I unexpectedly got into two Twitter discussions recently about Silicon Valley (SV) and its effects on the local real estate market. I felt constrained by the 140 character limit, so I thought I’d write a blog post explaining my thinking (and add supply & demand diagrams!).
To understand what is happening in SV, we need to think about three markets:
(1) the product market for what SV tech companies sell
(2) the SV tech labor market and
(3) the SV housing market.
First, what’s obvious: there’s been a huge increase in demand for what Silicon Valley sells: the world is using way more IT than it used to. Someone has to build & program this stuff, and so there’s been a large increase in demand for certain kinds of high-skilled labor—namely software engineers, designers, product managers and so on. Let’s call them “tech people.”
Most tech people are transplants, coming to SV specifically to work in tech. They need a place to live. As such, a demand shock for tech labor is also a demand shock for housing in SV.
How the labor demand shock plays out
In the figure below, the top diagram is the labor market and the bottom diagram is the housing market. The y-axes are wages and real estate prices, respectively. The x-axes are tech people hired and units of housing consumed, respectively. The connection between these two markets is so tight that I assume that changes in tech people employed must be met one for one with changes in housing units consumed. This is why the two diagrams are stacked on top of each other.
Here comes the iPhone: Tech Boom!
Let’s consider how a product market demand shock leads to a new equilibrium. First, the demand curve for labor shifts out (in red, top panel). If we ignored the housing market, we would just see higher wages and more tech people hired. However, these new tech hires want a place to live, so they shift out the demand curve in the housing market (in bottom panel, also in red).
But the tech people labor supply curve depends on housing costs
At this new higher price for housing, fewer tech people are willing to work at each wage (i.e., “I’ll stay in Seattle and work for Jeff Bezos, spending more on tissues and psychological counseling, but spending less on rent”). The higher housing prices shifts in the tech people labor supply curve. This shift takes some pressure off the housing demand, pushing down housing prices a little. This tatonment goes back and forth until a new equilibrium is reached with:
(1) more tech employees (but not as many as would be in absence of housing effects)
(2) higher wages and
(3) higher real estate prices
Where we are now:
The importance of the housing supply elasticity
As you might expect, how this process works out depends a great deal upon how these curves are shaped and how big these shocks are. One critical piece is the slope of that one curve that didn’t move around—the housing supply curve. From the perspective of of tech and non-tech workers and tech firms, we can say “elastic” = “good” and “inelastic” = “bad” (existing, homeowners are another story).
Elastic supply = good. Imagine a better world in which the housing supply is completely elastic. The housing supply curve is flat. This means that no matter how large the positive demand shock in the housing market, house prices stay the same. Here, the demand shock in the tech labor market has no effect on non-tech workers through the housing channel (because housing prices do not rise). Also note that there is no pulling in of the tech worker supply curve—the workers get the “full” benefit in higher wages.
Inelastic supply = bad. Now, let us imagine a world where housing is completely inelastic, making housing a vertical line. In this inelastic case, housing is fixed. We already “know” that tech companies aren’t going to be able to hire more. Tech wages are going to rise, but the main beneficiaries will existing owners of housing because of the price increase. They get enormous rents—literally. Of course, the curve is not completely inelastic because of one very controversial “source” of elasticity is displacement. The tech people move in, the non-tech person moves out. This is why people throw yogurt (at best) at tech buses.
How do non-tech people fare?
A more complete analysis might consider the effect of the tech boom on non-tech wages. Presumably they get some benefit from increase demand on their services from tech people. And to some extent, non-tech sectors have to increase wages to get people to still live and work in SV. It seems unlikely to me that this is fully off-setting.
The main adjustment is probably housing displacement, meaning longer commutes. It makes more economic sense for them to move farther away (i.e., travel an hour a day and save $20/day on rent). That being said, they are almost certainly worse off with these horrendously long commutes than they were pre-boom.
What are the solutions?
- Do nothing. One “solution” is do nothing, under the belief that things will run their course and the tech boom will fizzle. To the extent that the boom does not subside, other places in the world will become relatively more appealing for tech as the high cost of labor in SV persists (because of housing). However, to date, SV seems to be becoming more important and tech becoming more centralized in SV, not less, so this might be a slow-acting solution. Further, it seems bad for SV as a region: If I were king of SV, I wouldn’t be sanguine about the “Detroit solution” to too much product market demand for what my region specializes in.
- Build more housing. Another solution (of course) is to increase the housing stock. This should push prices down. A better solution might be to enact structural changes to make the supply of housing more elastic. Given how much housing prices have risen, it seems that the supply is very inelastic (more on this later).
- Let people work remotely. Another solution is radically different, which is to try to sever or at least attenuate the connection between the housing and labor markets. This is the “Upwork” solution in a nutshell, which their CEO outlined in a recent Medium post. If a tech company is open to remote hiring, then those remote hires never enter the local rental market and do not drive up prices. It does not even have to be either/or, as letting your employees work remotely some of the time helps: if I only have to be in San Francisco three days a week, living in Half Moon Bay rather than Cole Valley becomes much more attractive (Uber also helps here and autonomous vehicles would help a lot).
I’m particularly optimistic about, (3), the tech-focused solution, as it seems more likely “work” right away and it requires little political change. Also, somewhat ironically, the increasing maturation of technology for remote collaboration means that this approach should become more attractive over time.
Incidentally, why is the supply of housing in SV so inelastic?
Some of it is surely geography, about which little can be done. The peninsula is just not that wide and there aren’t large, nearby tracts of undeveloped land. I imagine that the, uh, interesting geological properties of the area matter for construction. However, the main cause seems not to be so much the quantity of land, but rather the intensity with which the land is used.
Take a Google streetview of walk of Palo Alto or Melo Park. When you consider how large the demand for housing is and then look at the built environment of those cities, there is a wild disconnect. These cities should be Manhattan-dense or at least Cambridge, MA-dense but they are not—it is mostly single family homes, some on quite large lots. They could be nice suburbs more or less anywhere. These are *very* nice place to live, of course, and I can understand the instinct to preserve them as they are. But the unchanging neighborhood character of Palo Alto is part of the reason why tech is having a huge negative externality on non-tech people, through the channel of higher housing costs.
Relevant disclosures: I used to work at Upwork’s predecessor company, oDesk. I still consult with them and I conducted academic research with their data. I also visited Uber as a visiting economist last summer and my wife works for them still. When I worked for Upwork, I lived in Redwood City until my landlord decided to not renew our lease so he could sell the place. We rented somewhere else that was a little cheaper, but my commute got longer. I might go back to SF to work for a bit this summer, if I can find a cheap enough place on Airbnb.