Three Virtues of the Price System

The parable of the price gouger teaches us the three great virtues of supply and demand. Those virtues are

1. An incentive to increase the supply
2. An incentive to ration demand
3. Information about the market

Let’s take a look at each of these three virtues.

Incentive to increase the quantity supplied

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. This stampede also plants the seeds of its own destruction. As more and more contractors move to the hurricane-stricken region, the storm damage became fixed more and more rapidly. The extra demand was met and the prices came back to normal. At that point the out-of-state contractors packed up and went 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. 

Prices ration demand

The second virtue of high prices is that they give an incentive for consumers to ration their 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. We can’t have unlimited amounts of everything that we want. So like it or not, something has to ration demand. 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. 

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. Brandon has the greatest need, and price as a rationing method makes sure that the people with the greatest need can hire a contractor. By contrast, let’s suppose that there were laws against price gouging. Then the contractors from out of state would have stayed home and there would be a big waiting list while the contractors worked their way through the hurricane-created backlog of work. Brandon might be on the waiting list for months before someone could fix his roof. 

Prices broadcast information

The third virtue of supply and demand 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 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. You don’t have to do a massive market research to find out that prices have gone up or down. Entrepreneurs can easily figure out where supply and demand are out of balance – and be handsomely rewarded for bringing them back to equilibrium.

Virtually everything that you need to know about supply and demand is found in the parable of the price gougers. Many books on economics spend hundreds of pages applying this lesson over and over and over again. We'll briefly apply these lessons in the next post.

The Parable of the Price Gouger

"Teach a parrot the terms “supply and demand” and you’ve got an economist. "

– Thomas Carlyle

The first lesson of economics is that people respond to incentives. The second lesson is supply and demand. It's what happens when we apply incentives to markets. The nice thing about economics is that even the most complicated lessons can be captured by a simple parable. Supply and Demand can be bought with the parable of the price gouger. The economist Walter Williams (2004  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.

This parable teaches the three important virtues of free markets. We'll cover them in detail in the next post, but your homework assignment is to try and figure them out on your own.

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Incentives: Wrapping it Up

Both economic progressives and conservatives fail to follow the first lesson of economics. Many progressive are like Karl Marx in that they judge a government program based on its intended outcome without appreciating the fact that it creates incentives that reward laziness. But conservatives fail to properly apply the first lesson too. They just look at the effect of government programs on laziness, but it’s not enough to just look at one effect, you have to look at all of them. And it’s not enough to list the effects. You have to get your hands dirty by gathering evidence so that you can find out the strength of the effects.  

Let’s keep things simple by focusing on job mismatch and laziness. Perhaps we’d see a huge increase in laziness and only a small decrease in job mismatch. In that case unemployment insurance would be a bad program that rewards laziness. But maybe we’d find the opposite – a big decrease in job mismatch and only a small increase in laziness. In that case, unemployment insurance would be a good program. So conservatives who point to government programs that reward laziness without showing the strength of all the effects are also wrong.

Let’s revisit the research by Summers and Clark. They found that unemployment only increases by about half a percent, such as from 5% to 5.5%. So it seems pretty clear that both the laziness effect and the “job mismatch” effect are pretty small. Even in the worst possible scenario – that all of the increase in unemployment is because of people abusing the system – you are still left with ten people getting a lot of help for every one person who is shirking. That seems like an excellent tradeoff to make. Unemployment insurance is a program that helps people who are down on their luck and doesn’t do much harm.

Human society is extremely complex and even small changes will produce a multitude of large and small effects. You can’t sit down in an armchair and carefully reason your way to a prediction about the consequences of a new law or government regulation. You have to spend time thinking about all the possible effects, both good and bad, and then spend more time getting your hands dirty by gathering evidence about the strengths of all these effects – or by going to Google Scholar and reading the papers of economists who have. Only then can you form a rational conclusion about whether or not unemployment insurance, or welfare, or Social Security is a good or bad program. Liberals and conservatives each have different ways of ignoring the first lesson of economics. It’s not clear which is worse.

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Get the Data

The second problem that conservatives sometimes make is only look at the effects of a policy on laziness and hard work. But there are many more. Human nature and human society is extraordinarily complex things. The Law of Unintended Consequences holds that new laws or regulations will have many different effects beyond those which were intended. A policy cannot be judged until all effects have been accounted for.

Let’s talk about “job mismatch”. People who are out of work still have to pay the rent and make the car payment. And when they are unemployed, their health insurance gets a lot more expensive because their employer is no longer picking up the lion’s share of the cost, so a lot of people forego health insurance. That’s not a good place to be, particularly if you have kids. The upshot is that most workers don’t have the luxury of doing a long and thorough job search. They can’t realistically expect to find their dream job; they have to take the first half-decent job that comes along. That’s bad for workers because it means their job may not be as fulfilling, but it’s also bad for firms. If workers had the luxury of taking longer and more thorough job searches, then employers would have a larger pool of job applicants to choose from. That means that workers could be better matched with a job that fits their skills. That in turn results in a more productive workforce and a stronger economy. Unemployment insurance – a Big Government program – actually boosts productivity and makes the economy stronger. That what’s economists mean when they say that insurance reduces “job mismatch”. 

Job mismatch is just the tip of the iceberg. Unemployment insurance has many other effects. Take dual income couples. Having a second earner in the family provides another type of safety net. If you lose your job you can rely on your spouse’s health insurance and paycheck to get by. So unemployment insurance rewards single income couples who don’t have a second income to fall back on, so we expect an increase in stay at home moms and dads. Savings is another effect. Unemployment insurance rewards people who didn’t bother to save for a rainy day, so we expect unemployment insurance to result in lower savings. If you spent enough time, you could find dozens or even hundreds of different choices that will be impacted in some way by the presence of unemployment insurance. Most of these other effects are likely to be trivial, but a few of them might very well be significant. 

To sum up, liberals often make the mistake of only look at the intended consequence of a law. In the case of unemployment, that means the unemployed workers being helped. Conservatives tend to go one step farther and look at the unintended consequences on laziness and hard work. But smart liberals and conservatives go beyond this and look at all the plausible effects. 

Europe's (perhaps too) generous unemployment system is a great example. It was intended to reduce job mismatch and the "commoditization" of labor. Having unemployment insurance gives workers greater negotiating power relative to their employers. Instead of being plugged into a job, they would have the time and the bargaining power to choose a job that they would find fulfilling. Whether or not they succeeded is an empirical issue. We have to be engineers and get our hands dirty gathering data to know know for sure. We'll take a look at some of this research in a much later post.

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Conservatives and Incentives

Case closed, right? Not so fast. Now let’s look at how conservatives fail to appreciate the way that people respond to incentives. Samuel Bowles divides economists into priests and engineers. The engineers are the ones who are getting their hands dirty with how real world people and economies actually work. Priests are the ones who sit down in ivory towers and reason about how economies work with abstruse mathematics or deductions from first principles. Conservatives sometimes go wrong by being priests.

Let's continue to use unemployment insurance. The conservative priest says "Unemployment insurance rewards shirking and punishes work. Therefore we'll get more shirking and less work. Therefore unemployment insurance is bad."

Problem One: The Size of the Effect Matters

There are two problems with this analysis. The first is that while we know that unemployment insurance creates an incentive to be lazy, we don’t know by how much. The strength of the effect matters. If unemployment insurance causes the unemployment rate to skyrocket then we might have a problem. But if it only causes a tiny increase then we probably don’t. Priests can't tell us that unemployment insurance is bad. We need an engineer.

That’s what Lawrence Summers and Kim Clark (1979) did. They went out and got the data and found that unemployment insurance doubles the number of cases where people are unemployed for three months or more. It also increases the unemployment rate by a half percent, such as from 5.5% to 6%. So the effect is actually pretty small. For every ten people who really need help, there is at most one person who is unemployed who would otherwise be working.

But it is the second problem that really gets conservative priests (not all economic conservatives) into trouble. We'll cover that in the next post.

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Liberals and Incentives

Liberals and conservatives can each fail to understand how people respond to incentives, but they do it in different ways. Liberals sometimes judge policies based on their intentions – on whether a proposed law means well. We’ve already seen that with communism. The concept of “from each according to their ability, to each according to their need” is a beautiful concept. That’s how my family works. I make more money than my wife does, but that doesn’t mean that I get to spend more money than she does. We share our money in common and use on whatever we think is the greatest need. This works well for our family but it didn’t work for the Chinese farmers. That raises another puzzle: how come Marx’s slogan works so well for families but so badly for villages? We’ll cover that in a later post, but you may want to start thinking about it now.

Progressives face the same challenge as communists. Many government programs are designed to help the poor and afflicted, so they are clearly well-meaning. Who is opposed to helping the poor and afflicted? The problem is that they also create some bad incentives. Take unemployment insurance, which is a government program that gives money to workers who have lost their jobs. It is clearly based on good intentions. Who doesn’t want to help people who are down on their luck? But let’s consider the incentives. It taxes (punishes) people who are working in order to give money to (reward) people who don’t have a job. Since people respond to incentives this means that unemployment insurance actually creates more unemployment. 

Does this mean we should get rid of unemployment insurance, much like how the Chinese farmers got rid of communism? Probably not, and we'll see why in the next post on conservatives and incentives.

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More Unintended Consequences

You can’t avoid the law of unintended consequences. It strikes everywhere, even in unlikely places. Take the designated hitter rule in baseball. That’s a rule that allows another player to bat in place of the pitcher. Since pitchers are usually very bad hitters, the rule led to more offense and more scoring. But it also caused some unintended consequences, one of which is that pitchers hit the batters more often (Goff et al. 1997). That’s because pitchers don’t fear retaliation. In the old days, a pitcher who hit a batter would likely get plunked himself when he went up to bat. That’s a pretty powerful deterrent against hitting a batter. The designated hitter means that pitchers are no longer punished for hitting batters, so the outcome is more hit batters. Even professional athletes respond to incentives. 

Stephen Dubner and Steven Levitt provide another example in an article for the New York Times (2008). The Endangered Species Act was created to protect the habitat of animals that were in danger of going extinct. It stopped developers from building strip malls or parking lots on land that was being used by a protected species. Now let’s think about what happens when we realize that people respond to incentives. What is punished? Owning land with endangered species. So landowners responded by cutting down trees on their own property in order to drive off the endangered species and prevent their land from being designated a critical habitat in the first place. 

Free and Equal Kingdom: Overview

Liberals and Incentives