Capitalism in 16 Lessons: Part 2, Prices and Supply and Demand

For the Introduction to this series of posts, click here. For Part 1, click here.

During Hurricane Sandy, New Jersey Governor Chris Christie issued a forceful reminder to merchants: “Price gouging during a state of emergency is illegal; will be investigated by the Attorney General and Division of Consumer Affairs; and will result in significant penalties.”  Price gouging is when, in times of greater than usual demand, particularly due to emergency situations, sellers will hike the prices of the good in question so as to increase their profits.  Central planners (whom we discussed in the last installment) such as Chris Christie think this is exploitation and evil. Free market capitalists, as we will see, affirm not only the right of the retailer to do this, but also praises him for his role in the proper allocation of resources in times of emergencies.

Prices, by definition, are always right and just, so long as they are set by the market and not influenced by compulsory government intervention, either directly or indirectly.

In capitalism, exchanges are made on a voluntary basis.  Neither Party A, nor Party B, is coerced into making the exchange. Thus, both parties view the good that they are receiving as more valuable than the good that they are giving up.  No voluntary trade can be made unless the person making the trade anticipates being better off with the good or service that he is seeking to attain.  Therefore, only he knows when a price is “absurdly high,” when it is “a great deal,” and when it is “barely worth it.”

Now, prices have a very important role in the market economy.  In fact, it is to their great disadvantage that so many mainstream economists (who are quite against the free market!) do not understanding that prices are not arbitrary numbers, but are actually signals that give information.  Information which if we did not have, would result in an economy that is barely above subsistence level.  A price is a cue, an indication of the relationship between the supply and demand of a certain good in an economy.  Or, as Robert Murphy stated (emphasis added): “A market price is the balance between how eager you are to buy something and how reluctant the producer is to sell it.”

When there is an abundance of goods in relation to the amount of demand there is for that good, the price is low. Conversely, when there is a sparsity of goods in relation to the demand, the price is high.  The reason for this is because when goods are scarce, the seller is more hesitant about giving it up.  For example, drinking water in the United States can be purchased for mere cents, and often times it is even free. This indicates that there is so much water available to drink, in relation to how much people can physically drink, that the price is very low.  The role of a price as a signal can be recognized in the example of, say, and entrepreneur who wanted to sell cups of water to make a profit. He would have a very tough time doing so because the cost of creating and running a business to sell water would be far more than people are willing to pay for the water; in other words, there is no profit to be found here.  Thus, the price acts as a signal that he should probably spend his efforts doing something else, something where he can actually earn a profit.  In other words, the price tells the entrepreneur, “sorry, your services are not needed at this time.”

Now, what happens if the government intervenes here “on behalf of the water producers” and creates a price floor, which declares: no seller of water is allowed to charge less than one dollar per cup.  Well, the market signal is suddenly distorted and the entrepreneur thinks that he will now be able to make a profit in the water business!  Is this a good thing?  Not only does this lead to the inevitable rise in prices for the consumer of water, it also has the effect of creating a surplus of drinking water.  For many entrepreneurs, who would have otherwise been told by the market that they should not produce drinking water, are suddenly entering the line of production and making something that the market does not want.  As the prices go up, there is less demand for the drinking water as people find other alternatives.  And that is just the immediate effect; the “unseen” effect is all the entrepreneurial activity which would have gone to other profitable places in the economy are now wasting their time producing drinking water. Contrary to popular thought, drinking water should be subject to the same laws of supply and demand as every other good.

Let’s move on.

Since we have stated that the price of a good represents the relationship between the supply of, and demand for, any good, we should explain the economic law of Supply and Demand.  Let’s look at a Supply/Demand chart.


What this chart is representing is the fact that, as the price (the vertical line on the left) rises, more entrepreneurs, seeking a profit, enter the production line of a given good.  As more entrepreneurs flood the market with this good the supply of the good rises.  But at the same time, again because of the price, demand begins to fall.  Where prices are higher, demand is lower.  This makes sense right? We tend to not buy as much as prices rise, primarily because we don’t have unlimited funds and we have to ration our limited supply of money.  So then at price level P1, there is an excess of supply of the good and not enough people are willing to buy it.

Conversely, where the price is far too low (P3), there is far more demand for a good than there is supply. Entrepreneurs do not think they can make a profit and hence will exit the line of production. It is a waste of their time.  This also makes sense. As a business owner, your goal is to make a profit so that you can accumulate money and buy the things that you need in your own life. If there is no profit to make, you must seek another line of work.  So then, at price level P3, there is a shortage of supply and not enough goods to satisfy all the wants of the people willing to buy it.

However, at price level P2, there is a nice balance between the level of supply and the level of demand. This is the price level toward which the market is always naturally pursuing. When supply increases too much, the price is lowered; when the supply decreases too much, the price rises.  Notice the intersection between the supply and demand line. This point on the chart is referred to as the equilibrium price or also the market clearing price.  This point is never actually known in the real economy, it is a mental construct to help us picture what is happening.  This meeting point is always in flux, because the tastes and desires of the consumers in the market are always fluctuating and changing around. Literally by the minute.  The point is, even though the market clearing price is not known specifically, the market will always correct itself toward this equilibrium price level, which is at one level one day and another the next.

Now then, we can go back and consider the scenario of Chris Christie and his war on price gouging in a time of emergency.  During Hurricane Sandy, New Jersey outlawed the quick rise in gasoline prices that had started to take place.  Now that we know about supply and demand, we know what the market was trying to do before Christie put a stop to it.  Demand had suddenly spiked as more people were trying to fill their tanks to drive out of harms way.  However, the supply of the gasoline had not risen with the demand (and in fact had fallen because of electricity outages, making the gas stations unable to pump). This means that the working gas stations would quickly run out of gas, were it not for the profit-seeking gas station owners who, wanting to “take advantage” of the situation, raised their prices toward the new equilibrium price level.  In other words, in their self-interested efforts, the gas station owners actually participated in gas rationing! What a novel solution in an emergency situation.  Suddenly, those who would have bought a full tank of gas, decided to only buy a half tank until they got out of harms way, leaving more gas for the people behind him. Or perhaps, instead of filling two or three gas cans to save for later, the consumer decided just to purchase one can since the price had risen too much to justify “stocking up.”  Again, this meant that he had left more gasoline for the next guy. In other words, the market has a perfect solution for emergency situations.

However, by setting a “price ceiling” on emergency-related goods (which include batteries, umbrellas, gasoline, candles, etc.), the State of New Jersey, in effect, outlawed the market system to do its job. And therefore the demand increased while supply and prices stayed the same, leading to a shortage of goods, long gas lines, and consumers that either had “too much” or nothing at all. The price system was was not allowed to contribute to society because a central planner thought that he could outsmart the economic law of supply and demand –which most central planners think they can do.

This result of “price controls” is the same everywhere they take place. In the infamous 1970’s gas shortage in which long car lines were everywhere, the cause was not “OPEC,” toward which many policy analysts like to point their fingers, but rather, the Nixon administrations price controls.  It was not until the price controls were relaxed, that the market system was once again able to do its job.  And again, the much debated rent control issue in big cities, wherein policy makers decided it would be helpful to the “little guy” to create a price ceiling on housing rents, created a shortage of rental options for the very people the policy makers were trying to help.  Rather than just keep rental prices down, they actually, in effect, told entrepreneurs, “your services are no longer needed.”  This meant that there were suddenly a shortage of available rental options for those who would have been willing to pay a higher price.  Moreover, the “unseen” effects of rent control included the fact that landlords, now having to keep their expenses much lower, neglected updating the apartments, repainting the walls, fixing repairs, installing washer/dryer machines, etc. In other words, with price controls, the standard of living itself begins to drop.

Prices are extremely important. The market system relies on them. To ignore them via political power is to destroy the market system and make everyone worse off. Prices reflect willingness of the owner of a good to give up what he has for the good that another person currently has.  Without prices, we’d be stuck in a world of barter and would lack the mechanism by which to grow the economy and raise the standard of living. As we will see when we get to the structure of production part of this series, prices are even more important than we have yet stated.

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