Pricing power

A run-of-the-mill suburban housing developer in a run-of-the-mill suburb doesn’t have much pricing power. If a particular developer asks more than the going rate for a new house, home buyers can simply skip to the next subdivision. But some locations are one-of-a-kind. Maybe they’re conveniently located. Maybe they have a great canopy of 100-year-old trees, great schools, or convenient access to downtown or the waterfront. In these cases, a developer can be a price maker, not price taker. They have a mini-monopoly over their special little neighborhood. They can decide what price they get by choosing how many houses they sell.

Let’s walk through an example. A 20-acre tract becomes available in central Affordaville, one of the last large tracts of its kind. A developer buys it and wants to build single-family homes. How many homes does the developer build? That depends on the demand schedule, the list of prices buyers will pay for a given number of units. We’ve listed this particular development’s demand schedule below. If the developer chooses to sell just ten houses, they can find ten buyers willing to pay $225,000. If they sell twenty houses, they can find twenty buyers at $210,000 a piece. And so forth. Each house costs $135K to construct.

Number of homes Price per home
10 $225K
20 $210K
30 $195K
40 $180K
50 $170K
60 $160K
70 $150K
80 $140K
90 $130K

<insert image in demand form>

The particular prices might vary sharply from location to location but the two essential characteristics of this demand schedule are common: 1) People are willing to pay more to live in an attractive location than they are willing to pay for less attractive locations. 2) There are only so many people who are willing and able to pay the highest rate so the more houses the developer decides to build, the more they have to drop their prices. While the developer will do their best to sell each house for as much as they can, it isn’t feasible to get one buyer to pay $225K for the same house that other buyers are only paying $160K for. For one thing, without the extra land, the lots may be worth somewhat less to the top buyers. But even more importantly, top buyers will have real estate agents who know that it’s not possible to sell 60 units in this location for $225K each and will advise clients to wait for price drops.

If the developer is trying to make as much money as they can (and they have to, to avoid losing money for reasons we will describe below), how many houses will they build? Based on the demand schedule, it would be easy to believe the answer is about 85. After all, if it costs $135K to build one more house, and you have buyers willing to pay more than that, why not build that house and make the profit? If the land were not owned by a single developer, but 100 different developers, this might be what you would expect! But expanding out the demand schedule tells a different story:

 

Number of houses Price per house Cumulative Revenue Marginal Revenue Cumulative Costs* Marginal Costs Profit*
10 $225K $2.25M $2.25M $1.35M $1.35M $900K
20 $210K $4.2M $1.95M $2.7M $1.35M $1.35M
30 $195K $5.85M $1.65M $4.05M $1.35M $1.8M
40 $180K $7.2M $1.35M $5.4M $1.35M $1.8M
50 $170K $8.5M $1.3M $6.75M $1.35M $1.75M
60 $160K $9.6M $1.1M $8.1M $1.35M $1.5M
70 $150K $10.5M $900K $9.45M $1.35M $1.05M
80 $140K $11.2M $700K $10.8M $1.35M $600K
90 $130K $11.7M $500K $12.15M $1.35M ($.45M)

*The costs and profit shown are excluding land costs, which will be discussed subsequently.

<insert image in supply/demand form>

Somewhat counterintuitively, the marginal revenue for each new lot of houses the developer sells is less than the total price the developer can get for those units. While selling more houses gets additional paying customers, the developer has to lower its prices in order to do it, reducing the revenue it can get from other potential customers.

The developer will maximize profit by selling houses until marginal revenue equals marginal cost. For our developer, the most profitable number of houses to build is about 35 priced at $187,000 – $188,000, yielding a profit of a little more than $1.8M before land costs. How much the developer actually makes depends on both their ability to execute and how much they paid for the land. A savvy seller will have offers from multiple developers so any developer who is not profit-maximizing will either lose money or be outbid for the land by a developer who has profit-maximizing plans.

In Chapter 2, we considered the impact of land prices on a developer’s choice of building technologies. There we assumed that land costs were determined by the land’s value if put to another use such as agriculture. But in our example here, the land price is effectively determined by the developer’s profit. A developer might be able to get a better deal from a property owner, but the developer in theory would be willing to pay up to $1.8 million for the land. That value — its value when put to its best and highest use —  is equal to the revenue from selling the homes minus the cost of building the homes. Put simply, land value is the value of the property minus the value of improvements. This will be an important point when we consider the incentives of homeowners.

The key elements leading to the developer’s pricing power are the uniqueness of the product and the lack of competition within the tract. If the entire tract is similar to other tracts, it must compete in the marketplace with those substitutes on price. If the tract is unique and special, it also must have a seller that is able to intentionally reduce the supply and take into account the profitability of the tract as a whole and not just the isolated profitability of a single parcel.