How Rising Prices and Profits Can Heal “Economic Wounds”
In the wake of Hurricane Sandy, New Jersey governor Chris Christie enforced price controls on a wide range of goods, with disastrous consequences. Because the prices of gasoline and lumber were not allowed to rise, people around the world holding onto stocks of lumber and gasoline had no incentive to send them to New Jersey rather than other places. And New Jersey consumers had no incentive to economize on these goods. As Texas Tech University economist Ben Powell put it,
When high prices are prohibited from serving their function the result is a shortage where there are more buyers than sellers. Buyers still compete with other buyers to try to get the scarce gas, but because price competition is illegal their competition takes less beneficial forms. The main way potential buyers compete to get scarce gas is by getting in line first. Long lines, in some cases miles long, are common in the stricken areas of New York and New Jersey. Stories like Reggie Ridley’s are common. He’s a janitor from Harlem and “he has woken up three hours earlier than usual — around 5:30 a.m. — to start looking for gasoline. Once, he was unable to find gasoline at all, so he had to park his car at a garage and take the subway to work… ‘I’ve been very tired. No sleep,’ he said. ‘Every place I go, it’s been a long line, four- to five-blocks deep.'” Unfortunately, efforts like Reggie’s don’t make sellers any better off so it doesn’t induce a greater supply like higher prices do. It also doesn’t guarantee that gas goes to its most valuable uses. Instead, whoever is lucky enough to get to the front of the line at the right gas station gets it.
Natural disasters harm people’s standard of living by destroying resources, but in a free marketplace, rising prices and profits in scarce goods give both buyers and sellers an incentive to heal the economic wound. Drawn by the possibility of making good profits at high prices, sellers bring the scarce goods to market from afar. Facing high prices, buyers demand less of the scarce goods than they would if prices were not allowed to rise. For this reason, George Mason University economist Alex Tabarrok calls a price a “signal wrapped up in an incentive” in the following video I showed my EEC students. Prices tell buyers and sellers which goods are most valuable, and where, and give them the right incentives to use resources efficiently. “Economic wounds” can come from sources other than natural disasters. Think about nonrenewable resources like oil. You might think that because their supply on earth is limited, we’ll eventually run out. But as the supply of oil declines, its price will go up, and buyers will conserve it more and switch more to alternative fuels. In the long run, rising oil prices and profits encourage new exploration of oil and other energy sources. Eventually oil might be so scarce as to be uneconomical for energy, but when that day comes, consumers will have already switched over to alternative energy sources without any subsidies or other central planning needed. Prices and profits aren’t just useful for healing economic wounds. They also drive progress into new areas. Whenever an entrepreneur comes up with a new innovation, she earns high profits, because she has a kind of temporary monopoly. Think about smartphones. When they first came out, they were very expensive, but the high profits that companies like Apple earned on their new phones incentivized other companies to come out with similar but more affordable products – first Samsung, and then even cheaper competitors. Innovation provides a temporary monopoly that rewards the innovator with large profits, but over time, those very profits attract competition, drive down profits and prices, and benefit consumers even more. The price system is a wonder of the human world. Prices aggregate complex, dispersed information and make it easy for us to understand and apply to everyday economic decisions. Profits provide the incentive for producers to create new things that we value. Without prices and profits, markets would be impossible, and so would human progress.