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China: Where Supply and Demand Laws No Longer Apply

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Price inelasticity in China is enough to make an economics professor reach for a drink. Or a new textbook.

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In the US, when demand rises, price increases follow and demand tapers off to a more natural level of supply and demand. Even for the wealthy.

In China, when demand increases, prices increase and attract more consumers willing to spend even more.

Searching for a domestic travel destination last week for the upcoming Chinese New Year (during which the entire country has a week off) I found the perfect example to depict this phenomenon.

I was targeting Sanya, a beach destination. A local four-star hotel that typically runs 350 RMB ($50) per night was being sold for 2,300 RMB ($340) per night. The Ritz Carlton, which can usually be had for 2,000 RMB ($300) per night, was selling its cheapest rooms for over 5,000 RMB ($750) per night. Numerous rooms were going for well over 7000 RMB ($1,000) per night.

Round-trip airfare from Shanghai to Sanya normally offered at 200 RMB ($30) to 1,000 RMB ($150) can't be found for less than 4000 RMB ($550).

Regardless of price, every single room in Sanya is booked solid and few plane tickets are left.

If you're wondering, I was priced out of the market and will be traveling elsewhere.

The point is that demand in China is seemingly inelastic. It doesn't end at holiday travel.

A private license plate in Shanghai costs, on average, $5,617. Total costs to buy and own a car (not including the physical car) can go upwards of $15,000, according to a local friend who just purchased a Honda. Yet, in January, 18,975 bidders convened at Shanghai's monthly license plate auction that allots just 8,000 plates.

The physical car itself sells for a premium here in China. A General Motors (GM) Enclave competitively equipped retails for about $37,000 in the United States. In China, it starts at around $77,000.

Despite high mark-ups and a high government barrier to own a car, GM sales in China hit 2.35 million in 2010, more than the 2.2 sold in the US, and recorded 29% sales growth.

To understand this phenomenon, you have to understand the Chinese people.

First, the Chinese lack a sense of value. Wealth is accumulated rapidly and in many cases, without taking on much risk since the government stands by its people's side. Real estate, frequently earned via unorthodox means, turns average workers into wealthy citizens without lifting a finger. The Chinese don't always associate high income through hard work and therefore don't value the ability to purchase a luxury item.

Second, the lack of a distributed class system results in a consumer market where you're either too poor to afford premium goods and services or you're so wealthy that you can afford just about anything. With no scale of wealth, consumers do not gradually get priced out of the market as prices rise.

Third, the Chinese tend to view a direct connection between price and quality. The higher the price, the better the product. The best example is the housing market: structurally poor apartment buildings that deteriorate at rapid rates continue to escalate in value. The quality of the inside of an apartment is rarely a determining factor of its market value.

Lastly, wealthy Chinese are very materialistic and status oriented. This has a lot to do with the fact that China is all new money. For example, a young co-worker's parents purchased her a car a few months back. She claimed she didn't have a driver's license and was unsure what she should actually do with the car. It was purchased purely for the fact she could say she owned it.

A recent quote from a Chinese dating game show, "I'd rather be miserable sitting in BMW rather than happy on a bicycle", sums up the Chinese mentality.

Clearly, the Chinese mindset is far different than in the US. Regardless of level of wealth, most rich Americans will think twice before a purchase and evaluate the value of what they are paying for goods or services. In China, money is spent with little to no consideration of value. It's spent because it can be spent.

The result? An inelastic demand curve for luxury.
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