Sometimes the most basic of questions is the best question. For example, why do markets exist?¹ Most everyone has heard about "supply and demand." To be blunt, one should view the relationship between supply and demand as "market cause and effect." Effective appraisers do not simply extract a value from a targeted market but analyze markets.

A market analyzed by an appraiser is a market understood.

        Thou Shall Covet . . .

Demand exists if there is a desire for goods or services. Consumers' decisions about acquiring products are sometimes in "consideration of possible future events." if prices are rising, buyers will purchase now to save money.

Keep in mind that consumers have certain preferences such as likes or dislikes. A consumer may love emeralds and loathe opals. A consumer gets pleasure from consumption.² The more pleasure the consumer gets from a product, the happier they are. if limited in budget and given two items they like, they will select and buy the one that will satisfy them the most. Speaking of limitations, what limits consumers' choices? if one's income is limited, their consumption will be limited. A single consumer may shop around but have little impact to influence prices and that is also a limitation.

"Thus, when an appraiser analyzes market cause and effect," states Bryan Aderhold, GG (GIA), FGA, an appraiser and owner of Nash James enterprises, "they must look at overall market activity." Often a source will no longer produce a gemstone. The prices for that gemstone will increase. Sharing his market savvy, he explains that, "everyone wants to buy while the prices are still affordable and take advantage of the future increase in profits when the prices increase due to a diminishing supply. That is basic demand and supply."

        Teeter Totter

The correlation between a product's price and the desirability for that product is one of the most influential factors affecting demand. We can assume that price increases equal less desire to consume a product and price decreases equal more desire to consume a product - this is called the "substitution effect."

If a product's price drops, there will be more consumption. Yes, consumers will be motivated to purchase based on lower prices. if natural diamond prices drop enough, consumers may decide to buy natural diamonds rather than laboratory grown diamonds.

If a product's price drops within the budget limit of a consumer, their purchasing power increases. This is the "income effect" (not to be confused with income approach). You guessed it, the "substitution effect" and the "income effect" will arise even with undesirable products. A jewelry customer likes emeralds but adores rubies. if the price of emeralds drops markedly, she will now consider buying emeralds.³

The link between price and consumption is what drives demand. An aggregate result of the economists' market analysis for a product is called "market demand." That is what an appraiser does when he or she properly determines a value based upon market activity. You probably know that there is a relationship between a product's value to a consumer and the actual price. This is called "utility."

        Boring Consumption

if a consumer seeks the most pleasure from a product, the more they acquire the product, the less joy they will gain. Consumers like a variety of products and will buy those from which they will gain the most satisfaction. Their first diamond will give a consumer extreme satisfaction. Each diamond purchase afterwards will provide less satisfaction. This is called "diminishing marginal utility."⁴ If the marginal utility of a product decreases, the product's "marginal value" will decrease. Thus, marginal value is what a consumer will pay for a product and that is a crucial cause affecting demand. Appraisers strictly seek value determined from market activity and are not to be influenced by diminishing marginal utility but do consider marginal value as an influence.

        Demand's Cause and Effect

What causes an increased demand in a market? if an increase in prices is happening, then consumers will buy a product at a higher price before the price increases even more. if consumers have more income, then prices will increase as well. even an increase in quality for a product can be a direct cause for increased demand. "Substitute" is a product that can be interchanged with another product. if the substitute product's price changes, then the alternate product's price will change. This is another cause for increased demand. For example, an increase in quality as well as consumer income will cause a higher demand for the high-qual ity products and an equal decline in demand for an (substitute) inferior product.

        Supplying the Coveter

We hear the expression supply and demand but need to realize that supply only exists when demand creates a market. Availability of a product to meet demand will dictate the selling price.

The production of a product has the goal of achieving an "economic profit." economic profit is the difference between what a company has in revenue and the "costs of opportunity." Costs of opportunity include the standard costs of doing business and the time involved.

A company wants to make the most money possible. Thus, a company must figure out what product will provide the maximum profit. Then the supplier must figure how to produce the product with minimal costs.

        Competition

Competition exists when there is an unrestricted ability to enter a market to meet demand. On the other hand, competition can restrict a market. if a company charges too much for a product, they will not sell it. if they charge too little, they will not earn the maximum profit. The market, through competition, will iron out the prices and who can continue to profit. An appraiser seeks the prices honed by competition as a basis for value.

        A Market Marriage

Market activity is driven by supply and demand. The result is what is caled in economic terms, "equilibrium." if the amount that companies want to sell matches what consumers want to buy, an equilibrium price happens. An appraiser seeks this ideal level of market activity called equilibrium as it results in a perfect value.

Without equilibrium, either sellers or buyers⁵ become exasperated. if, for example, buyers want more of an insufficiently a vailable product or sellers want to sell more than consumers want to buy, equilibrium does not exist. A market at rest is a market that is in a state of equilibrium. Markets that are seek ing equilibrium are not at rest. When does one know that a market does not have equilibrium? When there are prices below or above equilibrium.

        . . . Too Little

Consumers will acquire more of a product if the price is below equilibrium. This is called "excessive demand" or "shortage," not to be confused with scarcity.⁶ For example, emerald melee of a popular quality is selling for $40 per carat. The price is below the equilibrium price and consumers are buying more of them. Hence, emerald melee becomes scarce. Why? Because the supply cannot increase to meet demand. And consumers will start to pay more if a shortage exists. And that moves the market towards equilibrium.

        . . . Too Much

The difference between surplus of product or services and demand is excess supply. Again, the market will push in the direction of equilibrium. The prices will drop, and consumers will buy more just because the prices are lower even if they do not need the goods. usually supply and demand rise and fall simultaneously. Prices will increase if supply becomes limited or if demand increases beyond the supply available. And, of course, the reverse can happen.

        Market Cross Pollination

if you are thinking that a product's (or service's) equilibrium price is confined to just one market, that is not true. A diamond has a high economic effect on a young couple's budget, but still they want to get engaged. if diamonds become too expensive, couples may seek diamonds in pawn shops, and subsequently the price of pawned diamonds will increase. in other words, "complement" or "substitute" goods will be affected.

        Bucking Equilibrium

"Transition costs" occur on a short-term basis. What is a transition cost? it is the time and effort expended for sellers and buyers to locate each other, ending in the best prices for both. it is an expensive process and during the transition, market prices are unstable. Appraisers must be aware of transition costs as they affect the market and value conclusions.

How does one know when transition costs are happening? There is insufficient time for sellers and buyers to discover that either demand or supply has altered. And there is insufficient time to adjust permanently to the shifts of supply and demand. Next time you pay double the normal lodging prices for a hotel during a convention that books all the rooms in town, you are experiencing a transition cost incidence. rooms will shift back to an equilibrium price which means that it was a "transitory shift in demand." By the way, retailers who have large inventories meet temporary shifts in demand. Temporary shifts in demand and supply are not where value is found.

        What to Do?

We can learn from the past. A precedent setting published court case involved an appraiser who had used a formula to determine his value conclusion.

The French-point-system determines value by measuring a painting that was sold in the marketplace to determine the square inches involved, and then, calculating the price per inch to determine the value of a painting being appraised. This was rejected by the court since in actual market practice paintings are not priced and sold that way.⁷ The market dictates the approach to pricing and that dictates the approach to determining value!

Therefore, avoid a formulaic approach to determining value. Apply your knowledge of the marketplace. Do retailers buy a semi-mount from a trusted supplier and a diamond from their diamond wholesaler, put them together, and add a markup to determine an asking price for the finished piece? if that is the case, then mimic that chain of events.

If you are using a price guide, then adjust it to match real world transactions. "The reason that we use appraisers and seasoned wholesalers to research and report stone prices," reveals Richard Drucker, Publisher of the GemGuide, "is that they know what matches equilibrium and what to reject as extraordinary to the market. That results in more reliable published prices." equilibrium, after all, is the goal to a defendable value conclusion.

Although you can use a price guide, you must still research the proper market to be accurate. The prudent shopper who needs your appraisal has analyzed the market and made a purchase. unfortunately, these non-expert consumers often know more than most appraisers about prices in the targeted market. Be the prudent appraiser!

        Conclusion

Careful appraisers analyze markets to seek the ideal level of market activity and base their value conclusions on equilibrium prices.

Written by Bill Hoefer