The house price fairy visited me last night. She offered me three choices: she would instantly double all house prices; she would instantly halve all house prices; or she would leave all house prices the same.
"You stupid fairy!" I replied. "Don't you know i already own this house, and I have no plans to sell it or to buy another? I need somewhere to live, and I've got it; I have already covered the short position in housing I was born with. I don't give a damn what you do with house prices; it won't make me richer or poorer or affect me in the slightest. That's why I own exactly one house, not two houses, and not zero houses, so I didn't have to care if house prices went up or down. Next time you wake me up, at least offer me something interesting to choose from!"
She looked at me reproachfully. "Nick, I expected better from you. Non-economists can only think of wealth (income) effects, and usually get them wrong too. You got the wealth effect right, but you ignored the substitution effect".
She was right. What should I have chosen? Or rather, which of the three choices should I not have chosen?
The vertical axis shows the quantity of housing I consume. An upward move means I live in a bigger and better house. The horizontal axis shows the quantity of all the other stuff I consume. The black line shows my budget constraint. If I want to live in a bigger and better house, I need to spend more of my income on housing, and have to consume less other stuff. That's why it slopes down, showing that trade-off. The blue curve is one of my indifference curves. Each indifference curve shows all combinations of housing and other stuff that give me a particular level of satisfaction. I've only drawn one indifference curve - the one I'm on. I choose to consume that combination of housing and other stuff where my black budget line is at a tangent to my blue indifference curve. That combination maximises my utility, given what I can afford.
Suppose house prices rise. My budget line now becomes the flatter, green line. I have to give up more other stuff to get less extra housing. Suppose house prices fall. My budget line now becomes the steeper, red line. I have to give up less other stuff to get more extra housing. But notice that the budget line always swivels around my current endowment point. I can just afford my current combination of housing and other stuff given my current income. And because I own my own house, I can still just afford it, whether house prices rise or fall.
If house prices rise, I could continue to do what I'm doing now, if I wanted to. But if my indifference curve looks like the one I've drawn, I won't want to. I could do better by moving to somewhere like point B, moving to a smaller worse house and consuming more other stuff.
If house prices fall, I could continue to do what I'm doing now, if I wanted to. But if my indifference curve looks like the one I've drawn, I won't want to. I could do better by moving to somewhere like point A, moving to a bigger better house and consuming less other stuff.
At either A or B, I'm on a higher indifference curve than where I am now. I can't say (without knowing where the other indifference curves are) which of A or B is better. But they are both better than where I am now. I will want the fairy to change house prices, whether double them or halve them, I'm not sure.
It's always got to be like that, unless I've got significant moving costs that would give me a weird budget line. Or unless I've got weird preferences, that have a kink at where I am right now. Otherwise, I could always do better, by moving either up or down the housing ladder.
And since for every landlord letting a house, there must be a tenant renting it, the average household owns one house, which they live in, just like me. I'm not special; I'm the representative household.
Of course, fairies aren't real. House prices don't just change; they change for a reason. Something caused supply or demand to change. Unless of course the fairy is Tinkerbell.
[By the way, my house price fairy problem is formally identical to the substitution bias in the CPI.]