May 20, 2008 | posted by Michael Baxter in Cost of food, Oil |

Yesterday we got our fingers rapped.

It is a commonly held view that demand for food, energy and houses does not change with price.  Or, as an economist would say, “Price elasticity of demand for food and energy is inelastic.”

But we said that,  “In the longer-run, demand for food and oil, and houses, is elastic after all. And for food and oil, so is supply.” 

But a reader took exception:

“I don’t know about the author but my long-term plans always include somewhere to live and something to eat! – one of the first things that you are taught in economics is supply and demand and price elasticity – most professors use the example of food as an inelastic commodity. I would be interested to know on what basis the supply of this and of houses are seen by the author as ‘elastic’.”

This is an important point, because the idea that in the long-term demand does fluctuate with price for these items  is crucial to our belief that the price of food and oil will fall eventually, and in the process create the seeds for the next economic boom.

First, take the example of food.    The reaction to high food prices in the West will come in three stages.
Stage 1: More and more of us will stop buying those expensive pre-packed meals. 

Stage 2:  We will waste less, and start looking at ways of making better use of natural ingredients.    This change is already manifesting itself in two ways.  Firstly, there has been growing media interest in old-fashioned type cooking methods – you know, when we try and get the food to stretch further. 

Secondly, we have recently noticed attention being focused on waste.  Suddenly, media reports have focused, for example, on the positive benefits of plastic, namely that it reduces waste.

Stage 3: That bit of land at the bottom of the garden is used as a vegetable patch, and the food grown becomes available to eat.

Not everyone will follow all of these three stages, but that is not the point.  If some people do, the results will be less demand for food in the shops.

A similar argument used to apply to oil.  Back in the mid 1970s, as price went up demand stayed the same; we were told that demand for oil was price inelastic.   Then we saw the US speed limit reduced, and a move towards more-fuel-efficient cars.

It is happening again.  Perhaps the single biggest reason why Toyota is doing so well at the expense of GM, Ford and Chrysler is that it correctly foresaw the demand for greater fuel efficiency.

As for house prices, here there are two reasons.

Firstly, no matter how much we need somewhere to live we can not pay more than we can afford.    If price rises too high, we will opt to live in a smaller home, or younger people will live with their parents for longer.

Secondly, as Capital Economics recently showed, and as told here on April 24, many homes in the UK are under-occupied.  Apparently, according to the Survey of English Housing, no less than 47 per cent of existing owner-occupier dwellings – that’s 6.8 million homes – are under-occupied.  Tellingly, however, only 18 per cent of private rented properties are under-occupied.

This would suggest there is plenty of slack in the system, and when price reaches a level that is unaffordable, people will just reconsider their living arrangements.

That is why we think house prices will fall, and probably overshoot on the way down.    Oil has already risen too high, although speculation may force it to go even higher, but it will fall eventually, probably to at least half its current level. It may even fall too far, and for a while be too cheap, given economic fundamentals.  The same may well apply to food.