I outlined the argument and presented some of the empirical evidence supporting the idea that land use regulations played a key role in the housing bubble below. I want to expand on that argument, as well as provide more empirical evidence, in this post. First, Goodman and Thibodeau (2008), in a paper titled "Where Are the Speculative Bubbles in US Housing Markets?", find:

"We estimate housing supply elasticities for 133 metropolitan areas and conclude that although areas on the East Coast and in California had large observed price increases, they owe much of their house price increases to inelastic supplies of owner-occupied housing."
This is, I think, the key point: it was housing supply inelasticity more than anything that led to the housing bubble. What role do land use regulations play? Not surprisingly, it is land use regulations that lead to inelastic housing supply. In a 2005 American Economic Review paper, Quigley and Rosenthal report:
“For the growth in the overall housing stock, we find a significant and positive supply elasticity for unregulated cities and a negative and significant negative effect for regulated cities.”
Quigley and Rosenthal then turn to the effects on housing prices, finding:
“We find a positive relationship between the degree of regulatory stringency and housing prices for both owner-occupied units and rental units.”
Thus, restrictive land use regulations -- which make housing supplies inelastic -- turn a demand shock into a bubble because they lengthen the duration of price appreciation. This argument that land use regulations turn demand shocks into bubbles was bolstered by a recent paper by Dusansky and Koc (2007):
"We find that an increase in housing prices increases the demand for owner-occupied housing services. Thus, housing's role as investment asset with its potential for capital gains dominates its role as consumption good, which alone would produce a downward sloping own demand curve rather than one which is upward sloping."
Housing's dual role as an investment and a consumption good is what makes it more susceptible to bubbles. When house price appreciation is fast enough and lasts long enough, consumers don't demand less of it, as they would with normal consumer goods, because the expected capital gains from the house price appreciation, in the minds of consumers, offsets the higher price for housing as a consumption good. Moreover, the belief that house price appreciation will continue -- which is reinforced by the long duration of the price appreciation -- leads consumers to overestimate the expected capital gains. This is why, I think, land use regulations were likely a key factor in the housing bubble.

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