Why Fiddling With Prices Doesn’t Work


“The fact is, if you don't find it reasonable that prices should reflect relative scarcity,
then fundamentally you don't accept the market economy,
because this is about as close to the essence of the market as you can find.”

— Joseph Heath

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Inevitably, when the price of a good or service rises rapidly, there follows an accusation of price-gouging. The term carries a strong moral admonition on the price-gouger, in favor of the price-gougee. Gas shortages are a classic example. With a local shortage of gasoline, gas stations will tend to mark up the price of gasoline to reflect the supply issue. This is usually rewarded with cries of unfairness. But does that really make sense?

In his excellent book Economics Without Illusions, Joseph Heath argues that it doesn't.

In fact, this very scenario is market pricing reacting just as it should. With gasoline in short supply, the market price rises too so that those who need gasoline have it available, and those who simply want it do not. The price system ensures that everyone makes their choice correctly. If you're willing to pay up, you pay up. If you're not, you make alternative arrangements – drive less, use less heat, etc. This is exactly what market pricing is for – to give us a reference as we make our choices. But it's still hard for many well-intentioned people to understand. Let's think it through a little, with Heath's help.

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As Heath points out in the book, the objection to so-called “price gouging” goes back at least to the Roman Emperor Diocletian, who in AD 301 imposed an Edict of Maximum Prices:

If the excesses perpetrated by persons of unlimited and frenzied avarice could be checked by some self-restraint—this avarice which rushes for gain and profit with no thought for mankind; or if the general welfare could endure without harm this riotous license by which, in its unfortunate state, it is being very seriously injured every day, the situation could perhaps be faced with dissembling and silence, with the hope that human forbearance might alleviate the cruel and pitiable situation.

And with that, Diocletian set a hard cap on the price of over a thousand different items. Some were tangible, like wheat and barley, and some were intangible, like farm labor and barber services.

This was, of course, very dumb and did not last very long as people realized that one barber and another were not equal, that wheat and barley might have local supply constraints, and that an arbitrary government price was not the fair one for most of the 1000+ items.

Inflation vs. Supply

As Heath points out in his book, there are two separate issues to untangle when we talk about “price-gouging” — general inflation and constraints on supply. The two are very different, and confusing a supply issue for general inflation leads to a lot of wrong thinking:

If you wander into a Polish supermarket and discover that a kilo of carrots is selling for four zlotys, you probably haven't learned very much. It's only once you find out what a pound of potatoes costs, and a chicken, and a pint of beer, that you begin to discover whether carrots are expensive or cheap.

As a result, the price of everything going up is analytically equivalent to the price of nothing going up. It follows that if the price of everything seems to be going up, it must be because the price of at least one thing is (inconspicuously) going down. Usually that inconspicuous item with the falling price is hidden in plain sight — money. We tend to overlook money because it's not directly consumed; it simply circulates, thus we forget that it has a price. We think of “four zlotys per kilo” as the price of carrots, expressed in zlotys, while forgetting that it is also the price of zlotys, expressed in carrots.

As Garrett Hardin would well recognize, part of the problem is the way language misleads us. When the price of stuff is going up, we don't always make the equivalent connection that the value of our money is going down. And thus, we can often confuse a rising price environment for greedy so and so's who are simply reacting to the declining value of money.

Often, governments hurt the value of money purposely. In Diocletian's time, a denarius coin went from being made entirely of silver to being made of about 2% silver and 98% base metals – the origin of the term currency debasement. In a world of inflation, what seems like greed is often an illusion caused by money losing its value generally (a complex phenomenon in its own right).

To see the flow-through effects of this, imagine that all wage-earners were given a significant raise next month. Sounds good, right? Problem is, the increased cost of labor would be passed through in the form of higher prices for everything, or alternatively, businesses would figure out how to operate with fewer workers altogether. The owners of society's capital don't just sit back and lose money — they figure out a new plan or reallocate their resources elsewhere.

Thus, a wage increase would put us right back to where we started. This is why the minimum wage debate isn't simply a humanitarian “business versus workers” issue — there are no easy answers. (In other words, The consequences have consequences.)

Prices are simply signals which allow us to make decisions on how much we really need that thing. If each of us was handed $5,000 to spend each month, we could choose to spend X amount on food, Y amount on housing, and Z amount of organic 97% cacao chocolate. The alternative would be a state planner sitting in a high tower trying to fix prices based on how he or she thought everyone should make their food/housing/chocolate allocation for the month. The history of planned economies would show this to be a majorly bad idea.

This leads us to our next point which is that, of course, our income allocations are not the same. Might price-fixing help level the playing field?

Fixing What, Exactly?

Heath quotes the economist Abba Lerner who once said that the problem for the poor is not that prices are too high, but that they don't have enough money. (“The solution of poverty lay not with the manipulation of prices but with the distribution of money income.”)

On this, Heath turns to the example of electricity prices, an occasional hot-button issue which leads to subsidies because high electricity prices are seen as regressive — poor people spend a larger percentage of their money on electric power than those more well-off. Why not subsidize electricity prices to help?

The problem is that it's a massively inefficient way to help, and puts a lot of dollars into pockets of those who don't need it. Citing Canadian statistics on the use of subsidies to keep electricity prices down, Heath writes:

The middle-income quintile spends an average of $1,117 per year (2.4% of income), while the upper quintile spends $1,522 per year (1.1% of income). This means that the $250 million annual gift being bestowed upon the poor is coupled with a $408 million gift to the middle class and a $556 million gift to the richest 20% of the population. Needless to say, a welfare program that required giving $2 to a rich person for every $1 directed to a poor person would hardly be regarded as progressive (despite the fact that, when expressed as a percentage of income, the poor person is receiving “more”).

Of course, finding a way to get the entire $1.2 billion to the people who truly need it, through a deserving program, would be a far better solution, and one that would also avoid encouraging people to use more electricity than they need (which artificially lower prices can do).

This kind of thing happens, but worse, when it comes to rent control, the system of fixing rental prices for apartments in cities. In addition to subsidizing some of the wrong people, who also have access to rent-controlled housing, the lower prices tend to distort the market for apartment and housing construction.

With apartments so affordable, people who might otherwise have purchased a house now choose to rent, crowding out some people who could never afford a home at all. And with prices artificially low, fewer apartment houses are built! Not a great outcome for the people rent control hopes to help.

To understand why think about the massive spike in energy prices leading up to the 2008 financial crisis. At one time, oil neared $140 per barrel and natural gas reached $13 per MMbtu. The result was somewhat predictable: A massive investment went into the energy complex, leading to new resources and new technologies, while demand quickly abated. Almost no one correctly predicted that 8 years later, oil would be sitting below $50 per barrel and natural gas around $2 per MMbtu. This is, of course, how pricing markets are supposed to work. The signals did their job. Artificial prices for metropolitan apartments don't allow the market to do this job effectively.

Relative Scarcity: The Key to Understanding Market Prices

The main problem with manipulating and fixing prices is a misunderstanding of what determines prices. What usually determines prices in a true market is relative scarcity, the intersection between how much you want a particular good relative to another one, and the availability of that good. As our wants and needs change, and available supplies change, prices go up and down (ignoring, for now, speculative factors, which play a huge role in some price markets).

What exactly are we paying for when we buy an item?

Clearly, it's not just the cost of the physical thing being produced. A cup of coffee costs a lot more than a few beans and some water. The total cost is something Heath calls the “social cost” of the good, which includes the entire chain of costs and opportunity costs in producing it:

Whenever someone consumes a good (say, a cup of coffee), this can be thought of as creating a benefit for that individual, combined with a loss for the rest of society (all the time and trouble it took to produce that cup of coffee, now gone). Paying for things is our way of compensating all the people who have been inconvenienced by our consumption. (Next time you buy a cup of coffee at Starbucks, imagine yourself saying to the barista, “I'm sorry that you had to serve me coffee when you could have been doing other things. And please communicate my apologies to the others as well: the owner, the landlord, the shipping company, the Columbian peasants. Here's $1.75 for all the trouble. Please divide it amongst yourselves.)

“Social cost” represents the level of renunciation, or foregone consumption, imposed upon the rest of society by each individual's own consumption. This is a fairly abstract notion, since it's not just that the good could have been consumed by someone else, but that the labor and resources that went into making that good could have been used to produce something else, which then could have been consumed by someone else. (So when I drink a cup of coffee, I am not only taking away that cup of coffee from all those who might like to have drunk it, but taking away vegetables from those who might like to have used the land to grow food, clothing from those who might like to have employed the agricultural workers in a garment factory, and so on.)

[…]

If the price of coffee tracks changes in supply and demand, it will tend to reflect this level of hardship. If the rest of us really want coffee, then we will be prepared to pay more for it, and so the price will rise. Coffee will become more “dear” (as the British would say), reflecting the fact that the person who drinks it is denying the rest of us something we really want. Thus the coffee-drinker had better really want it in order to justify depriving us of it. His willingness to pay the higher price is precisely what ensures that he does, in fact, really want it.

At the price where the hardship of creating a certain amount of some good meets the desire for a good, a price emerges. It's this “market clearing” price which efficiently allocates most of society's resources the way we need them allocated.

If prices are systematically lower than they should be, consumers benefit from society's hard work in a way that might be better allocated elsewhere, where some other group would happily pay more for the same level of “social costs” imposed, and the producers would receive more for all their work.

Conversely, if prices are too high, then consumers don't really get to be as happy as they should be relative to the modest “social cost” they've imposed. Each outcome is inefficient and produces less happiness and material wealth. A well-established pricing mechanism does the job of sending the right signals about wants, needs, and supplies.

Income Over Pricing

Heath makes a final important point about the inequality of income in society, and that in many cases, people who have had a rough hand dealt to them do deserve help. It's just that playing with the pricing mechanism is usually the worst way to do it — as we saw above, you hand people money who don't need it while distorting an efficient allocation of resources throughout society. Heath calls this the just price fallacy — the idea that some alternative level of prices are more “fair” and that we should intervene to ensure them. The “just price fallacy” fails because it doesn't ask the crucial question: And then what?

Returning to the dictum that poor people simply don't have enough money (ridiculous as it sounds), the better method is to attack the other side — income — through the system of taxation and other mechanisms, things which we do in great heaps in modern society, but will always be argued over. If market prices tend to efficiently signal suppliers about the wants and needs of society, we can usually help the less fortunate best by giving them more “claim checks” rather than distorting the very thing that works.

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Still Interested? Try reading more from the wonderful book Economics Without Illusions, where Heath takes on some fallacies from the left and some fallacies from the right in the economic debate.

For more from Farnam Street, check out Charlie Munger's speech on what could make the economics profession work a little better or check out economist John Kay's recommendations on books about economics in the real world.