Thursday, May 18, 2017

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.

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