Examine the factors that determine the price of houses in a free market. How and to what extend could government policies affect house prices?
This research paper investigates the housing market in UK. Housing market in the UK is considered to be in a monopolistic competitive market. Therefore every firm has some what differentiated products. The barriers to entry and exit are very minimal (close to none). There are numerous numbers of firms operating in the housing market. The determinants of price in the free markets are set by the forces of demand and supply model (which will farther be discuss in the investigation). The research paper will also investigate the effects and implementation of Government polices to control and changes to the housing market in the UK (these will also be farther discussed in the investigation).
INTRODUCTION TO PRICE IN FREE MARKET.
Being in a free market economy there are many factors which affect the housing market but without any government intervention, meaning that the prices of houses are set by the forces of demand and supply model, which forces buyers and suppliers to make decisions using the demand and supply analysis, or in other words the model is used to communicate between suppliers and consumers in the decision making process this is known as the price mechanism. There are many factors that are used to analyze the change in quantity demanded or demand and the change in quantity supplied or supply of houses in the market. These different factors can be divided into two main categories:
Factors determining demand and Quantity demand of houses
1. Prices of houses (effects in terms of consuming)
2. Prices of substitutes/compliments of houses
3. Income effect (change in the level of income earned by the consumers)
4. Population level
5. Preference (likes and dislikes)
6. Future price expectation of houses (effects in terms of consuming)
Factors that determine supply and Quantity supply of houses
1. Prices of houses (effects in terms of supplying)
2. Prices of substitutes/compliments of houses in production
3. Prices of factors of production of houses
4. Changes in Technology used to produce houses
5. Number of suppliers of houses
6. Future supply expectation of houses (effects in terms of supplying)
The factors determining the demand of houses usually affects the buyers of houses or in other words the consumers and the factors determining the supply of houses usually affects the producers or suppliers of houses.
1. A change in the prices of houses
According to the law of demand as the prices of houses decrease, the quantity demand of houses should increase but according to the law of supply as the prices of houses decrease the quantity supply should also decrease. Therefore if the prices of houses in a free market increase then there will be an excess demand of houses as the quantity supplied is less then the quantity demanded causing a shortage in the housing market.
2. A change in the prices of substitutes/compliments of houses
In the UK many houses are sold based on leasing and renting system. Considering different hotels as the substitutes of housing, if the prices of renting a hotel room were to decrease compare to the prices of renting a house then the demand of houses will decrease as more consumers will rent hotel rooms as it will cost them less then renting a house, as a result forcing the prices of houses to decrease (the opposite is true for complements. As prices of compliments of houses increases the demand for houses increase).
3. A change in the level of income earned by the consumers
The level income earn is something that measures the consumption level of consumers. In theory, it is known that more money a person has then more that person is willing to spend (depending on the type of income the person possesses inferior/normal). So as the level of income earned raises then the demand of house will increases, forcing the prices of house to increase.
4. A change in the number of population
As the number of population increases, then that mean more people require houses to live in and require more to consume. As the level of population increases, the demand for houses increases as well due to more consumption again causing the prices of houses to increase as a result.
5. A change in the prices of factors of production
There are three (some books considers entrepreneur as the fourth major factor of production) major factors of production: land, labour and capital. These factors are what make a product and if the price for either one increases then the quantity produced decreases due to high cost, causing the price to increase.
6. A change in technology used to produced houses
Technology is a factor that always said to improve because due to competition and increasing knowledge new technology is created to replace the existing one for example computers now a days have almost replaced fax machines. Just like that new machinery is created in other replace the old one, to increase efficiency in production. As new technology is introduced to improve production of house causing the supply to increase, therefore reducing the prices of houses.
7. A change in the number of suppliers of houses
As more firms enter the housing market the level of competition between the firms also increase. Since there are more alternatives available for consume the prices of house tend to decrease.
8. A change in future expectations of houses
Forecasting, predicting and assuming for the future are major factors in the housing market because house are a product which might depreciate in time but the price of house tend to fluctuate up and down. There are few reasons to why the prices of different houses fluctuate and due to these fluctuations the demand and supply also fluctuates over time. In the UK and in many other countries, there are many individual who buy houses depending on the future price. This is because they either want to sell the house in the future (if they have predicted that the price of there house will increase in the future, getting them more profit in terms of business) and some people buy it because it’s cheaper now then in the future. So if the price is expected to rise in the future then the demand for houses tends to increase in the present time.
A similar situation is seen in term of the suppliers of houses. As the price of houses tends to increase in the future, then the suppliers of houses will decrease the supply now and supply more in the future as suppliers will earn more profit in the future.
INTRODUCTION OF GOVERNMENT IN FREE MARKET.
As said before that in a free market economy there is no government acting on different firms, which gives the firms in a free market the freedom to charge customer the maximum price or give low wages to the labor force, this enables the firms to gain as much consumer surplus as possible and increase profits. But what if government were to enter this free market system and make the economy more ethical and equal for the labor force and for the society. When in a country or an economy the government is introduced, the businesses present are usually forced to decrease there selling prices or impose laws that affects the performance of the businesses. Such laws may include the law of minimum wage, the law of minimum wage suggests that workers should not be paid less then a certain level or the minimum wage set. Before discussing the minimum wage lets look at the market of houses and the labor used in houses. As examined before that as the cost of production increases the supply tends to decrease as well. Similarly the wage rate is also a factor that affect the supply, in definition, other things remaining the same, the lower the wage rate, the greater the supply or greater the quantity demanded of labor (In the long-run, the supply tends to become elastic of supply).
Now if the government is introduced to this market (where assuming that the labour force in the housing market was given a wage of $3.00 per hour) and – 6 -passes a law of minimum wage (imposing a price floor on the wages) of $6.00 should be provided to the workers in the housing market. This law imposed will therefore increase the cost of production for the firms in the market, resulting in a decrease in supply of houses (the affect on the labour market as a whole will not be discussed, as it is irrelevant to the topic) in conclusion it will increase the prices of houses to increase from p1 to p2 as illustrated in the diagram below.
Similarly like the minimum wage concept in other words known as the price floor concept which is used to increase the prices of good, there is a concept of price ceiling which is used to decrease the prices of goods. In the housing market the price ceiling could be imposed on the amount of rent given (could also be called rent ceiling), which could also affect the prices of houses. The introduction of rent ceiling will also have a affect on the supply of houses because due to the rent ceiling policy then prices of houses are likely to decrease (rent ceiling price is always set below the equilibrium level of the market) which will increase the quantity demanded of houses to increase, resulting in a increase in supply of houses due to a increase the revenue earned by the firms in the market.
The concept of price floor and price ceiling are one of many ways through which government controls the supply of a certain market or the aggregate supply of the economy. These different ways of controlling the aggregate supply are also called the “supply-side policies”. Some of other supply-side policies may include: Privatization, Deregulation, free trade and other different methods which mainly tends to aim at changing the level of supply in an economy.
Just like the supply-side policies, there are also policies to change the demand of a certain market or the aggregate demand of the economy. These policies are also known as the demand-side policies. Unlike supply-side policies, there are two major demand-side policies which governments use to control the aggregate demand of the economy (to increase output):
* Fiscal policy
* Monetary policy
Each policy has its advantages and disadvantage but each is very affective in increasing the output of an economy. Fiscal policy tends to use the tools of taxation and government spending to implement a change in the aggregate demand (could also be used in changing the aggregate supply), the distribution of income, the pattern of resource allocation and the level of economic activities active in a current economy. On the other hand, monetary policy refers to the government policy in which the government, central bank and other monetary bodies tends to regulate the “money supply” with the help of the Federal Reserves. The monetary policy uses three major tools to regulate the money supply, these tools include:
* Reserve requirement
* Open market operations (the explanation of monetary transmission mechanism will not be explained, due to irrelevance of the topic)
* The discount rate
Money is an important part of every economy as it is described as medium of exchange which represents a claim on a product. In economics, the terms income is usually substituted for money as it represent the amount of money a person has, and the amount of money being used in an economy is usually described by the “circular flow of income”. The circular flow of income is a model which shows circulation of income between consumers (buyers) and producers (sellers). If the amount of money in flow leaks out then the flow shrinks causing a recession but if there is money being injected into the flow then the flow grows causing economic growth. To control or increase the level of flow the government uses polices, in which also includes monetary policy. The main purpose of monetary policy is to keep the prices, the level of employment and the level of productivity stable in an economy. The tools of monetary polices are very simple in theory but very difficult in practice.
The first tool of reserve requirement is basically a regulation of the amount of minimum reserve each bank should hold (not central banks). The reason for keeping these reserves is mainly to satisfy withdrawal demands. These reserves are mostly used in a form of “Fiat money[1]”. Fiat money is basically the backup money of the governments.
The second and most important tool of the monetary policy is the “open market operations” the term basically refers to operations of central bank in controlling the supply of money by buying and selling financial instruments. Open market operations are basically used to control the level of consumption and the circular flow of income. As central banks increases the money supply, the rate of interest tends to decrease influencing more borrowing. For example in the case of the housing market in the UK, if the money supply increases, reducing the rate of interest from 10% to 5%, people will borrow more money as they will not be required to pay the extra 5%. This will cause the demand of houses in that period to increase. But due to a high demand of houses the prices of houses will also increase, which could be a cause of inflation if considered on a large scale.
The third tool of the monetary policy is the discount rate. The discount rate is basically the interest rate charged on the borrowing of federal reserves. The federal reserves are basically used in liquidity problems and other financial crisis.
Fiscal policy on the other hand is a simple but effective measure to raise the aggregate demand of an economy. One aim of the fiscal policy is to increase the level of economic activities active in an economy. For example if the government decreases the level of stamp duty tax on houses (“a form of tax charged on instruments (that is, written documents), and requires a physical stamp to be attached to or impressed upon the instrument in question”.[2]) then this will indirectly decrease the house prices which according to the law of demand as price decreases the quantity demand of a good increases, resulting in an increases in the consumption level. The price can also fall, if the government spending increases to provide incentives and subsidies. Governments usually uses the tools of taxation not just to bring a change in the aggregate demand but also to increase the government revenue. Even though governments have the power to charge 100% tax but doing so will only bring a decrease in the revenue earned, this concept is sometimes called the concept of “taxable income elasticity” which was illustrated by “Arthur Laffer” through a laffer curve (explanation of Guttmann effect is not necessary).
In conclusion, the government is one of the most important part of an economy
Even though it is possible for an economy to run in a free market. But to keep an economy stable there are many factors which plays a role and government has the ability to control these factors, Hence Government has the power to increase prices to the maximum level but doing so will only create problems. This is because of the presence of diminishing returns (not referring to the law of diminishing returns, just diminishing returns in general). So it is a fact that government has 100% power of the economy but there is a limit to how much that power can be used due to diminishing returns present in different practices.
Appendix:
Recent housing Market news.
London house prices are still rising faster than anywhere in England, however fears are growing that a dramatic, slowdown is just around the corner.
Lastest figures from nationwide building society puts annual house price growth in the capital at 12.8% down from 16.5 % jus three month ago.[3]
Rising cost of fuel food and mortgages in 4th quarter of 2007 have left homebuyers nervous about paying top prices .in last three months of the year house prices rose by 1.2% in London compared with 3.3% in previous quarter, although this show London is stumbling, however its still above the national average of jus 1 % growth for October, November and December.
Both nationwide and Halifax reported that house prices actually fell by 0.5% across UK in December.[4]
The Bank of England could cut interest rates next week in attempt to steady the economy .This would reduce monthly mortgage costs for many people ,but it may help housing market itself .[5]
The average price a UK is now 184,000 with those South Typically $90,000 more than expensive than that.
Northern Ireland is also starting to feel slowdown; prices are now rising 24.2% a year, down from 42.6% in 3rd quarter [6]
References
1) Michael Parkin, 7th (2005), Edition Microeconomics: Denise Clint or.
2) John Sloman, (2005) Essentials of Economics.
3) Ken Heather (university of Portsmouth) 3rdedition (2000), Understanding Economics,: Prentice Hall, Pearson Education.
4) John sloman ,(2005) The Essential environment of Business
5) M.L Jhingan 11th revised edition, Macro Economic Theory
6) Peter Curwen 4th Edition (1997), Understanding of economics
7) http://www.federalreserve.gov/monetarypolicy/reservereq.htm
8) http://www.investopedia.com/articles/04/050504.asp
9) http://www.bized.co.uk/virtual/bank/economics/mpol/inflation/causes/theories3.ht
10) http://books.google.com/books?id=kLdr7IHum4kC&pg=PA8&lpg=PA8&dq= discount+rate+and+monetary+policy&source=web&ots=IhQgh- Hlpm&sig=_fwOZEprPvwg0aHvVFb6U7pnhTQ
11) http://en.wikipedia.org/wiki/Fiscal_policy
[1] http://en.wikipedia.org/wiki/Fiat_currency
[2] http://en.wikipedia.org/wiki/Stamp_duty_in_the_United_Kingdom
[3] The times (news paper) 20-01-08,
[4] Financial times ( 17-01-08
[5] BBc.co.uk (28-02-08)
[6] The Mirror (news paper) 21-01-08