from future incomes. Much attention is thus focused on the relationship between housing expenditure and income. This article estimates Engel elasticities of housing expenditure for each independent cross‐section of the Norwegian Consumer Expenditure Surveys in the period 1986–98, and finds that the elasticity remains surprisingly close to unity for all years. Its mean over the period is 1.02. This indicates that when incomes or total consumption increase by 1%, then housing expenditure also increases 1%. Engel and demographic effects are estimated in an errors‐in‐variables two‐stage‐least‐square regression model using random samples. This article documents that, given demographic composition, a household's demand for housing seems to increase proportionately with total consumption, in contrast to categories such as food and transportation. This empirical regularity appears to be quite resilient towards changes in business cycles, relative prices and other time‐dependent changes. It may represent a basic pattern of consumption, and thus yield forecasting potential and herald the possibility of estimating ceilings to housing expenditure. If the elasticity continues to be unity, then over a period of time future housing expenditures will keep the same pace as incomes.

Keywords:

• D12
• R21
• Budget share
• Consumption pattern
• Demand for housing
• Engel elasticity
• House price sustainability
• Housing expenditure

Acknowledgements

The author thanks Rolf Aaberge, Jørgen Aasness and Thor Olav Thoresen for ideas, comments and suggestions. Knut Reidar Wangen was especially helpful with resolving issues concerning handling and linking large data‐sets. Thanks are due to all of them; shortcomings only to the author.

Notes

1. Depending on whether eating out is excluded or included.

2. Engel's Law is perhaps the most robust empirical pattern in economics. It has been confirmed for different societies at different times, and has been used, for example, to derive equivalence scales and recently to assess CPI bias.

3. An income (or Engel) elasticity is a statistic that tells us how much, in percentage terms, the demand for or expenditure on a good increases when income (or total consumption) increases 1%. The elasticity I use will be formally defined in equation (7) below.

4. Reported by Cheshire and Sheppard (1998).

5. The definition in economics of a luxury good says that it is a good that has income (or Engel) elasticity above unity. A necessity is defined as a good with income (or Engel) elasticity below unity.

6. The expression in the denominator is the average budget share. An alternative expression for the budget share is the average of each household's individual budget share.

7. Lee (1964) informs us of this, and refers to Alfred Marshall (1952).