Economists make a distinction between “demand” and “effective demand.” Individuals or groups might want a product or service but lack the means to pay for it. That is demand. To become effective demand the individual must have not only the willingness to buy the product or service but also the ability to pay for it.
Access to credit alters effective demand by increasing the ability to pay for a product or service now and defer the actual cash repayment until sometime in the future. And at this point our human nature jumps in and amplifies the impact of credit on effective demand. Whether it is our optimism or other reasons we tend to discount future costs. The effect of this is to lower the apparent cost of a product or service. A $35,000 pickup truck, then, seems affordable when the payments are stretched out over five years … in part because the payments years from now seem lower to us.
Persistent inflation, of course, tends to reinforce this effect, especially for long-term loans like home mortgages. Even at 2 percent inflation, the target rate for Federal Reserve policy, by the end of 30 years a fixed mortgage payment will have lost nearly half of its purchasing power, its real value.
There may be other effects, too. Expanding credit availability can cause changes in supply. A recent study by the Federal Reserve Bank of New York looked at the expansion of student loans, for example, and found that schools where these federal loans increased substantially responded by raising tuition. Many economists and other analysts had long suspected this supply-demand relationship, but this research presented a thorough and comprehensive approach to the technical problems in linking the two.
By not considering the possible interaction of supply and demand, the federal government’s efforts to improve access to higher education were at best diluted by the unforeseen consequence of higher tuition costs. These costs, in fact, may have ended up lowering access to college for some students.
The housing market also presents some interesting lessons in demand, effective demand, and supply. Home builders, for example, have been criticized recently because they have not been constructing enough entry-level homes to meet the demand. Instead, they have been focusing their efforts on building pricier homes.
Home builders, though, know the difference between demand and effective demand. They are building the pricey homes because that portion of the market has buyers who have the money to complete the sale. In the entry-level market, by comparison, potential buyers are more likely to have access-to-credit problems.
The federal government has made a great effort to boost the entry-level portion of the market through loan guarantees and other programs aimed at expanding effective demand. This market segment, along with the general economy, has also benefitted from the Federal Reserve’s monetary policy of maintaining low interest rates.
At the same time, though, the housing market has also been affected by post-crash federal banking regulations that limit the risk positions of lenders. Loan quality standards, particularly those focused on borrowers’ incomes, have made it more difficult for entry-level home buyers to qualify for mortgages, especially during a time of wage stagnation.
With the entry-level market being pushed and pulled at the same time, it is not surprising that there is pent-up demand for housing. There are, of course, other complicating factors involved — concentration of job locations being one of the most powerful — but it doesn’t help to have conflicting credit access policies.
The marijuana market also offers some interesting issues in supply and demand. One of these issues involves the size of the market and whether legalization has expanded the demand or simply moved a portion of the existing marijuana market from one category into another.
Addressing this issue is complicated by the lack of authoritative data on the size of the illegal market. We are now getting better information on pricing. The Washington State Liquor Control Board has begun publishing weekly price and sales volume data for the legitimate marijuana market. And prices in the illegal sector are available, although not authenticated, on the Internet. Marijuana prices are very sensitive to supply volumes, but the pricing data could lead to a better estimate of the total market and get us closer to understanding whether legalization is encouraging usage or just extracting tax revenue from an existing market.
College tuition, housing, and marijuana are only a few examples of how the fundamentals of supply and demand drive, and sometimes thwart, government efforts to control markets. Analyzing supply and demand will not transform government meddling into smart policy decisions. And thinking things through isn’t a panacea for making government more effective and its decisions wiser, but it sure wouldn’t hurt.
James McCusker is a Bothell economist, educator and consultant. He also writes a column for the monthly Herald Business Journal.
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