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Why is real estate market an oligopoly?

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DRE Research Seminar 15 February 2006 Why is real estate market an oligopoly? James D. Shilling University of Wisconsin- Madison School of Business – PowerPoint PPT presentation

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Title: Why is real estate market an oligopoly?


1
Why is real estate market an oligopoly?
  • DRE Research Seminar
  • 15 February 2006

James D. Shilling University of Wisconsin-
Madison School of Business
Tien Foo Sing National University of
Singapore Department of Real Estate
2
Presentation Outline
  • Introduction Bertrands Paradox
  • Basic model and assumptions
  • A mono-centric city model with capacity
    constraints
  • A Multi-nodal urban land market model
  • Differentiated markets in Hotellings linear
    space
  • Mergers and predatory pricing strategies
  • Variable price structure
  • Conclusions future extensions

3
Industrial organization and real estate market
  • Industrial organization (IO) literature is
    expanding rapidly
  • Issues relating to functioning of market, like
    market structure, incomplete information, and
    predatory strategies, exit and entry deterrence
    etc.
  • Limited IO studies in real estate market
  • Real estate market has unique features for IO
    study because of the inherent spatial
    characteristics
  • Differ by location (distance from city centre),
    by property type (sub-markets), by
    countries/cities (institutional features)
  • Real estate market provide a good platform for IO
    studies
  • Products are typically heterogeneous
    differentiated by location and by type
  • Information is inefficient/imperfect
  • Supply side constraint fixity in land / density
    control through zoning

4
Basic model and assumptions
  • A static game theoretic model with two players
  • They develop homogenous products at a fixed
    location, xi
  • Two firms compete on prices to optimize profits
  • Information complete and decisions are
    simultaneous
  • Demand function is given as
  • Di(pi, pj) a bpi dpj
  • b demand elasticity d cross-elasticity of
    substitution
  • Such that 0 lt d lt b
  • The market is pareto-efficient
  • In Nash equilibrium, duopoly firms earn zero
    profits
  • Prices will be driven down to equal to costs
  • The result is welfare sub-optimal
  • Bertrands Paradox

5
Bertrands Nash Equilibrium
Rj
pi
Ri
Nash equilibrium
pipj c
pi
pj
pj
6
Bertrands paradox and real estate market
  • Real estate markets are not monopoly, and they
    are dominated by several players, and the number
    of players in each market varies
  • The responsiveness of the market may vary across
    cities and sub-markets
  • Is real estate market a special test case that
    rejects Bertrands paradox?
  • If not, why are the following questions not
    answered?
  • Why are mergers and predatory strategy not
    operative in real estate market?
  • Is the real estate market welfare sub-optimal?
  • Could developers earn more than zero profits?
  • What factors that drive an oligopoly real estate
    market?

7
Why is real estate market an oligopoly?
  • In manufacturing technology, the adoption of
    flexible technology promote concentration of
    market (Eaton and Schmitt, 1994)
  • Firms avoid diversification and expansion of
    basic products, and thus reduce fixed costs
  • Ownership structure is irrelevant, and mergers
    and cartels are welfare optimal strategies that
    lead to concentration of market
  • Flexible technology is not applicable to real
    estate markets
  • Land is fixed and immobile, and ownership of
    lands is a prerequisite of any development
    activities
  • Is oligopoly structure of real estate market
    welfare optimal? why?
  • Other forces limiting concentration of real
    estate market
  • Capacity constraint (The Edgeworths solution,
    1987)
  • Differentiated products/ spatial characteristics
    of real estate market
  • Imperfect information
  • Dynamic market / repeated strategies

8
Flexible Production Structure by Eaton and
Schmitt (1994)
Xi
Xj
Xh
9
Limiting forces (1) Capacity constraint
  • In a mono-centric city where both developers
    co-exist at xi
  • Supply is inelastic and density on each land
    parcels is controlled by zoning
  • Maximum density is binding in each market at xi,
  • such that
  • Capacity constraint is imposed by ?, where 0 ? ?
    ? 1
  • Demand functions
  • In Nash Equilibrium

10
Capacity constraint and demand structure
11
Proposition 1
  • Capacity constraint,?, in a duopoly market is a
    function of the demand elasticity, b, and cross
    elasticity of substitution, d. In a market with
    highly substitutable products, and where buyers
    are less insensitive to price changes, i.e.
    inelastic demand, a developer requires a higher
    capacity constraint of ?m in order to preempt
    entrants and earn monopoly return
  • In a market with highly substitutable product,
    developers are required to increase their
    capacity substantially to preempt entry and
    obtain monopoly profit
  • This is commonly observed in highly homogenous
    market, and lower end housing markets

12
Limiting forces (2)
  • A multi-nodal urban land model
  • Spatial features are incorporated using
    Hotellings linear city kernel (1929)
  • (x, q) (x1, q1), (x2, q2), . ,(xN, qN)
  • where , m (1, 2) indicates a bi-nodal
    urban market
  • x1 lt x2 lt x3 lt.. xN
  • distance vector is a continuous function that
    increases in an equally space distance,
  • Two developers, each of them establishes
    competitive edge at the two city centroids

13
Cost structure in Hotellings linear city
14
Solving for optimal market boundary
  • Assume that price is inelastic
  • Aggregate profit functions over a distance, (Xi,
    xi)
  • In Nash equilibrium, p1 p2 MCi(x1)
  • Equilibrium price is equal to the marginal cost
    of the second most efficient developer
  • MCi(x1) max MC1(xi), MC2(xi)
  • Market boundary where both developer earn optimal
    profits is derived as

15
Aggregate Profits in duopoly market
16
Optimal market boundary of duopoly
17
Aggregate profit of developer 1
18
Proposition 2
  • Given the optimal market boundary that gives
    welfare-optimal return to each of the developers,
    , aggregate profits of the
    developers increase with an increase in the
    linear size of a bi-modal city. However, the
    aggregate profits of developers will be lower, if
    they face an increasing capacity constraint.
  • Both developers are better off when the city size
    is expanded
  • Aggregate profits decreases when capacity is
    raised by either one of the developer
  • The above two conditions are sufficient to reject
    a monopoly market

19
Entry and mergers in real estate market
  • Proposition 3
  • There are positive profits for new entrants to
    establish strong foothold in space along the
    linear city, , and the profits of
    incumbents will be eroded with the new entrants.
    The loss in profits for incumbents as indicated
    by shaded area (a) and dotted area (c) is
    dependent on the location at which the new
    entrants possess competitive edge in their
    production technology. The loss for incumbent
    developer m increase, when is
    smaller.
  • Proposition 4
  • Merger of two developers with established home
    market reputation in adjacent markets are welfare
    optimal. However, there are no externality
    effects on the developer outside the merger. The
    profit level of the developer not involved in the
    merger remains unchanged.

20
Effects of entry and mergers
21
In a multi-nodal city with elastic demand
  • Demand function qi Di(pi, pj)
  • Proposition 5
  • In an elastic market where demand is responsive
    to price changes, the profits of developers will
    be an increasing function in the cross-elasticity
    of substitution, d, and an decreasing function in
    the demand elasticity, b.

22
Variable price structure
  • Utility function of buyers
  • Profit function
  • Proposition 6
  • When the marginal rate of increase in unit cost
    is lower than the marginal disutility rate,
    developers will be able to maximize the profit by
    stretching their market boundary outward from
    their home-base. When t? lt r, there is no
    incentive for developers to expand their market
    boundary, and it would be better off for the
    developer to focus only on its home-market where
    he has competitive advantages.

23
Limitations possible extensions
  • Reputation of developers
  • D1(p1, p2) a (b-?)p1 dp2
  • Incomplete information on cost structure
  • Location dependent capacity constraints
  • Different sub-market and switching costs

24
Urban land pricing structure for two different
uses
25
Conclusion
  • For manufacturing firms with homogenous products,
    flexible production technology promotes market
    concentration (Eaton and Schmitt, 1994)
  • Costly to expand basic products
  • In real estate market, flexible production
    technology is not applicable
  • Ownership in real estate market is critical
  • Fixity in supply and capacity is constrained
  • Using Hotellings linear city kernel, models with
    two city centroids were developed
  • Given capacity constraints, and also that cost
    structure of developers is tied to location
    advantage
  • Forces that promote concentration of market are
    ineffective
  • Real estate market is an oligopoly, yet there is
    no reason to reject that the market is welfare
    sub-optimal
  • Empirical hypotheses can be developed to further
    verify propositions that reject concentration of
    ownership in real estate market
  • Thank you!

26
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