Impact of Demand and Supply Forces in the Market
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In general, equilibrium market price is determined by where quantity demanded meets quantity supplied. This holds true for the property market in the UK, where prices are being driven by large demand for housing and an almost fixed supply of property. This larger demand of housing over existing supply has been the main factor driving UK property prices up in the last 10 years. However, these increased prices cannot last forever, the market (through changes in supply and demand, as well as government intervention) will find a new equilibrium due to factors that will bring demand down again.
According to demand and supply theory, for a downward sloping demand curve, as price increases, quantity demanded moves leftward along the demand curve, resulting in a lower quantity demanded. On the other hand, in an upward sloped supply curve, as price increases, then quantity supplied moves rightwards along the supply curve for a higher quantity supplied. In the case of the UK housing market, let’s suppose we had a downward sloping demand and upward sloping supply, which intersected at P0 and Q0. About 10 years ago, the UK economy was starting its upwards growth cycle. This gave people more money which they could freely spend on purchasing property, increasing demand for housing. This increased demand caused the demand curve for property to shift outwards from D0 to D1. With this increase in demand, and the same supply curve S0, prices would have increased from P0 to P1 and quantity demanded and supplied would have increased from Q0 to Q1.
However, this increase in demand which caused higher prices would also affect supply, so more builders and developers would want to construct housing in order to fulfil this growing demand. Yet, this increase in supply is always smaller than the increase in demand because of resource constraints—where will you actually build new housing and the time it takes to build such once you have found a place to do so and also because the builders know that others will be building too and so the increased price will not be as high as they initially saw. In the end, the total increase in supply is smaller than the increase in demand. This increase in supply (which takes a bit longer to be reflected in the market than the increase in demand) would imply an outwards shift of the supply curve from S0 to S1. This in itself would then reduce prices from P1 to P2 and increase quantity even more from Q1 to Q2. Since the increase in supply is not enough to offset the increase in demand, the cycle begins again with another outward shift in demand, since those demanding Q2 at the lower price P2 are willing to pay up to P3, driving demand out again and helping the boom in housing prices.
In reality, this increased demand and supply is continuously occurring and the process cannot be explained by the diagrams above. Some believe that part of the real reason why prices are so high right now is because people are buying based on how prices have been behaving and are not arbitraging: instead of correcting each others mispricing, they reinforce it. (Farlow 2004)
However, in the future, demand for housing could become lower than supply, which would mean that prices would go down. Given the high prices to date, more developers are building new housing which would imply that supply is increasing. If this continues or even grows, then supply could at one point exceed demand, driving prices downwards. This is unlikely, as when builders are making decisions as to whether or not create new homes they factor in the supply of housing being built by their competitors, which sometimes causes the overall growth in supply to be lower than what some expected. Another factor that could influence a price crash is an economic recession, whereby many people are laid off and their disposable income is reduced. Were this to happen, then demand for property would decline, and again, prices would have to reduce to accommodate the lower demand. A third factor that could influence is if the government increased interest rates dramatically. In this case, the increase in interest rates would result in two main issues: reducing consumer spending, which would include buying property, in favour of saving money, as savings rates would increase, and secondly, a reduction of people wanting to borrow money for properties, as mortgages would go up. This two-way reduction would also reduce demand for property, with a result of a reduction in property prices.
As we have seen above, demand and supply forces can be used to explain how it is possible to get such a continued increase in the prices of UK housing over the last 10 years, beginning with a strengthening of the economy which injected cash into the market. This led to increased demand for housing which was not offset by identical increase in supply, which combined with continued economic growth and low interest rates just continued putting upward pressure on demand for housing and thus increasing prices. There have been many recent articles wondering when this upwards spiral will end but it is difficult to predict. The Bank of England has been trying to intervene by increasing interest rates in the last few months with yet another increase predicted in the near future, but this is not reflecting in a reduction for housing demand. A big factor that could help reduce property prices is a reduction in the overall economy, as occurred in the 1980s, when unemployment hit certain areas and many were left with little income for buying homes. This, however, does not seem likely, given the pressure to maintain the economic boom. However, there will come a point when the majority of people will be unable to afford any housing due to its continuous price increases, driving demand for housing down.
Farlow, A., 2004, “Part two: The UK Housing Market: Bubbles and Buyers”, Credit Suisse First Boston.
Lipsey, R.G. and K.A. Chrystal, 1999, Principles of Economics, 9th edition, Oxford: Oxford University Press.
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