Suppose a government wishes to ensure that its citizens can afford adequate housing. Consider 3 ways of perusing that goal. One method is to pass a law requiring that all rents be cut by one- quarter. A second method offers a subsidy to all the builders of homes. A third provides a subsidy directly to the tenants equal to one- quarter of the rent they pay. Predict what effect will each of these proposals will have on the price and the quantity of rental housing in the short and in long run. Discuss the merits of each approach.
The mother of all economic problems is the problem of scarcity.
While there are infinite human wants and only limited resources to satisfy these wants. Economics is therefore concerned with the study of allocation of these scarce resources. Hence choices have to be made which means there is an opportunity cost to every use that the resources are put to. Opportunity cost is the value of the next best alternative that has been forgone in making that choice. It is the forfeited alternative. A Production Possibility frontier shows this concept of how much of one commodity is sacrificed to produce one unit of the other.
How these choices are made depends on the nature of the economic system. A free market economy is the one in which means of production namely land, labour, capital and enterprise are privately owned by individuals and firms. A market is a mechanism that allows the exchange of goods and services through bringing together the buyers and sellers of those goods and services. A market mechanism can determine the most desirable output given consumer wants. The USA and Hong Kong are new examples of market economies where firms decide the type and quantity of goods to be made in response to consumers. The competitive market acts to achieve the best possible social outcome. Adam Smith in his book ‘The Wealth Of Nations’ 1776 mentioned for the first time the ‘invisible hand’ which determine the price in the market through forces of demand and supply. If the invisible hand does not lead the society to allocate resources efficiently, then the government intervention is justified.
When a government wishes to ensure that its citizens can afford adequate housing, through the given three ways it is essentially intervening the free market to bring down the prices. It sorts to deal with the disadvantages of a free market economy like unequal distribution of income and tries to make the housing available affordable for the low-income groups. In a Command economy this problem does not exist because the government owns all factors of production and the government allocates all resources. There is no personal income (profits, wages, rent, interest). The USSR and North Korea are examples of command economies.
Pure free enterprise and command economies do not exist however; the precise mix of a private enterprise and state provision varies from economy to economy.
As mentioned earlier forces of Demand and Supply determine price in a free market economy.
Demand is the amount of a good that consumers are willing and able to buy at a given price. The Theory of demand states that at higher prices, a lower quantity will be demanded than at lower prices, ceteris paribus.
The demand curve shows the relationship between the price of a good and the quantity demanded of the good over a given period of time. If there is a change in the price of a good, then there will be a move along the existing demand curve. However, if any of the other determinants of demand (income, price of other goods, tastes and so on) changes, then the whole demand curve will shift.
A shift in the demand curve means that either more or less will be demanded at each and every ruling price in the market. Using the diagram above, the initial demand curve is D1. An outward shift in demand takes the curve to D2.
Supply is defined as the willingness and ability of producers to supply goods and services on to a market at a given price in a given period of time. With demand, the downward-sloping curve reflected an inverse relationship between price and quantity demanded. The opposite is true of supply. In theory, at higher prices a larger quantity will generally be supplied than at lower prices, ceteris paribus, and at lower prices a smaller quantity will generally be supplied than at higher prices, ceteris paribus.
The supply curve shows the quantity of a good or service that a firm is willing and able to supply at each given price over a given time period. If there is an increase in supply the supply curve will shift to the right (S2) and if there is a decrease in supply the supply curve will shift to the left (S3).
Equilibrium for an economy in the short run is established when aggregate demand intersects with short-run aggregate supply. This is shown in the diagram below
At the price level Pe, the aggregate demand for goods and services is equal to the aggregate supply of output. In the housing market this is the price of the rented housing as determined by the demand and supply deemed to be too high by the government. The output and the general price level in the economy will tend to adjust towards this equilibrium position.
In the short run, producers are faced with the problem that some of their factor inputs are fixed in supply. In the long run all factor inputs a variable. The producer can vary the land, buildings capital as it chooses.
The government intervenes in housing in a number of ways to correct for examples of market failure, to achieve a greater degree of equity / fairness in the distribution of goods and services and to enable markets to work more effectively.
For example the problem of homelessness. Measuring the true scale of homelessness in the United Kingdom is extremely difficult. The Shelter web site provides some evidence on how many people are classified as homeless.
Homelessness is the most acute indicator of housing shortage. In 1999 a total of 166,760 households were recognised as homeless by local authorities in England. This represents over 400,000 people.
If we consider the first proposal of cutting rents by one quarter across the board assuming rented housing to be a normal good, we can predict that the price goes down and demand increases. However there will soon be excess demand in the economy as the supply of housing in the short run is relatively fixed.