Estimating the housing production function with unobserved land heterogeneity

Abstract

Housing supply in dense cities depends on the ability of builders to substitute capital for scarce land. This margin is difficult to estimate because builders choose capital after observing microgeographic conditions that are only imperfectly observed by researchers. This paper develops a method for estimating revenue-based housing production functions in this setting. Because observed capital variation reflects both technological substitution and endogenous responses to latent local conditions, existing estimators can transmit unobserved heterogeneity into the estimated production function. The method treats the unobserved local conditions that affect capital choice as a scalar Markov state and combines the capital share equation with Markov moments implemented using repeated cross-sectional construction data. Monte Carlo simulations show that the estimator recovers capital and land elasticities under flexible production technologies when capital choices respond to latent local conditions. An application to newly constructed housing in Tokyo's 23 special wards illustrates how the method can be implemented in a dense single-city setting. The results show that explicitly modeling latent local heterogeneity matters for estimated capital-land elasticities and implies returns to scale close to one.