Negative housing demand shocks have afflicted many American cities in the 20th century and are the main explanation for city decline. But what is the role of housing supply? We argue that rational entrepreneurs should not invest in new buildings and renovation when home values are below replacement cost. Households with an investment motive should behave similarly. Empirically, we find that construction costs are not very sensitive to building activity but do vary with local income, unionization rates in the construction sector, the level of local regulation, and region. We also document that the variance in building costs generates substantial variance in renovation expenditures across cities. Using instrumental variables techniques to account for the endogeneity of home values to renovation expenditures and for measurement error, we find that owner-occupied homes with market values below construction costs spend about 50 percent less on renovation than similar average homes. Simulations point to an important role of construction costs in the decline of marginal areas in ailing cities.
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