Economics 101 for Lefties: Part 2 — The Price System
The nice thing about economics is that is that you can teach the most complex topics with a simple parable. In this article we’ll use price-gouging to teach about the virtues of high prices. Walter Williams explains:
In [hurricane] Isabel’s wake, private contractors from nearby states brought their heavy equipment to Virginia to clear fallen trees from people’s houses. Producers and shippers of generators, plywood and other vital supplies worked overtime to increase the flow of these goods to Virginians. What was it that got these people and millions of others to help their fellow man in time of need? Was it admonitions from George Bush? Was it conscience or love for one’s fellow man?
I’ll tell you what it was. It was rising prices and the opportunity for people to cash in on windfall profits.
The first virtue is that high prices are an incentive to increase the supply. The first few entrepreneurs to get their heavy machinery to Virginia would reap windfall profits. That creates a stampede as contractors rush to be the first one to get to Virginia. High prices also plant the seed of their own destruction. As more and more contractors move to the hurricane-stricken region, the storm damage would rapidly become fixed and the prices came back to normal. At that point the out-of-state contractors would pack up and go back home. Without price-gouging, the contractors would have stayed home and people would have had to wait a lot longer to get their houses fixed.
The second virtue is that high prices ration demand. The word “ration” is usually a bad word, but the fact of the matter is that we can not have unlimited amounts of everything we want. I don’t care what your economics are; a global revolution to worldwide communism is not going to put more oil and steel under the ground. The essence of socialism is that the government does the rationing. The essence of free markets is that consumers do their own rationing based on prices.
Here’s why prices work so well. Suppose the hurricane damaged Alicia’s garage and Brandon’s house. Alicia doesn’t want to pay the “price gouging” rate to fix her garage, so she decides to wait until the first rush of hurricane repairs are done. Then she can then hire a roofer at the normal price. Brandon is in a different situation. He doesn’t want it to rain into his living room, so he swallows hard and pays the high prices. But if there weren’t price-gouging then the contractors would have stayed home and he might be stuck waiting for months with a hole in his roof.
The third virtue of the price system is that prices carry information. If the price for apartments in Houston goes up, then entrepreneurs know to build more apartments in Houston. If the price for apples in New Jersey goes up, then entrepreneurs know to ship more apples to New Jersey. In the real world information is not free. It takes time and money to gather and process information. In socialist economies it takes teams of bureaucrats pouring over detailed lists of inventories of various goods to figure out where there is a glut and where there is scarcity. With free markets, it’s easy to get the same information because the prices start going up. Entrepreneurs can easily figure out where supply and demand are out of balance — and be handsomely rewarded for bringing them back to equilibrium.
Speculation and Arbitrage
Let’s apply the lessons of the price system. One example is arbitrage. Suppose that corn is selling for $5 per bushel in California and $3 per bushel in Iowa. The first few entrepreneurs to buy up corn in Iowa and ship it to California would reap windfall profits. But as the supply of corn in California grows the price would come down. And as the supply of corn in Iowa decreases the price would go down. Eventually the prices would get close enough that it wouldn’t make sense to ship the corn across the country anymore.
Speculation is a bit like arbitrage over time. Suppose an entrepreneur thinks that the next corn harvest will be poor. Then he could buy up corn on the current market and store it (perhaps by grinding it into corn flour or preserving it by canning). This would raise the current price of corn due to the increased demand, but it would lower the price of next year’s harvest due to the increased supply. So the price of corn in 2020 and 2021 would come into balance.
The Bill Gates Objection
Suppose the Brandon’s house was damaged in the hurricane as well as Bill Gates’ garage. Since Bill Gates has so much money, he outbid the contractor to get them to fix his garage, even though it meant Brandon had to nail a tarp to his roof and set out buckets in his living room whenever it rained. Our previous example before was based on Brandon and Alicia being equally wealthy and having equal amounts of money. You can see how prices are fair and work efficently. But Bill Gates breaks that. So is this a problem?
No it isn’t. Let’s think about what Brandon would do with his money if the storm hadn’t come. Maybe he was going to remodel his kitchen, or go on a nice vacation, or buy a new car. Instead he spent that nest egg paying for price-gouging contractors. All things considered, he’d rather pay the price-gouging rate and not have a giant hole in his roof, but it’s a tough choice. When Bill Gates outbid him he lost the option of paying the price-gouging rate to get his roof fixed immediately, but it does mean that he’s a lot closer to buying the new car or going on his dream vacation. The contractor, who is probably not wealthy, wins because his windfall is a little bit bigger. Bill Gates wins because his garage gets fixed. And while Brandon is probably a bit disappointed, he is not getting a raw deal.
The disinfectant during a pandemic objection
The parable of the hurricane teaches an important lesson, but it is also rigged. It is a case where high prices increases the supply of goods and demand being an effective rationing method. But think about the run on disinfectant, hand sanitizer and other cleaning supplies during the Covid pandemic. In that case, the price gougers were not creating a new disinfectant, instead they bought out the current supply from local stores only to turn around and sell it for extremely high prices.
Similarly think of the demand side. Any individual person could minimize their own risk by paying the high prices and hoarding hand sanitizer. However, for society as a whole to minimize the spread of Covid, you want everyone to be using disinfectant. Using prices to ration demand results in the most risk-averse people hoarding an outsized share while much or most of the population doesn’t have any. (When we get into a future series of posts on market failure we’ll see that this is a type of tragedy of the commons). A better policy, that was unfortunately instituted too late, would be to have stores limit sales to one per customer.
The positional goods objection
There is a joke about two hikers who encounter a bear and immediately start running away. One of them says to the other “Why are we running? We can’t outrun a bear?” The other hiker says, “I don’t have to outrun the bear, I just have to outrun you.” There are some types of goods where what matters is there relative rank you have against others. Some examples are luxury goods where the goal is to signal to others that you are wealthier than they are. College degrees are another example, where schools can be ranked based on their prestige. Brandon may feel very proud of himself for going Dartmouth until he finds out that Alicia went to Harvard, which is more prestigious. Housing is also at least partly a positional good, as are “winner take all” job markets. And of course, the most positional good of them all is social status. We’ll take a deep look at positional goods in a future posting series on market failure. For now the key point is that we can’t rely on supply and demand to tie a neat little bow on efficient markets. Most of the time supply and demand works well, but not always.
