Friday, November 2, 2012

In Praise of Prices

And a cautionary tale of trying to control them.  Before getting all pedantic let's cut to the chase and point out two things about 'price gouging' now that the topic is all the rage (see here and here) given gas and other shortages in the NY/NJ area:

1. Allowing prices to rise uncontrolled will act as a efficient allocation mechanism, doing away with shortages and assuring those whose valuation of the good is highest get it.

2.  This has absolutely nothing to do with 'fairness' or 'equity' and it is very much the case that high valuations and income are highly correlated.

What, of course, is true is that I have just described free markets in general.  

So now to the pedantic part.  Here is Matt Yglesias making point number one:
The basic imperative to allocate goods efficiently doesn’t vanish in a storm or other crisis. If anything, it becomes more important. And price controls in an emergency have the same results as they do any other time: They lead to shortages and overconsumption. Letting merchants raise prices if they think customers will be willing to pay more isn’t a concession to greed. Rather, it creates much-needed incentives for people to think harder about what they really need and appropriately rewards vendors who manage their inventories well.
The last part is a bit of a stretch, it is a windfall profit that vendors get but no more so than the seller of vitamins after a new study shows a daily dose vitamin Q will cause you to live forever not because they are brilliant inventory managers.  But the basic idea is correct: prices are an efficient way to ration a scarce resource.  The part about the vendor also missing the most important point, if gas prices are allowed to rise to market levels, imagine how much harder suppliers would try to get gas deliveries in, how much harder gas stations would work to get temporary power, and so on.

But the second point is not made in either linked article (well, article and radio story) which is that those that would end up with scarce and essential resources would disproportionately be the wealthier members of society.  This is not new, Ferraris are scarce, gold is scarce, 20,000 square foot mansions are scarce, and so on.   So even in the absence of disaster, this is how markets work - something we have known for a long time: markets are efficient but not 'fair.'

None of this solves the question of how we ration scarce resources in a time of crisis, however, and in such this is a lesson in both the power and limitations of free markets. The key, though, is that free markets do a lot better job than price controls.  Price controls mean that, in large part, the lucky get resources and the unlucky do not.

Lines are a rationing mechanism, those with the most need are more willing to wait on line for hours upon hours, but they are terribly inefficient, that time is also a valuable resource where they could be doing more productive things. But prices, for their faults, will assure efficient distributions, will ration and will promote the speedy replenishment of resources.  And the great thing about prices is that it takes no institutional control - all of the efficient rationing would take place immediately and naturally.

A crisis is not the time, I suppose one could say, to start worrying too much about the inequality prevalent in our society - it amplifies it and perhaps suggests we should be doing much more - but price controls only make a bad situation worse.

Now, there could potentially be hybrid solutions - the first two gallons of gas, say at reduced prices, but then whatever price the station wants to charge - but these take institutional control.  It could be that low income folks can get vouchers for stuff, but that would be hard to implement in a crisis. In the end, despite their problems, prices are the first best solution.


Jarrod said...

This post makes some key assumptions about crises, particularly major crises of the scale of this one. The two key assumptions are that the suppliers (i.e. gas station owners) have agency over the situation and that information allows consumers to make informed decisions.

The first assumption is that market owners have agency over their ability to access resources. Control over electricity for their businesses is largely out of their hands. Sure they could use backup generators, but they need to a) access those generators and b) acquire fuel for those generators. Sure they are in a great position to get fuel for the generators, but that brings me to the second point about agency: access to the facilities is limited through roadblocks, destroyed infrastructure, power outages and general destruction.

Secondly, there is a considerable information deficit in place regarding these resources. With millions experiencing power outages, transportation infrastructure destroyed, vehicles and homes destroyed, there is a strong potential for a market failure.

These arguments aside, I think you are missing the point of disaster response. While efficiency is a major goal, equity is crucial to the maintenance of stability and government authority. If rationing is not the most efficient mechanism, it is considerably more equitable. If generators are the main source of electricity in regions decimated by flooding and without power to refrigerate or prepare foods, then a market efficient outcome that moves resources to only those who can pay for it is the quickest way to ensure that Hurricane Sandy acquires the legacy of Hurricane Katrina.

theorioleway said...

Echoing Jarrod's point, suppose let's take a hypothetical:

Two individuals are competing for the final gallon of gasoline. One is rich and wants to run a generator in order to keep his cell phone charged and refrigerator running since he has lots of expensive food that he does not want to spoil. Another is poor and wants gasoline to drive to work. The poor man's marginal utility of the gasoline is extremely high, even higher than the rich man's because if the poor man does not go to work he will lose his job. The rich man, though, has a much higher ability to pay. If we ration purely on price, the rich man gets the gasoline. If we ration on time, the poor man does because he has the same number of units with which to pay as does the rich man. Prices are an effective rationing mechanism, but that certainly doesn't mean they are the most equitable. In many situations, that is perfectly fine. In others, this clearly creates inefficiencies from an equity perspective.

What's the solution? For most goods, price works. But I think our society has pretty clearly decided that some "essentials" (electricity, gasoline, some basic foodstuffs, maybe even health care) should not be priced purely by the market in emergency situations but should instead be offered to each member of our society.

Sam said...

I'm not sure how line rationing is more goes to whoever gets there first. It is quite possible that all the rich people, because of their resources and thus ability to get out of a disaster more effectively (through generators, SUVs, etc), are able to get to line before the poor and get the majority of the gas before it runs out. While theorioleway's proposal of giving based on need is "feel good", nobody is checking what the purchaser needs gas for, the gas station owner is only worried with selling and how would you confirm the story they're telling is true and how would you rank who has more need in a line of hundreds of people in the aftermath of disaster?