Hate price rises? Please blame supply and demand, not me
Have you ever observed how, according to numerous economists, every phenomenon ultimately boils down to the interplay between the availability of products or services and people's desire for them? Grasp this fundamental concept, and you seemingly possess all the necessary knowledge. However, it fails to encompass the intricate details awaiting comprehension.
What is causing the sudden rise in the cost of living? It is the result of an imbalance between the increasing demand for goods and services and the inability of the economy to meet that demand, leading businesses to raise their prices.
If the number of available rentals had been high, landlords who have taken out mortgages would have been much less likely to raise the rent.
Given the limited options available to governments for boosting supply in the near future, the solution involves employing elevated interest rates to deter excessive expenditures. This will result in diminished demand, causing businesses to exhibit less enthusiasm towards further price hikes. By putting substantial pressure on demand, there is a possibility that businesses may be compelled to reduce their prices to a certain extent.
However, as someone pointed out to me not long ago, claiming that supply and demand account for everything in the economy is akin to explaining every aircraft accident based solely on gravity. While this statement holds true, it fails to provide substantial insights.
Think about this. Instead of gradually increasing over the past ten years, rental prices are suddenly skyrocketing. Why is this happening? You might hear from some individuals that it's because nearly half of all rental properties have been purchased by regular people, who have taken out loans to invest in them (utilizing "negative gearing" and similar strategies).
The significant increase in interest rates in recent months has negatively impacted numerous real estate investors, resulting in a substantial loss of money. As a result, they have raised the rent they are demanding.
Oh, no, according to numerous economists (including a central bank governor who is leaving his position), that's not the cause. Since the rate of empty properties is remarkably low, it indicates that the need for rental spaces is nearly equal to the supply at hand, which allows landlords to exploit this situation by increasing their prices.
Well, which option is it? I believe it's a mix of both. If the rate of unoccupied properties was high, landlords with mortgages would have experienced the impact of increased interest rates, but would have been less willing to raise the rent out of concern for losing their tenants.
However, it is probable that the synchronicity of a restrictive housing market alongside an increase in interest rates has accelerated and magnified the growth of rental prices to a greater extent than it would have naturally occurred. It would be intriguing to ascertain if landlords without any financial obligations have raised their prices at a similar pace and to the same extent as those burdened with debts.
The main idea is that understanding how the supply and demand process operates doesn't provide much insight. It doesn't enable you to forecast the future changes in supply or demand, nor does it explain the reasons behind their fluctuations.
It is primarily advantageous for what economists refer to as "retrospectively justifying" – also known as the insight gained after the fact.
Economic theory proposes that all businesses, including landlords, aim to maximize their profit. However, in their groundbreaking book, Radical Uncertainty, esteemed British economists John Kay and Mervyn King challenge this conventional belief and argue that, contrary to what textbooks may suggest, businesses do not actually strive to maximize their profits.
Why not? Not because they lack the desire to do so, but because they lack the knowledge on how to proceed. The existence of an optimal "price point" that would enhance their profits remains unknown to them.
For economists, when you're solely involved in the sale of widgets, it is all about discovering the precise blend of "p" (the price assigned) and "q" (the demanded quantity). Elevating p ought to enhance your earnings – but solely if the benefits accrued from the higher p exceed the losses incurred due to the decrease in q, which occurs when certain customers decline to pay the escalated price.
To achieve the optimal balance between p and q, it is crucial to have an understanding of "the price elasticity of demand," which refers to how responsive customers are to price changes. This elasticity value is usually taken for granted or calculated based on a study conducted in the United States three decades ago, as mentioned in academic references or mathematical frameworks.
In the real world, there is uncertainty, prompting us to proceed cautiously and remain prepared to lower prices if necessary. Our decisions are based on a blend of personal emotions, the sentiments of other traders, our perception of customers' emotions, and their potential reactions to a price increase.
The conduct of actual individuals in real marketplaces is influenced by their mood, feelings, attitudes, accepted social conduct, and collective tendencies – all of which economists intentionally ignore in their models and have limited understanding of.
Keynes referred to this phenomenon as "animal spirits", while the younger generation may refer to it as "the essence of the matter". It concerns the psychological aspect rather than strictly economic factors. Due to the fact that traditional economics disregards the ethereal realm of psychology when attempting to forecast economic outcomes, economists' predictions frequently prove to be incorrect.
While they might possess greater knowledge about the functioning of the economy compared to the general population, there remains a plethora of information that eludes their understanding. To worsen matters, a considerable number among them harbor the belief that acquiring such knowledge is unnecessary.
It is evident to me that psychology has greatly influenced the significant rise in prices following the pandemic. While it may not have directly caused it, psychology certainly amplified its extent.
The brief interruptions caused by the pandemic and the conflicts in Ukraine significantly impacted the availability of resources like fossil fuels and food. These disruptions served as solid reasoning for substantial increases in prices, allowing businesses to easily include additional amounts for their stakeholders.
The media clearly anticipated significant price hikes and thus, they eagerly sought out the opinions of industry lobbyists who were more than willing to make exaggerated forecasts about the impending surge in prices. (I'm personally still curious to witness the ABC's projection of coffee costs skyrocketing to $8 per cup.)
In this way, the understanding that it was now the moment to increase profit margins extended from the large oligopolies to every small local shop. One thing that limits the prices set by small businesses is the resistance they face from customers, both through complaints and by choosing to shop elsewhere.
The excessive attention from the media regarding upcoming price hikes convinced customers to be more accepting, and reassured shopkeepers that there wouldn't be much resistance to deal with.
In the housing rental industry, which is mainly controlled by inexperienced individual investors, there is a legitimate concern about losing tenants and facing extended periods of property vacancy. It is the estate agents, driven by their commission incentives, who possess the knowledge of when to advise landlords on increasing rent and the extent of the increase they can reasonably achieve.
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