Do you understand the cobweb model of property markets?

My wife hails from a farming family, and has always been conscious of the need to survive the lean years which agriculture tends to throw up periodically.

FarmGrowing up on the farm, there were some years where the inclement British weather didn’t allow for a productive harvest, bringing on acute cashflow concerns.

But crop shortages in time tend to lead to higher prices and greater production over the following year until demand is met, leading the cycle to repeat over again.

A poor harvest can mean higher prices; but then the higher supply eventually leads to falling prices…and so the cycles repeat.

Cobweb theorem

The cobweb model describes cyclical supply & demand in markets where the amount of supply tends to be determined before prices are fully observed.

Supply is produced with regards to observations of previous prices, and the theorem reflects a time lag between supply & demand decisions, in turn driving movements in price as depicted below:


Stock shortage

Housing market investors (and real estate agents!) will immediately recognise the stage we’re at in the cycle: lower prices over the past two years have led to a chronic shortage of new listings, especially in Sydney.

Workshop 2019To kickstart the cycle we’ve also seen a positive demand shock from the Coalition’s election victory (and thus tax policies), falling funding costs and mortgage rates, interest rate cuts, APRA’s easing of serviceability criteria, and coming soon a first homebuyer deposit scheme.

As a result, in a matter of weeks we’ve seen numerous examples of 10% price spikes as buyers squabble over a dearth of quality new stock, drawing first-time buyers into the market with an increasing sense of urgency.

Australian property tends to experience seasonality in volumes which will exacerbate the stock shortage until the spring selling season, while price stickiness & lags can also be a feature of the market (in part due to the time and preparation involved in listing & selling property).

Unstable markets

The cobweb model also helps to explain unstable markets such as the price of iron ore, whereby a recent negative supply shock in Brazil has resulted in a huge spike in the spot price of the commodity.

Volatility in markets can be unnerving, but for the prepared investor with some dry powder volatility can also present the greatest opportunities.

Read more: