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Discover How Market Equilibrium Determines Property Prices
Ever wondered how property prices are determined? According to Dr Gabriel Ahlfeldt, it’s all about supply and demand. While there are many other factors that can influence how these prices are set, beyond what people are willing to buy for and sell at, a good place to start is by determining the market equilibrium.
Transcript
Have you ever browsed through property advertisements and wondered how the property prices were determined? We can use supply and demand theory to help us gain an understanding of some of the factors that determine how these prices are set.
The demand curve represents a range of theoretical prices at which buyers are willing to buy certain quantities. The supply curve presents a range of prices at which sellers are willing to sell certain quantities. But how do we determine what the actual price and quantity offered in the market are? This is done by determining the market equilibrium, which is where the quantities demanded and supplied are the same.
The demand and supply curves indicate the prices at which products are bought and sold respectively. If you look at the supply and demand curve jointly, we can determine the market equilibrium, which is the point at which supply and demand curves intersect. At this point, buyers want to buy exactly the same amount that suppliers want to sell. The market equilibrium implies that demand and supply are equal. There is one quantity and one price where this condition is met.
How does the market converge to an equilibrium? If prices are lower than equilibrium prices, demand will exceed supply, as individuals are willing to buy more than what producers supply. This will lead to a shortage and consumers will try to outbid one another until the price goes back to the equilibrium price. The same happens when the prices are above equilibrium. There will be an over supply as supplies are willing to produce more than what consumers demand. This leads to a fall in prices, which reduces production until demand and supply are equalised.
Therefore, in the long run, market prices will tend towards equilibrium. Now suppose that there is an increase in demand in the market. Typically, demand shifters include population growth, income growth, or a change in preferences. In the housing market, demands increase as good results because of a change in housing structure, such as an increase in single households or single-parent households with corresponding higher per capita housing space consumption. This will mean that at any given price, we have a larger demand for housing and a shift in the demand curve to the right. In this case, with a positively sloaped supply curve, the shift and the demand curve will result in a new equilibrium price and quantity, both of which are higher than before.
The same rationale applies to the supply curve. Typical supply shifters include the change in construction costs or wages, or a change in policies or planning such as new safety requirements or design standards. The production of housing units therefore becomes more expensive, so that at any given price a lower quantity is provided. Therefore, a new equilibrium, where we have higher prices and low quantities, emerges.
One characteristic of demand is that it tends to increase over time. This is because the population grows and income generally tends to increase over time. Given that the supply curve is not normally fully elastic, we observe over time an increase in the price of housing. The increase in the price is now determined by the slope of the supply curve. Therefore, if we are in a situation where there is more restrictive planning or we are in a location that is subject to create a land scarcity, in other words, the supply curve is steep, then we will, in the long run, observe higher prices. Both the price level and price trends being the increase and decreases in prices over time are determined in the long run by the interplay of demand and supply. In the long run, the slope of the supply curve is critical in determining increases in housing prices.