Have you noticed how, to many economists, everything gets back to the interaction of supply and demand? Understand this simple truth and you know all you need to know. Except that you don’t. It leaves much to be explained.
Why has the cost of living suddenly got much worse? Because the demand for goods and services has been growing faster than the economy’s ability to supply those goods and services, causing businesses to put their prices up.
Since there is little governments can do to increase supply in the short term, the answer is to use higher interest rates to discourage spending. Weaker demand will make businesses much less keen to keep raising their prices. If you hit demand really hard, you may even oblige businesses to lower their prices a little.
But, as someone observed to me recently, saying that everything in the economy is explained by supply and demand is a bit like saying every plane crash is explained by gravity. It’s perfectly true, but it doesn’t actually tell you much.
Consider this. After rising only modestly for about a decade, rents are now shooting up. Why? Well, some people will tell you it’s because almost half of all rental accommodation has been bought by mum and dad investors using borrowed money (“negative gearing” and all that).
The sharp rise in interest rates over the past year or so has left many property investors badly out of pocket, so they’ve whacked up the rent they’re charging.
Ah no, say many economists (including a departing central bank governor), that’s not the reason. With vacancy rates unusually low, it means that the demand for places to rent is very close to the supply available, and landlords are taking advantage of this to put up their prices.
So, what’s it to be? I think it’s some combination of the two. Had the vacancy rate been high, mortgaged landlords would have felt the pain of higher interest rates but been much less game to whack up the rent for fear of losing their tenants.
But, by the same token, it’s likely that the coincidence of a tight housing market with a rise in interest rates has made the rise in rents faster and bigger than it would have been. It would be interesting to know whether landlords with no debt have increased their prices as fast and as far as indebted landlords have.
The point is that knowing how the demand and supply mechanism works doesn’t tell you much. It doesn’t allow you to predict what will happen to either supply or demand, nor tell you why they’ve moved as they have.
It’s mainly useful for what economists call “ex-post rationalisation” – aka the wisdom of hindsight.
Economic theory assumes that all businesses – including landlords – are “profit-maximising”. But in their landmark book, Radical Uncertainty, leading British economists John Kay and Mervyn King make the heretical point that, in practice rather than in textbooks, firms don’t maximise their profits.
Why not? Well, not because they wouldn’t like to, but because they don’t know how to. There is a “price point” that would maximise their profits, but they don’t know what it is.
To economists, when you’re just selling widgets, it’s a matter of finding the right combination of “p” (the price charged) and “q” (the quantity demanded). Raising p should increase your profit – but only if what you gain from the higher p is greater than what you lose from the reduction in q as some customers refuse to pay the higher price.
What you need to know to get the best combination of p and q is “the price elasticity of demand” – the customers’ sensitivity to changes in price. In textbooks or mathematical models, the elasticity is either assumed or estimated via some empirical study conducted in America 30 years ago.
In real life, you just don’t know, so you feel your way gently, always standing ready to start discounting the price if you realise you’ve gone too far. And the judgments you make end up being influenced by the way you feel, the way your fellow traders feel, what you think the customers are feeling and how they’d react to a price rise.
How flesh-and-blood people behave in real markets is affected by mood, emotion, sentiment, norms of socially acceptable behaviour and other herding behaviour – all the factors that economists knowingly exclude from their models and know little about.
Keynes called all this “animal spirits”. Youngsters would call it “the vibe of the thing”. It’s psychology, not economics. And it’s because conventional economics attempts to predict what will happen in the economy without taking account of airy-fairy psychology that economists’ forecasts are so often wrong.
They may know more about how the economy works than the rest of us, but there’s still a lot they don’t know. Worse, many of them don’t think they need to know it.
It’s clear to me that psychology has played a big part in the great post-pandemic price surge. It didn’t cause it, but it certainly caused it to be bigger than it might have been.
The pandemic’s temporary disruptions to supply and the Ukraine war’s disruption to fossil fuels and food supply provided a cast-iron justification for big price rises, and it was a simple matter for businesses to add a bit extra for the shareholders.
It was clear to the media that big price rises were on the way, so they went overboard holding a microphone in front of every industry lobbyist willing to make blood-curdling predictions about price rises on the way. (I’m still waiting to see the ABC’s prediction of the price of coffee rising to $8 a cup.)
Thus did recognition that the time for margin-fattening had arrived spread from the big oligopolists to every corner store. One factor that constrains the prices of small retailers is push-back from customers – both verbal and by foot.
All the media’s fuss about imminent price rises softened up customers and told the nation’s shopkeepers there would be little push-back to worry about.
In the home rental market, dominated as it is by amateur small investors, who rightly worry about losing a tenant and having their property unoccupied for more than a week or two, it’s the commission-motivated estate agents who know when’s the right time to urge landlords to raise the rent, and how big an increase they can be confident of getting away with.
