Retail prices rise as a direct result of surges in home prices—the same reasons that bar prices do: Wealthier people don't mind.
Call it the $14 Cocktail Rule. D.C.'s Washington City Paper has made that figure shorthand for describing rising demand for services in the city's hotter neighborhoods. That this measure is indexed to the price of cocktails tells you something about the local alt-weekly, but also about the elasticity of demand for alcohol.
As it turns out, the relationship between rising housing prices and rising everything-else prices is broader than just what's happening at the bar. A new paper released by the National Bureau of Economic Research susses out the causal link between rising demand for housing and retail prices. In neighborhoods with large house-price movements, retail prices rise accordingly.
It's one of those things that everybody already knows (or thinks they already know): Things cost more in more expensive neighborhoods. But arriving at proof without relying on assumptions is not so easy. The paper, coauthored by Johannes Stroebel at New York University and Joseph Vavra at the University of Chicago, demonstrates "direct causal evidence on the response of household shopping behavior and retail price-setting to changes in wealth and demand."
When the elasticity of demand for a product falls, markups grow larger. And in neighborhoods where households grow less sensitive to prices—neighborhoods that where wealth is rising—markups rise for retail and services alike. During a housing boom, the effect can be staggering:
Across a variety of empirical specifications, we estimate an elasticity of local retail prices to house price movements of approximately 15%-20%. This elasticity is both highly significant and economically large: for example, a two-standard deviation increase in house prices over the housing boom from 2001 to 2006 causes an increase in retail prices of 4%-7%. The median increase in retail prices over this same time period is 7.9%, with a standard deviation of 4.5%. This suggests that the local demand shocks we identify can account for a significant fraction of the overall regional variation in retail price changes in our sample.
Further, the report shows, there's a link between high ownership rates and rising retail prices (not just high home prices). "In zip codes with a high homeownership rate, house price increases lead to large increases in retail prices," the study reads, "while in zip codes with the lowest homeownership rates, house price increases actually lead to declines in retail prices."
Could higher retail prices at the pharmacy or the grocery store reflect higher marginal prices, somehow, or are they—like higher cocktail prices—the result of higher markups?
Nope. For the study, the researchers focused on goods from grocery stores and pharmacies that aren't produced locally. The costs for providing these goods wouldn't be affected by local conditions. The researchers were also able to rule out increases in local wages or rents as a factor in rising retail prices. Shocks in supply don't explain the results.
"When households become richer, they become less price-sensitive and firms respond by raising markups and prices," the paper concludes, telling us something we all know (but didn't know that we know).