Dear Economist

Heads you win, tails you win too

Dear Economist,

I am planning to buy a new house in a year or two. My old house has gone up 50 per cent in price since I bought it. Everyone tells me it will be unfortunate if prices fall by the time I sell. Yet I am convinced I will be lucky if prices fall. My new, more expensive house will cost me less and, on the whole, I will be better off. Who is right?

— Vladimir Gorelov, Bournemouth

Dear Vladimir,

Your problem is that you and your friends are confusing money with utility. As a matter of arithmetic, if both houses fall proportionately in value, your plans will be less expensive to execute. But I do not understand why you would stick to those plans regardless of what happens to house prices.

Consider what will happen if house prices rise. Then you can make different choices, cashing in your expensive house, buying somewhere smaller, and spending the proceeds on other pleasures that have become relatively cheaper.

In fact, economist David Friedman proposes the following paradox. You are better off if house prices rise, but also better off if they fall, and for exactly the same reason: the change in house prices gives you new options. If they rise you have the option to consume less housing by buying somewhere smaller, and you will be better off. If prices fall, housing becomes cheaper and you should consume more of it by trading up. Again, you will be better off.

In either case, you could stick with what you had and be no worse off, but your new options almost certainly offer some improvement. Friedman’s reasoning is impeccable. You may find it confusing or unsatisfying because you lack the imagination to work out your response to changing prices. My advice is to stop the dinner party prattle about the housing market and start making contingency plans.

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Addendum: This one made the New York Times again – read the full version here.

4th of June, 2005Dear Economist • Comments off