Real economies don’t always work the way they are depicted in Microeconomics 101 at the local college.
That statement is not a criticism of the discipline. Introductory courses in most subjects have to leave details for subsequent ones. But people who have taken only introductory econ must realize that what they have learned does not cover all situations.
A report on office space in the Twin Cities released earlier this week by United Properties illustrates one such situation. The report notes that a fifth of office space in the metro area is vacant. For St. Paul, the vacancy rate is 28 percent.
That does not square with outcomes predicted in introductory economics. In beginning courses, students learn about supply and demand. The intersection of supply and demand determines both a market price and the quantity that changes hands. That point is described as equilibrium because no one has an incentive to do anything that would change either the prevailing price of quantity.
Everyone who wants the product at that price or below gets what they want, and everyone who wants to sell at that price of below finds a buyer. There are no surpluses or shortages.
If some external factor affects supply or demand, the equilibrium quickly moves to a new price-quantity combination where again, no one faces an incentive to change price or quantity. The market “clears” in economists’ jargon.
How then can economists explain a market where 28 percent of an available good, in this case commercial office space, goes unleased? Isn’t price supposed to drop enough so the market will clear?
Prices certainly have dropped. United Properties notes that rental rates in downtown Minneapolis, for example, have fallen by nearly a fourth since 1999. Price decreases must have motivated some people to rent space they would not have otherwise. Still, a fifth of all space remains empty.
The answer is that understanding behavior in markets for products that take a long time to produce requires more sophisticated theory than elementary supply and demand. Subsequent courses in micro theory introduce students to a model that explains gluts of office space, beef and aeronautical engineers, among other things.
The process works like this: A given area has some amount of office space, and some base level of annual new construction. The economy grows, and demand for rentable office space grows faster than the usual pace of new construction. Rental rates rise and property managers decide they can make money with new buildings.
The problem is that many property managers arrive at the same conclusion simultaneously. They tend to underestimate the degree to which their competitors also will expand. Plans are drawn, contracts are let, and after a period of two to four years, shining new buildings are being opened all over the city.
Suddenly, there is more space offered than can be rented at prevailing rates. Rental rates drop. But they seldom drop enough so that all the available space is rented. In the meantime, new construction slows to a near halt.
In the Twin Cities, the cycle is about 12 years. There was a boom in office tower construction in 1987 that resulted in a space glut until 1994 or so and another building boom that peaked in about 2000 or so. Current depressed rents and high vacancy rates are the result. The situation will change only as gradual economic growth slowly absorbs the surplus.
Cattle production follows a similar cycle. Prices rise and ranchers respond by holding young females back from slaughter to expand breeding herds. This curtails supply, and prices rise even more. A few years have to pass, however, before the females held back from slaughter have offspring that reach market weight.
When they do, the simultaneous expansion of thousands of herds becomes evident in prices. Dramatically increasing numbers of animals sent to market drives prices down. Eventually, producers respond by culling the least useful cows in their breeding herds and shipping them to slaughter. This addition to kill numbers further depresses prices. Furthermore, producers hold back few young females as replacements.
Eventually, the glut is absorbed, and the smaller breeding herds resulting from harsh culling with few replacements produce fewer slaughter animals. prices start to rise and the whole cycles begins again.
The office rental and cattle markets do differ in that while office space can sit vacant, farmers have to sell most cattle when read for slaughter. The cattle market does “clear” in that all the available physical supply does get used up. And the price swings are even more dramatic than for office space.
Such cycles have been evident for more than a century. Why don’t property firms and ranchers wise up and sop? Once answer is that producers know there is money to be made by increasing output during rising prices if one can act quickly enough. Most are irrationally optimistic about their ability to cash in before the fall. They also know their own stinting won’t make others do the same and an eventual bust is inevitable. As long as you are going to suffer the bust in any case, you might as well try to make some money during the boom.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.