Transcript

Using a model of demand and supply to understand house prices – Part 2

NARRATOR

So far, our model has looked at the effect of price alone on the quantity demanded or supplied. To do this, it assumes that everything else that could influence the quantity of housing demanded or supplied is held constant. Economists call this the ceteris paribus condition.

So what happens if we relax the ceteris paribus condition in order to look at the effect that factors other than price might have?

Suppose interest rates in the economy fall, making mortgages cheaper. This does not directly affect house prices in the first instance, but it encourages more people to consider purchasing for the first time or moving up-market.

The quantity of housing demanded is now higher at each and every price. This means that the demand curve shifts to the right.

I’ll call the original demand curve D₁ and the new demand curve D₂.

Now, more people than before want to buy homes at price P_e. But sellers still only want to sell quantity Q_e if the price is P_e. In other words, there is now excess demand at price P_e.

This causes prices to rise along the new demand curve D₂, progressively choking off some of the new demand but bringing more sellers into the market as the price becomes more attractive to them, until a new equilibrium price and quantity are reached.

I’ve relabelled the original equilibrium price, P_e1 and the original equilibrium quantity Q_e1. The new, higher, equilibrium price is labelled P_e2. The new equilibrium quantity is labelled Q_e2 and is higher than Q_e1.

So, to summarise, a rise in demand causes upward pressure on prices; the demand curve shifts to the right, meaning that equilibrium price and equilibrium quantity both rise.

Now let’s look at another example of how non-price factors could affect the housing market.

Suppose housebuilders, speculating that house prices will be much higher in five years’ time, decide to halt building new homes for now and just sit on the land that they’ve already bought until the price rise happens.

As a result, the quantity of housing potential sellers are willing or able to supply is now lower at each and every price. This means that the supply curve shifts to the left.

I’ll call the original supply curve S₁ and the new supply curve S₂.

The number of potential buyers hasn’t changed, so there is again excess demand at the previous price, P_e1.

This time, it’s because not enough sellers can supply houses equal to Q_e1 even though that’s the amount buyers want at price P_e1.

This causes prices to rise, progressively choking off some of the existing demand but also stimulating some extra supply – drawing in some of those potential sellers who had dropped out of the market at the previous equilibrium price, which was deemed too low – until a new equilibrium price and quantity are reached at the increased price P_e2 and decreased quantity Q_e2.

Notice that, unlike the rise in demand in the previous example, which led to an increase in the equilibrium quantity, the decrease in supply has led to a decrease in the equilibrium quantity.

So, to summarise, a fall in supply causes upward pressure on prices; the supply curve shifts to the left meaning that the equilibrium price rises but the equilibrium quantity falls.

I’ve looked at factors that put upward pressure on prices, but some changes have the reverse effect.

Starting with our original situation with S₁ (before the developers withdrew their supply), now suppose the government decides to require firms to use land more efficiently by building homes at a higher density than before – for example, requiring 100 homes per hectare instead of, say, 60. Since land is a large part of the cost of supplying a home, building firms are now willing to provide more homes at every price (the supply curve shifts to the right).

This means there is a rise in supply and this causes downward pressure on prices; the supply curve shifting to the right means the equilibrium price falls but the equilibrium quantity rises.

Equally, downward pressure on prices might be caused by a fall in market demand. You saw before how reduced interest rates may attract more buyers. So, conversely, increased interest rates will reduce the number of buyers as mortgage repayment becomes more expensive.

At every price, there would be fewer people wanting to buy, and so the demand curve would shift to the left.

So, the fall in demand has caused downward pressure on prices; the demand curve shifting to the left means the equilibrium price falls, and so does the equilibrium quantity.

Here is a summary of the four ways non-price factors affect the market.

Notice that a shift in the demand curve causes the equilibrium price and quantity to change in the same way – in other words, both rise or both fall, but, a shift in the supply curve causes the equilibrium price and quantity to change in opposite ways. In other words, if price rises, the quantity falls; but, if price falls, the quantity rises.