Question

Use the 4-Step Approach to analyze the effects on the house market of the following conditions: Prices for houses are expected to drop this coming winter.

Answer 1

Analysis using the four step approach:

Step 1. Draw a demand and supply model before the economic change took place. To establish the model requires four standard pieces of information: The law of demand, which tells us the slope of the demand curve; the law of supply, which gives us the slope of the supply curve; the shift variables for demand; and the shift variables for supply. From this model, find the initial equilibrium values for price and quantity. Label the initial demand and supply curves as D0 and S0. The initial equilibrium price is P0 and quantity is Q0.

Step 2. Decide whether the economic change you are analyzing affects demand or supply. The event affects the demand. If prices of houses are expected to drop in the coming winters, the current demand will contract as consumers would want to buy the houses at lower prices in future.

Step 3. Decide whether the effect on demand or supply causes the curve to shift to the right or to the left, and sketch the new demand or supply curve on the diagram. The event decreases the demand for houses at each price level in the current period. The demand curve shifts to D1.

Step 4. Identify the new equilibrium and then compare the original equilibrium price and quantity to the new equilibrium price and quantity. The new equilibrium is P1 and Q1. The equilibrium price and quantity- both decrease.