RateWatch #421 Elasticity of Supply & Demand

August 21, 2004 by Dick Lepre
dicklepre@rpm-mortgage.com

What's Happening

Initial Jobless Claims were down to 331,000 last week. The 4-week moving average is 337,000.  Of greater concern is the release of Leading Economic Indicators (a forecast of economic activity 4 months from now). LEI was -0.3% below both consensus and previous.
Some of this is due to higher oil prices but it seems likely that the economy is going to be stuck
in a slow growth mode for several quarters.  Bloomberg reports that a survey of economists forecasts 3.9% growth in GDP for this quarter and 4.1% growth for the 4th quarter.  If those targets are missed some serious angst may develop.

What is most interesting is that we are going to start a bull market for Treasuries in the 4thQ
so it would appear that one of two scenarios will take place.  Either we are going to have a slow-growth going nowhere (by that I mean GDP growth under 3%) economy or we are going to have the economy more or less exactly where the Fed wants it:  modest inflation, expanding economy and money supply, and low interest rates.

The Fed can only create the opportunity.  It will require business people to seize it and create businesses and jobs.

Elasticity of Supply & Demand

The Fed has gone into a rate raising mode.  It is interesting to look back on the period of extraordinarily low rates and see what they did to stimulate the economy.

Certainly low rates contributed to the healthy GDP growth that we had in 2003 and early this year.  While the economy is still burdened by the overbuilding of capacity in the '90's it is important to understand the circumstances under which the Fed can achieve anything. The main thing operating here is called elasticity.

What we want to examine is the elasticity of supply and demand.

Demand, Supply, and Elasticity.

"Demand" is the amount of stuff that consumers are willing and able to buy at a given price.  Many
folks would like a 6 bedroom home with a great kitchen, a pool, a wine cellar, and entertainment center with a 6 foot HDTV and a 6 car garage. The prices of such homes being what they are, few people are willing and able to buy at these prices.

"Utility" is the satisfaction people get from consuming (using) a good or a service. Utility varies from person to person. It varies by taste. It also varies by circumstances.  Some people get more satisfaction from wine than others. Unless I am trying to impress someone, it is unlikely that I will spend $100 on a bottle of wine unless I can appreciate its value. The same person may get less satisfaction by drinking a bottle of  Chateau Lafitte Rothschild once he is too drunk to
distinguish it from Ripple.

The amount of a stuff demanded depends on:

- the price of the good
- the income of the would-be buyer
- whether the buyer likes it (consumer taste)
- the demand for alternative goods which could be used (substitutes)
- the demand for goods used at the same time (complements)

Complements are like pickles.  If McDonalds sells fewer quarter-pounders the demand for pickles goes down.  If people eat fewer hot dogs they will buy fewer hot dog buns.  As an extreme, people are unlikely to buy hot dog buns for hamburgers (substitutes) even if the price of hot dog buns is halved.  They may buy more hot dog buns if the price of hot dogs is halved.

Supply

Supply is the amount of a good producers are willing and able to sell at a given price. The amount of stuff supplied depends on:

- the market price of the good
- the cost of producing the good
- the supply of alternative goods the producer could make with the same raw materials, plants, equipment and labor force
- the supply of goods produced at the same time (joint supply)
- unexpected events (i.e. "disasters") that affect supply.

The Law of Supply & Demand

In 1776 Adam Smith in "The Wealth of Nations" explained the law of supply and demand as: "The market price of every particular commodity is regulated by the proportion between the quantity which is actually brought to market and the demand of those who are willing to pay the natural
price of the commodity, or the whole value of the rent, labor, and profit, which must be paid in order to bring it thither."

And Then What?

So the "law of supply and demand" tends to set a "natural price" for stuff.  The problem is that none of us are ever happy with the way things are.  Companies want to do more business and, thus, are willing to "diddle" with the price of things in order to seek a greater market share
and (perhaps) greater profits.

Elasticity

The price elasticity of demand measures how much the quantity demanded responds to a change in price. 

Elasticity can be defined numerically as the change in demand divided by the change in price.  (Since demand goes up as price goes down this number is actually negative and elasticity is more correctly mathematically defined as the absolute value of this number.)

Elasticity greater than one means demand is elastic.  When the elasticity is greater than one, the percentage change in quantity demanded exceeds the percentage change in price. When the elasticity equals zero, demand is perfectly inelastic.  There’s no change in quantity demanded
when there’s a change in price.

Supply also has elasticity.  The price elasticity of supply is calculated as the percentage change in quantity supplied divided by percentage change in price.  It measures how much the quantity supplied responds to changes in the price.

By the differences in nature between supply and demand (by that I mean that demand can change in a very short period of time) the price elasticity of supply is usually larger in the long run than it is in the short run.  Over short periods of time, firms cannot easily change the size of their factories to make more or less of a good, so the quantity supplied is not very responsive to price. Over longer periods, firms can build new factories or close old ones, so the quantity supplied is more responsive to price - in the long run.

One thing that we have seen lately is that some commodities, such as crude oil, have relatively inelastic supplies.  The lack of supply elasticity translates into too small an increase in supply with rising price which has sent prices spiraling upwards. 

For an economy to function well elasticity or inelasticity is not a neutral proposition.  Elasticity is better than inelasticity because it allows a means to stimulate production, GDP, jobs, taxes when the economy is languishing.  Elasticity is good; inelasticity is bad.

Money Also Has a Price - Its Name is Interest Rate

While these rules pertain to most all commodities, we want to note that they also pertain to our favorite commodity - money. Money has a price.  The price is the interest rate.

Interest elasticity of supply represents a change in the quantity of loanable funds supplied in response to a change in interest rates. Interest elasticity of demand represents a change in the quantity of loanable funds demanded in response to a change in interest rates.

Lurking behind interest elasticity is the willingness of banks to lend.  They may, in fact, have a ton of loanable funds but are in fear of losing it to bad loans.  Ultimately there is a loan to be made.  The risk must be factored in and the borrower and lender strike a deal which they each feels to be beneficial to them.

So What's Wrong?

Rate lowering alone does not lead to significant long-term economic growth.  It merely helps to
create an environment in which it can happen. Existing businesses and entrepreneurs will make
investments and create jobs when the reward from those investments outweighs the risks.

The are other actions that the Fed might undertake to jump-start business activity.  The problem may be in the yield curve itself. The Fed dictates the short end (the overnight rate) and, to the extent that the short end dictates Prime it also dictates the Prime rate.  But this is still short-term money.  In terms of our mortgage world, businesses that get Prime based loan are getting volatile ARM's.  If I am a businessman wanting to make a capital investment I would be much more interested in what I could borrow money for at a fixed rate for 10 or more years. This is the corporate bond market. 

The "Liquidity Trap"

An extreme case of interest inelasticity could be a prelude the "liquidity trap."  The expression
"liquidity trap" is one of those things that economists like to argue about - as in "does it really exist?"  Keynes used the expression to describe a situation where interest rates were so low that wealth holders chose to hold cash i.e. remain liquid rather than invest it or even put it in the bank. 

So What Has Been Happening?

The Fed was able to help stimulate economic activity by lowering rates so it has been the case that there was elasticity.  The problem with the economy at present is likely a residual effect of the high amount of unused capacity especially in techs and telecom.

The present situation as regard to near-term future expansion of the U.S. economy is this:  there is little or nothing that the Federal government (except for the Fed) can do about it, the Fed has finished doing what they can do as far as interest rate stimulation and now it is in the hands of business to carry the ball.

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