How Rising Prices and Profits Can Heal “Economic Wounds”
Photo: boldride.com
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.
I don’t know how much I can add, as this article seemed pretty definitive, yet I will try my best to share my personal opinion of How Rising Profits and Prices can Heal “Economic Wounds”. To begin, I like the example of natural disasters, but for the purpose of diversity I will create my own example. There is a mill situated beside a river, and it makes clothes for the entire town. What with the excess of cotton stored in the mill, it catches fire and burns to the ground. Luckily no lives were lost. The town now has a so-called “Economic Wound”, even larger so because the mill was the largest business operating within the town. Now with a shortage of jobs, loss of product, and in turn profit, this wound must be dealt with. As seen in the previous example, when there are such a drastic turn of events, people tend to make the problem worse rather than let nature run its course. In this case, the mayor Yis Yistie decides to let the matter be, rather than interfere with the economic structure already established in the town (and besides the point he is a economist extremist who is running a social experiment for his class of high school students that he visits once a week). Back on track, the affects of the wound on the town may be similar to those of the victims of the disaster, yet the outside effects are much different. Due to the town’s size, there will not be such an exuberant amount of inflow relieving the stress of the loss of the factory. In larger cities and with larger disasters come more support and more mediating of prices, yet how will this be achieved in a smaller community? Say this clothing factory supplied other towns with clothes as well. Will another simply come in and take over the market, knowing that it must now increase its production to make up for all of these people? Or would this second company raise its prices (again like the previous example) to cope with the inflated amount of demand? These questions are ones that can be answered with the economic principles we have learned, yet one must not forget that other factors such as location and circumstance can also greatly influence what would otherwise be straightforward.
Thanks, Braden. Well, a smaller town needs a smaller inflow, right? Why wouldn’t the inflow of needed resources be proportional to the need (extra quantity demanded times the extra price)?
Thank you Dr. Sorens, I hadn’t considered that. I was trying to do a “stream of conscience” type of writing and see where it went from there. In reflection that would make sense and perhaps my example was a little off the wall. My prior reasoning as to my thoughts regarding why “the inflow of needed resources” would not be “proportional to the need”, I was thinking that since the area was so small compared to something like New Jersey, distant companies/businesses would not take as much of an interest in it and be drawn in. I guess I created a paradox though in saying that the mill supplied other towns with clothing as well. This would contradict my original thinking and most likely be the reason why the inflow of resources would be higher than I originally thought (Inflow = companies, businesses, etc.). Also, with a smaller “Economic Wound” to heal, the inflow would not have to be as great, so even if these companies did not flock to the “Wound” then the smaller, more tightly wound community would likely be able to fix the problem without major outside intervention (if over an extended period of time). Hopefully this was not too confusing to read and I appreciate your help!
No worries, that’s what give and take are all about! Now, while I don’t think small areas as such will have higher prices due to being ignored by sellers – that situation would create a market opportunity; it pays to pay attention to under-served markets – I do think more distant markets from population centers will tend to have higher prices, because the costs of transporting the goods are higher. So in small Arctic towns you can only reach by plane, pretty much everything will be expensive!