Why Do Inventories Rise When Demand Falls in Housing and Other Markets?
Inventories and price changes are correlated. The inverse relation is most obvious in housing where inventories build in low demand markets and shrink in high demand markets. This is a puzzle. Symmetry of information among buyers and sellers would seem to imply that sellers would change their reservation value by the amount that buyers change their offers. Because there is heterogeneity among buyers in the valuation of a given house, sellers set prices strategically. When demand falls, sellers rationally lower their prices, but not by enough to keep the probability of sale constant. As a result, inventories grow.
This paper was revised on December 5, 2011