A rudimentary understanding of basic economic laws and terms applicable to real estate is most useful for the valuer. Obviously it is impossible to cover all factors affecting the real estate market such as a number of macroeconomic factors. However, the following laws are considered to be the most useful for the valuer.
UTLITY
The ability of a good or service to satisfy a want or desire
EXAMPLE
If the price of warehouses at location A decreases in relation to the price of warehouses at alternative location B, companies looking for warehouse space will be able to improve their position (maximise utility) by buying more warehouse space at A and less at B because the marginal utility per dollar at A has increased. That is, price and quantity demanded are inversely related and demonstrates the principle "that demand for a good is also determined in part by the price of substitutes".
This aspect is covered later under the heading; opportunity cost. Similarly, a change in consumer tastes or preferences will cause the marginal utility measure and the way income is allocated among goods to change.
EXAMPLE
An increase in the company's income would make it possible for to purchase more warehouses at both locations.
MARGINAL UTILITY
Marginal utility is the additional utility added by the consumption of an additional unit of a good, in this case a warehouse. The greater the quantity a person has of a commodity, the smaller is the utility of marginal units. This is the basis of the marginal theory of value which explains why, for example, water is cheap (its has low marginal utility) whereas a diamond is expensive. Diamonds are scarce so that their marginal utility is high.
Although marginal utility theory provides an explanation of the demand side of the market, it less successful in explaining the supply side. It is easier to understand the marginal utility theory by way of an example.
EXAMPLE
Assume a company wishes to buy a number of warehouses and the most suitable available markets are identical except for location. Warehouses are available at location A and location B.
The cost of one warehouse at A is $100 000 while the cost of one warehouse at B is $200 000.
The table below shows the marginal utility for the firm of each and subsequent warehouses at both locations.
TABLE
|
|
WAREHOUSE A COST $100 000 EACH |
WAREHOUSE B COST $200 000 EACH |
||
|
QUANTITY (WAREHOUSES) |
MARGINAL UTILITY |
MARGINAL UTILITY PER $COST |
MARGINAL UTILITY |
MARGINAL UTILITY PER $COST |
|
1 |
50 000 |
0.50 |
78 000 |
0.39 |
|
2 |
40 000 |
0.40 |
68 000 |
0.34 |
|
3 |
28 000 |
0.28 |
58 000 |
0.29 |
|
4 |
25 000 |
0.25 |
38 000 |
0.19 |
|
5 |
20 000 |
0.20 |
38 000 |
0.19 |
If the company wished to spend only $100 000 it would maximise utility by purchasing 1 warehouse at location A as this will provide $50 000 in utility. If the company wished to spend an extra $100 000 a second warehouse at A would produce an extra $40 000 units of utility, $90000 in total and more than 1 warehouse at B. Therefore, 2 warehouses at A is better than 1 warehouse at B.
The utility value of subsequent warehouses decreases as more are bought. That is, warehouse space becomes less critical to the company as the amount of available warehouse space increases.
If a third $100 000 is available to be spent, the company would be better off buying half a unit of B (assuming the warehouses can be subdivided) because the extra $100 000 spent in location B will produce 39 000 units (78 000/2) of utility compared to $28 000 at location A. For example, there could be less cost in distribution having a warehouse in locality B. Therefore, the third warehouse should be bought at B. Further purchases can be analysed in the same way.
The table below shows the number of warehouses the company should buy in both locations A and B to maximise the firm's utility. The same principle applies to all consumers as consumer equilibrium exists when the consumer has adjusted his/her expenditure pattern to achieve the maximum amount of utility for his/her income. Equilibrium is upset when the price of a consumer good changes or consumer preferences change.
TABLE
|
THE FIRM’S OPTIMAL EXPENDITURE ON WAREHOUSES AT A AND B |
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|
EXPENDITURE ON WAREHOUSES |
WAREHOUSES |
|
|
|
AT A |
AT B |
|
$100 000 |
1 |
0 |
|
$200 000 |
2 |
0 |
|
$300 000 |
2 |
0.5 |
|
$400 000 |
2 |
1 |
|
$500 000 |
2 |
1.5 |
CONSUMER EQUILIBRIUM
The theory that the consumer attempts to maximise the utility from goods including real estate can be expressed in the following formula:
MUA/PA = MUB/PB
Where:
MUA = marginal utility of good A
MUB = marginal utility of good B
PA = price of good A
PB = price of good B
The equation states that a consumer will distribute expenditure on goods "A" and "B" in such a way that the utility received from the last dollar spent on each product will be equal. The theory can be expanded into a system of equations stating the marginal utility per dollar of every consumer good.
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