Rate Watch #1289 – Supply, Demand, Price, Elasticity.
January 19, 2021
By Dick Lepre
dicklepre@rpm-mtg.com
www.loanmine.com
There is a lot of discussion about markets such as housing. People too often have personal views about what is good for us as a society and use those without considering some basic realities about markets.
In order to understand what the prices of things change it’s best to understand that four things are tied together; these are price, supply, demand, and elasticity.
Supply
Supply is the amount of a good that producers are willing and able to sell at a given price. The amount of stuff supplied depends on:
- the market price of the good
- the cost of producing the good
- the supply of alternative goods the producer could make with the same raw materials, plants, equipment and labor force
- the supply of goods produced at the same time (joint supply)
- unexpected events (e.g. disasters) that affect supply.
The housing market has two sources of supply: new homes and existing homes. Supply is in fact severely restrained by land use regulations and zoning. This is a magazine article I wrote on why this is so important https://www.scotsmanguide.com/browse/content/viewpoint-why-housing-prices-are-rising
A consequence of the pandemic is that more people are working from home and no longer bound by having to live close to their job. In some places people are leaving the city for suburbs. Supply is there but in the wrong places because housing is not portable. In the San Francisco Bay Area the effect is an increase in home prices in the suburbs https://www.mercurynews.com/2020/10/07/bay-area-home-prices-soar-with-suburban-boom/
Demand
"Demand" is the amount of stuff that consumers are willing and able to buy at a given price.
The amount of a stuff demanded depends on:
- the price of the good
- the income of the would-be buyer
- whether the buyer likes it (consumer taste)
- the demand for alternative goods which could be used (substitutes.) In the case of housing this is the rental market.
In the housing market demand is enabled, to a significant extent, by mortgage lending. Buyers’ ability to purchase depends on how much money they have for down payment, the payment relative to their income and their credit worthiness.
Elasticity
The price elasticity of demand measures how much the quantity demanded responds to a change in price. Reductions in selling prices should spur sales and gross revenue.
Elasticity is not a vague description but rather can be defined numerically as the change in demand divided by the change in price. (Since demand goes up as price goes down this number is actually negative and elasticity is more correctly mathematically defined as the absolute value of this number.)
Elasticity greater than one means demand is elastic. When the elasticity is greater than one, the percentage change in quantity demanded exceeds the percentage change in price. When the elasticity equals zero, demand is perfectly inelastic. There’s no change in quantity demanded when there’s a change in price.
Supply also has elasticity. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by percentage change in price. It measures how much the quantity supplied responds to changes in the price. In housing supply is very inelastic. That is what that Scotsman article was about. People are now recognizing that zoning is responsible and we are starting to see this change. This piece is about zoning in Alameda a city next to Oakland, CA https://www.planetizen.com/news/2020/10/110769-ballot-alameda-end-single-family-zoning Many of these ordinances are too little, too late. Once lots are developed it is not easy to convert from SFR to multi-family.
The supply of various items depends on their portability. Housing is almost entirely not portable. It needs to be built where it will be used.
Elasticity vs. inelasticity is not a neutral proposition. Elasticity is better than inelasticity because it allows a means to stimulate production, GDP, and jobs when the economy is languishing. Elasticity is good; inelasticity is bad.
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