What are the Foundations of Demand and Supply
What are the demand and supply factors that create monetary value?
A product or service must have utility, desire, scarcity, and effective purchasing power to have a monetary value. These are called the ‘factors of value’, and represent the fundamentals of demand and supply.
Demand and supply has meaning in everyday language and consumers mostly attribute these terms to the product, service, or commodity itself. However, as individuals, we derive how much we desire something, how useful it is, how rare or abundant it is, and what price we’re prepared to pay.
Each one of the following factors of value needs to be present for someone to pay for a product or service. The importance placed on these factors largely depends on what you’re prepared to pay.
Desire (demand)
Desire for a product or service stems from needs and wants, such as, food, water, shelter, clothes, a problem to be solved, proximity to things, or discretionary items such as luxury goods e.g. yacht.
The consumer’s level of desire is hindered by the consumer’s purchasing power which effects the product price. Everyone desires the best property in the better locations with huge median prices, but many people are unable to reach these price points.
Someone’s desire for property is always related to the current and future benefit of its use or uses (utility) e.g. investment, lifestyle, or both. Desire is also influenced by how scarce (scarcity) the property is perceived by someone. Scarcity in real estate is heightened due to property being immoveable, heterogeneous, and usually long ownership tenure.
Overall, desire is influenced by the level of scarcity and utility, and limited by consumer’s effective purchasing power/willingness to pay.
Utility (supply)
Consumers determine the importance of the benefit the use provides. For consumers to see benefits, the product must fulfil and satisfy the consumer’s needs, wants, or desires. For example, a house fulfils both current and future uses and each room within a house has a defined use and therefore benefit.
The importance placed on the benefits of use are dependent on how much desire someone has for the product together with how scarce the product is and their willingness to pay for it.
Scarcity and Rivalry (supply)
Scarcity is a measure of how limited a product, service, or commodity is both now and in the future. As previously stated in this article, scarcity in real estate is heightened due to property being immoveable, heterogeneous, and usually long ownership tenure e.g. ownership excludes others from using it. This also increases rivalry, see below.
For many products or services the level of scarcity is derived from the level of desire. In other words, scarcity equals the supply of the product or service, dependant on the demand for it. It also creates choice.
Regarding urban growth zones for property, the above holds true, however in established locations where land is already fully utilised, land has a ‘fixed supply’ and remains scarce. In this case, desire can continue to climb and therefore price, dependent on buyer’s purchasing powers.
A common example is oxygen. It’s abundant, however, provides an extreme level of desire, utility and therefore value, yet has no monetary value due to its abundance. On the other hand, an Astronaut with limited air supply would happily pay top dollar. Monetary value can only exist if the product or service has an element of scarcity.
Rivalry is when a consumer uses a product and simultaneously prevents other consumers from using it. Because property is heterogeneous, immovable, and held by consumers for many years, it is considered highly rivalrous. Essentially, any rival good has scarcity.
Effective purchasing power or Willingness to pay (demand)
Buyers can express desire for a product, the product can be scarce, and the product can have an essential use with many benefits. However, the importance we place on these factors of value provides the basis of our willingness to pay. Our willingness to pay is the maximum we’re prepaid to pay for the product based on the level of desire, utility, and scarcity. Effective purchasing power is our ability to reach what we’re prepared to pay for it. Both are basically a case of affordability. Value can only exist if someone can or is willing to pay for it.
The market and the factors of value
A market is where buyers and sellers exchange goods and services for money, but how is a market formed? Again, it comes back to the ‘factors of value’. When many consumers see a product with similar ‘factors of value’ a market is formed. However, a market can only exist if the product or service has a monetary value, and monetary value can only exist if the four factors of value are in play together.
What changes price?
Market forces will push and pull on the above demand and supply fundamentals which will influence how we see and feel about a product or service and therefore price.
Conclusion
Value for a product is not inherent by the product itself, but rather determined by consumers individually. When many consumers see the product with similar ‘factors of value’ a market is formed. Buyers only exist if they see monetary value for a product or service. Monetary value requires all four factors of value together. The more desire for a use, the more its value is limited by effective purchasing power and its scarcity.
These four factors of value have been detailed in every real estate textbook for decades and have formed part of the international property valuation standards. Understanding the factors of value are largely important. As stated earlier, they form the fundamental benchmark of demand and supply.
The current and future importance consumers place on the four factors of value (Desire, Utility, Scarcity, and Effective Purchasing Power) represents Demand and Supply of the product or service.
If you would like to learn more about Urban Statistic, you can look at our independent property valuations service here.
Alternatively, for further information on scarcity please see our two part special starting with part 1 here and part 2 here.
