WHY SHOULD INVENTORIES RISE WHEN DEMAND FALLS IN HOUSING ANDOTHER MARKETS?

Inventories and price changes are correlated. The inverse relation is most obvious in housing whereinventories build in low demand markets and shrink in high demand markets. This is a puzzle. Ifsellers and buyers had symmetric views of the world, one would think that sellers would lower theirreservation value at the same rate that buyers lower their offer price. Because there is heterogeneityamong buyers in the valuation of a given house and because houses are not homogeneous, sellers setprices strategically. When demand falls, it is optimal for sellers to lower their prices but not by enoughto keep the probability of sale constant. As a result, inventories grow. This is consistent with the mostbasic theory of monopoly pricing and requires no irrationality on the part of sellers or buyers. Furthermore,a distinguishing feature of this theory is that it implies that the negative correlation between inventoriesand price changes should not be observed in perfectly competitive markets where goods are homogeneous,e.g., stock or commodity markets....