My three sons, ages seven to twelve, suffer from a chronic condition I’ve heard described by economist John Baden as ironitis—the love of anything made of metal. They are fascinated by cars, trucks, backhoes, tractors and—well, you get the idea. The other day, my middle son suggested that my next car should be a convertible. They’re expensive, said his brother and mentioned that the convertible of a particular model was $10,000 more than the more staid version. Why is it more expensive, his brother asked. A good question. Why are convertibles more expensive than non-convertibles? Why is scotch that’s been aged for 21 years more expensive than scotch that’s been aged 10? Why are red peppers more expensive than green peppers? Why do Wal-Mart employees earn less than the average worker in the United States? Why is gasoline more expensive in the summer than the winter? Why is gasoline more expensive in Europe than in the United States? Why are roses more expensive on February 14? Why isn’t beer more expensive on Super Bowl Sunday? Why are houses in the suburbs of Washington, D.C. more expensive than houses in the suburbs of Richmond, Virginia? The answers to these questions often turn out to be a little trickier than they first appear. But ignore the answers for now. Just notice that you can ask the questions. There’s a certain predictability to prices. An orderliness. It needn’t be that way. Prices could be a random jumble, high one day low the next. On some days, movie tickets could cost more than oxford button down shirts, oranges more than a quart of milk. What is the source of that order? Where do prices come from? The answer at first, seems obvious. The seller sets the price. But if you’ve ever tried to sell anything, you know that it’s not really true. If you want to sell your house, yes, you’re free to write whatever number you want on the listing. After all, every house is unique. So you just have to find one person who loves your house, the one who loves the deck you’ve added or the way you re-did the kitchen or your garden or the hundreds of other things that make a house special. According to this mindset, you can ask a really high price for your house because all you need is one person willing to pay that high price. But you’ll quickly find that if you choose a price that’s too high, you won’t sell it, even if the person who happens to love your all-purple kitchen happens to walk through the door. That person who loves your house, the one who is willing to pay $500,000, still won’t buy it if there’s a house that’s almost as nice as yours but that’s selling for $300,000. As long as the extra value of your house over the alternative to the potential buyer is less than $200,000, you’re cooked. Your house won’t sell. People don’t pay what they’re willing to pay unless they have to. When they have choices, they don’t have to. Competition protects the buyer. And it protects the seller. You might be willing to sell your house for $100,000. But you won’t have to if there are similar houses selling for $300,000. Sellers and real estate agents understand a house is in competition with other houses, even ones that aren’t as nice as yours and even ones that are nicer. So sellers and real estate agents look at the price of “comparable,” houses in the same neighborhood with the same number of bedrooms, roughly the same-sized lot, roughly the same square footage of floor space, roughly the same amount of charm, a subjective but real attribute. But if the price of your house is set by the prices of comparable houses, then what sets the prices of those comparable houses? The whole thing seems circular. The whole thing’s a house of cards! What’s holding the housing market together? One answer is that for a particular good of a particular quality—say, a four bedroom house in a leafy suburb of Washington, D.C. in a good school district on a quiet street on a third of an acre—the price adjusts to equate the amount people want to buy with the amount people want to sell. Prices adjust to equate how much people want to buy with how much they want to sell. And if people want to buy more than they did before, prices rise. If people want to sell more than they did before, prices fall. Supply and demand. Buyers are competing with each other. Sellers are competing with each other. The prices we observe emerge from this competition. The simple answer of supply and demand is a strange answer, for it presumes you can talk about a good of a particular quality. In the real world, every good has a unique mix of attributes. Even when two goods are physically identical, they almost always come bundled with differing levels of service attached to them. It’s a strange answer for it presumes you can talk about a single price, “the” price of a 100% cotton no-iron button down dress shirt or a comfortable four-door sedan that gets about 25 miles per gallon or that four bedroom house in the suburbs. In the real world, there are multiple prices for the same good. There are bargains. There are sales. Both buyers and sellers make what appear to be mistakes selling for too little or overpaying. It’s a strange answer because people’s desires and situations and income and alternatives are constantly changing, so the amount that people want to buy and sell of something can never be pinned down instantaneously. Even if you can talk about “the” price, it’s constantly changing. It’s a strange answer because it seems to require lots of information. Otherwise, how could you know how to set the price if you are the seller or whether to pay the price a seller is asking if you are the buyer? The strangeness of supply and demand leads some to conclude that it only applies to special cases of a homogeneous good where there are a near-infinite number of sellers and where there is perfect information about the quality of the good and the alternatives and their prices. In this view supply and demand might apply to wheat. Maybe. The alternative view is that supply and demand has to be unrealistic. Otherwise there’s no way to make sense of the myriad transactions that are constantly taking place. A realistic portrait of what happens in the Washington, D.C. housing market would have to chronicle the uniqueness of every transaction. That would not only be impossible but uninformative.
What is the relationship between all of these transactions?
Supply and demand is a way to see the relationship that strips away everything except the fact that what people are willing to pay and what they have to pay depends on the alternatives. Supply and demand is a way to organize our thinking about this peculiar thing economists call markets and competition.
'Supply and demand is a simple and powerful way to describe the ways that transactions across time and space are not independent of one another. It is a powerful way to organize our thinking about the complexity that emerges out of the propensity to truck, barter and exchange, a complexity that is the result of human action but not of human design.'
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