News on the front page of Tuesday’s business section offered a classic demonstration of how markets for different goods respond differently to changes in demand or supply. The top story reported that the number of houses sold in the Twin Cities area is down nearly 5 percent from a year ago. The story below it noted corn prices increased nearly 20 percent in the last six months.
Both changes largely are the result of demand and supply — people are less willing to buy houses and they’re less willing to sell corn. The most noticeable effects differed, however. For housing, the adjustment was largely in quantity, although median price increases have slowed. For corn, it was almost entirely in price.
The dissimilar reactions tell us something about how markets operate.
Markets for houses and corn are driven by supply and demand. Even so, these forces are not just physical quantities. They also depend a lot on human willingness. Buyers usually are willing to buy more of a good when the price is low and less when it is high. Sellers generally want to sell more of the same thing when the price is high and less when it is low.
But neither housing nor grain prices are driven only by the collective willingness of individuals. The federal government intervenes by subsidizing production of certain crops. Government taxes, zoning and other policies affect the housing market.
Such government policies change little in the short run, however. Month-to-month price or quantity changes stem largely from supply and demand. But why do corn and housing respond differently?
Some goods — hot dogs, running shoes, gasoline, for example — are produced, sold, purchased and consumed on a daily basis. This is not the case for grain and housing.
Although grain is consumed daily, it is produced growing season by growing season. The 2006 corn crop is planted and mostly fertilized. No real change in inputs can be implemented before April 2007. That will not change output until the crop is harvested in fall 2007.
While farmers decide how many acres to plant and what inputs to use, the external force of weather greatly affects actual production. Ongoing drought in some corn-growing areas is one factor pushing up corn prices. The preconditions of output are decided on a yearly cycle, but actual output varies with sun, rain and frost. Perceptions of what might happen in production and use fluctuate daily.
Grain, unlike fresh bread or gasoline, can be stored cheaply for long periods even in farm-level quantities. So, on any given day, supply is determined by grain owners’ willingness to sell their existing stocks and not on producers’ willingness to crank out more.
Housing is a special case in that it not only provides the human necessity of shelter, but also a long-term household or business asset. Houses are a physical investment, and people spend lots of money building them. But they last a long time and provide a real service (shelter) or financial income (rents and capital gains).
The amount of bread consumed in a month about equals the bread produced. The corn used in a year equals that produced in a year. All this bread or corn must change hands in short periods.
New housing construction, however, increases the total stock of housing by just a few percent a year. On average, many years pass between the purchase of a house and its resale. Some owners face time pressure to buy or sell because of factors like job relocations. But most households have some discretion in when to sell or to buy a house.
Unlike grains or hot dogs or gasoline, purchasing a house usually involves long-term financing. So, the effective monthly “price” of shelter for a family depends at least as much on a mortgage interest rate as on the actual amount paid for a house.
Households don’t base purchases of hot dogs or running shoes on their expectations of what the world will be like six months or a year from now. Buyers and sellers of grain and houses do. Indeed, their expectations of what the future will bring often are more influential than conditions today.
What are the general lessons in all of this? For many goods, the immediate impact of a change in supply or demand is on price. Quantity adjustments often take longer but might be more important. When output is fixed and usage is hard to change in the short run — as is the case for corn or wheat — practically all the visible impact is on price.
When a good such as housing lasts a long time and turnover of the total stock is slow, most of the short-term change is in the number sold with little immediate change in price. But price changes set in eventually. Housing price increases greatly outpaced income increases and general inflation over the last five years. They can go the other way, too.
© 2006 Edward Lotterman
Chanarambie Consulting, Inc.