Elementary Economics: The Price as a Rationing Mechanism

Based on the comments to this post I’ve decided that a post on elementary economics is in order (or in other words I get to be really patronizing to those who just don’t seem to get it). Since this is a post about elementary economics lets start out really, really simple.

1. We live in a world with finite resources.

At any given time resources are finite. Have you ever heard your parents say something like, “I wish there were 28 hours in the day”? The implication here is that they don’t have enough time to do everything they wanted to that day. In short, time is a finite resource of sorts. Since we live in a world with finite resources those resources have to be rationed in some manner.

2. Demand for goods declines as price increases.

This is basically the Law of Demand. The idea here is that once again at any given point in time people have finite income, and hence even if they spend everything on a single item as the price increases they have to buy less. The actual effect here is actually a bit more complicated in that there are two effects at work here. The first is the income effect. The income effect is that the price increase could be caputred as a decline in income instead of an increase in the price. Hence people consume less of the good. The other effect is the substitution effect. The substitution effect is when as the price of one good goes up, the price of the remaining goods have declined. Hence people will shift consumption away from the higher priced good to lower priced goods.

3. Supply of a good increases as the price increases.

This is the Law of Supply. The reason for this law is that as the price increases for the good, the profits for the firm increase. This increase in profits induces not only existing firmst to produce more, but may also induce new firmst to enter the market and increase the amount of the good supplied at the new higher price.

Now, based on all of this, it should be pretty obvious that the price of a good is a rationing mechanism. For those who the price is too high they either buy very little or none of the good in question. For firms whose average cost is equal to or lower than the price, they produce the good in question. Otherwise they shut down. The firms that produce the good in question demand other goods that are inputs to the production of the good in question. Hence prices tell people where to send their resources and what to buy. The market rations resources, but in a decentralized way. If the government were to try to do what the market does it would have to know things like the cost function/production function of various firms. Further, the government would have to know about the welfare (satisfaction) people derive from consuming various goods. Since it would be difficult at best to aquire this information and even if aquired, by the time it is aquired it would be out of date, such centralized decision making is going to be practically impossible. This problem was put forward by Friedrich Hayek and is called the economic calculation problem. Given what we know about places like North Korea, Cuba, and the former Soviet Union we can pretty much consider that Hayek was right.

Now this doesn’t mean that the price/market mechanism is perfect when it comes to rationing. Inefficiencies can be present in markets and many moderate economists (myself included) see these inefficiencies as necessary conditions for government intervention in markets.1 However, things like price floors/ceilings, regulations, and other things like the investigation by Bill Lockyer can make a bad situation worse. Right now, there has been a major hit to the supply process for gasoline. This is a fact and indisputable. Further, basic economic theory indicates that the price should indeed rise. But, these price increases are going to be what brings the damaged capacity back online faster (that thing called the Law of Supply). Valero is looking at the price of gasoline in various markets and wishes very much that they could get their St. Charles refinery back up and running at full capacity. Take away this profit incentive and they might be in a little less of a hurry to bring the plant back online. Frankly, I just don’t see why this is hard to grasp. Does it mean we should be happy paying more for gasoline? No. Does it mean that the oil companies are good guys or something like that? Again, no. But this notion that oil companies are evil is just stupid. Keeping prices low at a time like this will impose another type of cost: going without. You see there is another lesson most people who have spent a reasonable time studying economics have learned. That there is no such thing as a free lunch. Even if the price were kept at the pre-Katrina levels, many gas stations tanks would be empty and instead of bitching about the higher price some of you too would have an empty tank and have to walk, ride a bike, or take the bus instead (assuming the buses have gasoline). Instead of paying the higher prices, you’d pay via not being able to drive at all.
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1These inefficiences are things like externalities, public goods, and even imperfect information. And also note, the term “necessary condition”, this means that these inefficiencies must be present to justify intervention, but they don’t make intervention necessary. Or another way of putting is that intervention could be more costly than simply living with the inefficiencies.

FILED UNDER: Economics and Business
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. ken says:

    Steve, you seem to have a hard time understanding the moral and ethical dimensions of anti-gauging laws and also assume the only motivation for fixing a supply problem is monetary.

    While it might be counterproductive to put price ceilings, during a temporary supply disruption, on things like diamonds and furs, this is not true of essential commodities like food, shelter, or energy. Unless the management of companies are pure heartless beasts a large part of their motivation to get supply back on line is because their fellow citizens need it. Excess profits are nice but are just an unearned adjunct to what they would do anyway. Making criminal the explotation of of a temporary supply disruption helps them keep their moral and ethical obligations clearly in mind while they go about their job.

    If everyone thought like you we would not have a civil society.

  2. Steve Verdon says:

    Ken,

    Of course, I understand that people want to caste “gouging” as a moral issue. It makes it easier to justify going after the person who is “gouging”. But as I keep pointing out, higher prices is what brings in competition and drives down the price. Artificially keeping the price low only slows down the arrival on new supply and ensures that people pay via going without. Exactly how moral is it to enforce laws that keep people without food?

    When will people finally get rid of this Medival notion of a “just price”?

    Oh and ken, you just don’t seem to get it?