The Fallacy of Supply and Demand

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A fundamental law of economics is that increases in the supply of a good or service will pull prices down, decreases push prices up. As prices rise demand decreases – less can be bought with the same limited funds – and as prices fall demand increases – more can be bought with the same limited funds. The interaction of these two mystical forces will find a price level that provides the most goods to the most people possible, the price point of stable equilibrium. The law of Supply and Demand relies upon two underlying assumptions; we have unlimited wants (Demand) and there is scarcity, limited supply of goods and services.

. There is no market in the world that follows these laws and not surprisingly there is no market in stable equilibrium. The apologists blame this on externalities, regulation and imperfect markets. They argue if there is more deregulation markets will operate more efficiently and therefore equilibrium will magically appear. An efficient market is one with many buyers and seller, with perfect or near perfect information about all the products on sale, and all market players behave as rational self interested utility maximiser’s. It is impossible to achieve any of these prerequisites without regulation (therefore the theory is fundamentally flawed). All players in a market who are self interested have a tendency toward monopoly, collusion, and misinformation because they are trying to maximise profits and this is best done not by competition but by dominating a market by creating points of difference or killing off competitors by predatory pricing and acquisition thus monopolising the market. Where this cannot occur any intelligent rational self interested being would collude with their competitor and fix the price so they can both survive and maximise profits. This is evidenced in all our major markets, two major retail outlets Coles and Woolworths, 4 major Banks ANZ,nab, CBA, and Westpac two major beer producers CUB and Lion Nathan and so on, smaller players are forced out of the market and the oligopolies price in unison. So self interest destroys the many sellers and perfect information requirements of the efficient market, but that’s not the only problem. We are not intrinsically rational self interested utility maximiser’s, we only become so when forced by an accepted group theory which advocates this behaviour (see trust game tests on economics students) which is coupled with financial rewards and sanctions for following this behaviour (see effect of sanctions in ultimatum games).

Studies in behavioural economics is uncovering the multitude of behaviours which are distinctly irrational, herd mentality when demand increases as the price rises, or loss aversion when people sell a falling stock rather than buying more because the price is lower are the complete opposites of the supply and demand model. We are also affected by sanctions and manipulations. When advertisers use framing, priming and identity associations to trap us in emotional buying decision-making we are happy to pay premiums for high status goods like D&G sunglasses or Tiffany & Co jewellery, the high price can even add to the status and therefore the price we are willing to pay. Financial sanctions and threats can trap us into overly isolated short-term rationally self interested decision making where we care little for the impacts of our buying and selling choices as long as we get enough to survive. We are happy to pay $5 for a t-Shirt made in a sweat shop by people working 14 hour days for a pittance. Or buy a $5 McHappy meal even though we know there is little nutritional value but it is high in salt, sugar and saturated fats all detrimental to our long term health. Limited money forces short-term self interest. I have satisfied hunger within budget at the expense of long term longevity. A combination of financial sanctions and emotional manipulations can make a market player a puppet for anyone wishing to separate them from their money.

So let’s look at some data and see if supply and demand can explain prices in a market. To test supply and demand I will use a basic good that we all require that is still effected by scarcity and one which we could expect unlimited wants. One with many sellers and very good information because buyers usually personally inspect before their purchase and the market has tight regulations on quality (building regulations, soil quality tests, environmental compliance, council aesthetic and access compliance).  The housing market should follow – if any can – the rules of supply and demand and therefore should respond to increases in cost – interest rate rises with decreased demand and therefore a drop in overall house prices.

Housing Market

This is the house prices index for Australia sourced from the Australian Bureau of Statistics (ABS)

home loan interest rates

Homeloan interest rates sourced from the ABS

A glance at these two price indicators shows that interest rates move in unison with overall prices rather than acting as a controller of demand  used by the RBA to regulate price the rates follow the price or the price follows the rates. Rising prices seem to cause more rises and falling prices seem to flatten the market, this supports the herd mentality and loss aversion emotional behaviours rather than classic supply and demand. The spike in rates in early 1990 coincides with a spike in house prices. As does the drop in rates in 2008/09 as the GFC started to bite, which also coincided with a tiny dip in overall housing prices. Falling rates in the nineties coincided with a flattening of overall prices and rising rates in the 2000’s with a boom in the housing market.

Perhaps the constantly rising prices have been caused by supply restrictions?

New dwelling construction in Australia sourced for ABS

As you can see over the corresponding period new dwelling construction in Australia is fairly stable, always between 30,000 and 45,000 dwellings per year. Perhaps an increase in demand is because is due to population growth.

Population growth per year sourced from ABS

Now we might be onto something the rapid increase in population growth from 2005 to late 2008 correlates with the rise in house prices but its come off its peak and house prices are still rising, and it doesn’t explain the beginning of the boom from 2000 to 2005 where population growth was flat.

We are left to think that an increase in demand from  an increase in population growth may be just one of many factors in that determine price but it is not the overall answer. Perception, confidence and the more human behaviours like herd mentality, loss aversion, and accepted group theories such as we are all in a recession put your money under the bed as happened in the early nineties when house prices did drop slightly, are the overriding influences on price.

So where does this leave the Reserve Bank and its attempts to regulate demand and therefore prices by raising and lowering interest rates (monetary policy), well they end up exacerbating the problem rather than addressing it. Raising interest rates tells buyers the market is booming so they buy more, lowering says there is panic of a recession so they buy less. The opposite of what classical supply and demand rules dictate ends up occurring. We must be smarter and realise the best way to control money supply in the economy is with a broad underlying Flow Siphon Flat Payment (FSFP), not the misguided and harmful use of official interest rate movements.

David J Campbell

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