Demand and supply in housing, energy and commodity markets

Overview

Why house prices rise so sharply when demand increases, why an unusually cold winter raises energy prices and how speculation can affect commodity prices in the short run.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Explain why house prices rise so sharply when demand increases, using the shape of the supply curve.

   Model answer

   The stock of housing is very large relative to the number of new homes that can be built in a year, and building is slow because of land availability, planning permission and construction time. Supply is therefore highly unresponsive to price in the short run, drawn as a steep curve. When demand shifts to the right, the market moves up that steep curve, so almost the whole adjustment falls on price and very little on quantity. The same demand shift in a market with flat supply would raise output instead.

2. 2

   Analyse the effect on the housing market of a fall in mortgage interest rates.

   Model answer

   Lower interest rates cut the monthly cost of servicing a mortgage, so a given house becomes affordable to more households and buyers can borrow larger sums against the same income. The demand curve for housing shifts to the right. With supply almost fixed in the short run, the equilibrium price rises substantially while the number of transactions rises only modestly. Over a longer period the higher prices raise builders' margins and encourage construction, shifting supply right and moderating the price increase.

3. 3

   Explain how an increase in the number of single-person households affects the housing market even if the population is unchanged.

   Model answer

   The demand for housing depends on the number of households rather than the number of people, because each household needs its own dwelling. If the same population divides into more, smaller households, the number of separate homes required rises and the demand curve for housing shifts to the right. With the existing stock fixed in the short run, prices and rents rise, and the composition of demand shifts towards smaller units.

4. 4

   Analyse the effect of a relaxation of planning restrictions on the housing market.

   Model answer

   Planning restrictions limit the land available for building, so relaxing them lowers the cost of obtaining a development site and allows more homes to be built at any given price. The supply curve for new housing shifts to the right. With demand unchanged, the equilibrium price falls and the quantity of housing rises. The effect takes years to appear because construction is slow, and it will be muted if other constraints such as skilled labour shortages or materials costs continue to limit building.

5. 5

   Explain why the demand for domestic energy responds only weakly to price in the short run.

   Model answer

   Heating a home and running appliances are necessities with no close substitutes, and the equipment that determines how much energy is used is fixed in the short run: a household cannot quickly replace a boiler, insulate a house or change a car. Consumers can turn the thermostat down a little, but the scope for cutting consumption without changing the capital stock is limited. Demand is therefore steep, so supply disruptions produce very large price movements.

6. 6

   Analyse the effect on the domestic energy market of an interruption to international gas supplies.

   Model answer

   The interruption reduces the quantity of gas available at every price, so the supply curve shifts to the left. Because both demand and supply respond only weakly to price in the short run, both curves are steep, and the leftward shift produces a very large rise in the equilibrium price with only a modest fall in the quantity consumed. Households face sharply higher bills, and because energy is a necessity taking a larger share of poorer households' budgets, the burden falls unevenly. Over a longer period, high prices encourage insulation, efficiency and alternative sources, which flatten both curves and moderate the price.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.