A Lesson in Supply and Demand

In his column today, Economic Whodunit, Thomas Sowell provides a great example of using supply and demand to explain things.   Here, he uses supply and demand to explain the behavior of housing prices.

But an increased demand for housing does not automatically mean higher housing prices. In places where supply is free to rise to meet demand, such as Manhattan in the 1950s or Las Vegas in the 1980s, increased demand simply led to more housing units being built, without an increase in real prices– that is, money prices adjusted for inflation.

What led to a boom in housing prices was increased demand in places where supply was artificially restricted. Coastal California was the largest of these places where severe legal restrictions on building houses led to skyrocketing housing prices. Just between 2000 and 2005, for example, home prices more than doubled in Los Angeles and San Diego, in response to rising demand in places where supply was not allowed to rise to meet it.

Lessons in supply and demand are good, because I think there are widely held misconceptions about what ‘supply and demand’ is.

Two examples:

  • A few nights ago, a friend of a friend wrote on a Facebook comment that the ‘laws of supply and demand do not apply to commodities because these are controlled by speculators”.
  • Someone in my family often tells me that ‘supply and demand doesn’t work because prices of cars keep going up.”

In both of these cases, I think the owners of these comments believe that ‘supply and demand’ means that prices will always go down or be favorable in some sense.  This is not a correct view of supply and demand.

Supply and demand governs price behavior and you can use what we know about supply and demand to explain what caused changes in price levels and what might happen in the future.  Whether you’re talking about the price of a stock, education, health care, cars or commodities – the laws of supply and demand apply.

Sowell continues:

The problem was that, not only were these mortgages based on housing prices inflated by the Federal Reserve’s low-interest rate policies, many of the home buyers had been granted mortgages under federal government pressures on lenders to lend to people who would not ordinarily qualify, whether because of low income, bad credit history or other factors likely to make them bigger credit risks.

This was not something that federal regulatory agencies permitted. It was something that federal regulatory agencies– under pressure from politicians– pressured and threatened lenders into doing in the name of “affordable housing.”

To sum up, housing prices in some areas were on the rise because demand was increasing due to low interest rates and a Federal government goal to get people into the house buying market that were not there before – poor credit risks.  At the same time as demand was increasing local building restrictions in some areas limited supply.  Increase demand without changing supply and rising prices result.

When the poor credit risks to the expected – stop paying their mortgages and try to get out of the homes they can’t afford, that puts more supply on the market while demand is shrinking because higher interest rates make it less affordable for people to purchase homes.  Increasing supply and decreasing demand leads to price drops.


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