On Price Formation Theory

Summary: On price formation theory in Sabiou M. Inoua and Vernon L. Smith Economics of Markets

To suppose that utility maximizing individuals choose quantities to buy (sell) contingent on given prices is to pose a consumer demand and supply problem without a price-determining solution. This neoclassical problem formulation imposes (1) exogenous prices, (2) price-taking behavior, and (3) the law of one equilibrium-clearing price on markets, before prices can have formed. Hence, unexplained prices are presumed to exist before consumers arrive in the market. If conditions (2) and (3) are hypothesized to characterize markets, the theoretical challenge is to show that they follow from a theory of how markets function. Hence, neoclassical economics did not, because it could not, articulate a market price formation process.

 

The classical economists suffered none of these inconsistencies. (see for example Adam Smith, 1776, book 1, chapter VII) They articulated a coherent theory of price formation and discovery based on operational pre-market assumptions about the decentralized information that buyers and sellers brought to market, their interactive market behavior in aggregating this information, and simultaneously determining prices and contract quantities in the market’s end state.

Buyers (sellers) were postulated as having pre-market max willingness to pay, wtp (min willingness to accept, wta) value (cost) for given desired quantities to purchase (sell) that bounded the price at which each would buy (sell) as they sought to buy cheap (sell dear). We articulate a mathematical theory of this classical price formation process, its connections with

Shannan information theory, and the unexpected role of early experiments in using designs and reporting results consistent with classical theory:

  1. Individuals go to market with pre-market max wtp (min wta) reservation values (costs) for discrete (integer) units Arriving, they bring aggregate WTP (WTA) conditions governing price bounds, and motivation to buy cheap (sell dear).
  2. Any trial (bid/offer) price, P, if too low, tends to rise; if too high, tends to fall. Hence, in classical price adjustment, the “law of demand and supply”, is dynamic. Formally, price change and excess demand, e(P), have the same sign: e(P) ΔP/Δt > 0, if e≠ 0; price changes if excess demand is not
  3. Short side rationing: If any (bid or offer) trial price, P, is too low, the units bought (demanded) are limited by the supply quantity; if P is too high, the units sold (supplied) are limited by the demand quantity. Hence, quantity traded is the minimum of quantity supplied and quantity demanded, or formally, min[s(P), d(P)].

From 2., let V(P) = integral (sum) of -e(P) [namely excess supply, s(p)-d(p)]; for discrete values

𝑉𝑉(𝑝𝑝) = � |𝑣𝑣 − 𝑝𝑝 | + � |𝑐𝑐 − 𝑝𝑝 |,

𝑣𝑣≥𝑝𝑝                      𝑐𝑐≤𝑝𝑝

 

where the notation means summation over all values, v ≥ p, and all costs, c ≤ p, to assure that no goods trade at a loss. Define (the market center of value),

C = arg Min V(P),

which includes market clearing, with C = P* (“equilibrium” price), but is more general, by including important cases like constant cost industries where the exchange quantity is determined by demand.

 

Notice that V(P), a Lyapunov function, measures the distance between price and the traders’ reservation values in profit space. At any P we have, ΔV/Δt = ─e(P)ΔP/Δdt ≤ 0 where t is transaction number.

Hence, V changes non-positively as transactions increase, a parameter-free law of classical market convergence. To get convergence speed, a quantitative result, we would need institutional parameters relating transactions to calendar time.

For a smooth “large market”, where we let the number of agents increase without bound (infinite),

𝑉𝑉(𝑝𝑝) =  𝑝𝑝 𝑆𝑆(𝑥𝑥)𝑑𝑑𝑥𝑥 +   ∞ 𝐷𝐷(𝑥𝑥)𝑑𝑑𝑥𝑥

                 ∫0                                    ∫𝑝𝑝

 

and dV/dt = -e(P)dP/dt ≤ 0.

 

Here is a chart illustrating the above equations for large markets in which all “motion” is in terms of transactions, t ≥ 0 , not time, and is therefore a qualitative dynamics.

(0 COMMENTS)

Read More

Hayek, Prices, and the Super Bowl Halftime Show

“I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind.”

~ FA Hayek, The Use of Knowledge in Society

 

The price system is one of the greatest, and most understood, elements of society. Prices drive market exchange. They tell us who wants what and how much of it they want it, and they give others a reason to supply it. The ways in which prices and markets guide human interaction are endless and fascinating.

Anyone who has taken Econ 101 knows – or should know – that market exchanges are based on mutual benefits. If I want a cup of coffee more than I want $2, and you want $2 more than a cup of coffee, an exchange takes place and we’re both better off.

The purchase of a coffee is an example we’re all familiar with. But an interesting feature of markets is that it’s not always clear who should pay whom.

How much is the old couch in you garage worth? Maybe you could get $50 for it. Maybe it would be taken if you left it by the curb with a “FREE” sign. Maybe you’d have to pay for two guys with a truck to come and haul it to the dump.

Which brings us to the Super Bowl halftime show.

The NFL needs a big musical artist to perform. Viewers have come to expect a big show, and many of them aren’t actually that interested in the football game. A promising up-and-comer with a niche following just won’t do. The big game needs a big star.

The performer who takes the stage at halftime is guaranteed a massive audience –more than 100 million– plus lots of media coverage. Even globally known artists like Jennifer Lopez, Shakira, and Maroon 5 have seen increased sales and streams following a Super Bowl performance, enough to put millions of dollars into their pockets.

So should the NFL pay an artist to perform? The singers and bands who are offered this opportunity typically earn hundreds of thousands for every show they do.

Or perhaps the artist values the opportunity enough that they should pay the NFL? A 30-second advertisement during the Super Bowl goes for upwards of $5 million. At that rate a 15-minute show provides exposure worth over $150 million!

In recent years the solution has been that the musical artists play for free and the NFL and its sponsors pay for the costs of producing the show – estimated to be upwards of $10 million. It’s a simple solution that avoids haggling over fees and writing checks. Some performers do turn down the opportunity, but there doesn’t seem to be a shortage of rock, pop, and rap stars for whom “nothing” is the right price.

But what if someone is leaving money on the table? If 15-minutes during one of the most-watched events of the year is really worth $150 million, then musicians and their labels should be shelling out for the opportunity.

But perhaps the rules of marketing soft drinks and cars don’t apply to music. The NFL spends tens of millions of dollars organizing the Super Bowl. Shouldn’t they be willing to pay a million-dollar performance fee to have just the right entertainment at halftime, rather than insisting on someone who will play for free? Wouldn’t the most popular artists in the world demand such a fee if they believed they could get it?

Well, it turns out that The Weeknd paid $7 million to perform at Super Bowl LV. The singer “spent almost $7 million of his own money beyond the already generous budgets to make this halftime show be what he envisioned,” his publicist told the New York Post.

Perhaps The Weeknd is just an uncompromising artist with a specific vision for what his turn on one of the world’s biggest stages should look like. But perhaps he knew that compared to the immense value of the air time he was receiving, $7 million was a relative bargain and a shrewd investment in his brand.

It will be interesting to see what happens in future years. Some candidates for next year’s show might be willing to work with the NFL for free, but the ones who really want it may have to show them the money.

 


Matt Bufton co-founded the Institute for Liberal Studies in 2006 and has served as the Executive Director since 2010.

(0 COMMENTS)

Read More

Golden Parachutes: The Alchian Thesis

Where do ideas come from, and how are they disseminated amongst economists? One of the great ironies in the history of economic thought has been the development of particular concepts, the theoretical importance of which is misattributed to another economist. For example, the concept of a Giffen Good, attributed to Robert Giffen, was first coined by Alfred Marshall in Principles of Economics (1890 [1920]). The Coase Theorem first appeared in the 3rd Edition of George Stigler’s The Theory of Price (1946 [1966]: 113). Moreover, what is known as the “Alchian Thesis” was first coined by Mark Blaug (1980: 117), which is “the notion that all motivational assumptions in economics,” such as assumption of profit-maximization among firms, “may be construed as as-if statements.”

At first blush, it makes sense for an economist to first develop a concept, to be named only later for its recognized importance. For example, the concept of rent-seeking, developed by Gordon Tullock (1967), was only later coined as “rent-seeking” by economist Anne Krueger (1974), who also was foundational in developing the concept.  However, it is oftentimes questionable whether or not each concept should be directly attributed to its namesake.

For my purposes here, I will focus on the Alchian Thesis, its interpretation, and its applicability, but before doing so, I will briefly illustrate how my argument runs parallel to the reception of another myth in economics, such as alleged existence of Giffen Goods. I realize that this is a strong claim to make, but let us consider how this concept has been applied, and if indeed its application has distorted our understanding of historical facts.

 

Dwyer and Lindsay (1984) challenged the notion that Giffen goods violate the law of demand by appealing to the very historical example used to exemplify their existence, namely the Irish Potato Famine. They raise two important points, which I’m paraphrasing. First, Giffen himself never wrote directly about this alleged exception to the law of demand (see also Stigler 1947). Second, and more importantly for my point here, if indeed there was an upward sloping demand curve for potatoes during the Irish Potato Famine, and if indeed (as we would expect during famine) the supply of potatoes contracted, then this would imply that the Irish ate less (not more!) potatoes as the price for potatoes fell. Could it really be the case that, as people are starving, they would eat less of a staple food as its price fell? In spite of the absurdity of this conclusion, this example is still utilized to demonstrate an alleged violation of the law of demand, to the expense of understanding how individuals are acting, given the particular circumstances of time and place. A more plausible explanation, given the expectation that potatoes would become more scarce in the future, is an outward shift, or increase, in the downward sloping demand curve for potatoes, not a change along an allegedly upward sloping demand curve.

Now let us turn to the alleged “Alchian Thesis,” the notion, presumably originated by Armen Alchian (1950) himself, that firms act as if they are profit maximizing. Not only is the claim absolutely false, but importantly, this interpretation of Alchian’s argument regarding firm behavior undermines its explanatory power. But before illustrating how misleading this interpretation is for understanding market processes, it’s important to ask how this interpretation first originated. As Neil Kay (1995) has argued, the influence of Milton Friedman’s “The Methodology of Positive Economics” (1953) on economic methodology had been instrumental in presenting this interpretation of Alchian’s argument. Though Friedman himself is careful to restate Alchian’s point that, as “a result of uncertainty,” profits “cannot be deliberately maximized in advance” by firms (Friedman 1953, p. 21, fn. 16) – not to mention the fact that it was Friedman who encouraged its publication at the Journal of Political Economy – Alchian’s argument has nonetheless been interpreted through Friedman’s broader methodological claim, namely that it’s not the realism of assumptions that matter for economic theory per se, “but whether they are sufficiently good approximations for the purpose in hand,” namely the accuracy of predictions (Friedman 1953, p. 15).

Alchian is very clear, however, that in “an economic system the realization of profits is the criterion according to which successful and surviving firms are selected” (1950, p. 213). “Realized positive profits, not maximum profits, are the mark of success and viability” (ibid., emphasis original). He goes further to argue that the “crucial element is one’s aggregate position relative to actual competitors, not some hypothetically perfect competitors…Even in a world of stupid men there would still be profits” (ibid., emphasis added). Therefore, contrary to the traditional interpretation of the Alchian Thesis, “[t]here are no implications of “profit maximization,” and this difference is important” (Alchian 1950, p. 217), because “[t]he pursuit of profits, and not some hypothetical undefinable perfect situation, is the relevant objective whose fulfilment is rewarded with survival” (Alchian 1950, p. 218). None of this implies that firm owners are unpurposive or irrational, but it does imply that the postulate of profit-maximization is neither a necessary nor a sufficient condition for understanding firm behavior.

One may object here and claim that I (or Alchian) am splitting hairs, and the point here is purely one of semantics. Perhaps so, but to conflate “profit-maximization” with “realized positive profits” across particular circumstances of time and place renders the term into a tautology, and therefore meaningless for explaining the particular manifestation of firm behavior adapting to at a particular time and place, specifically through adaptive variation and selection (see also Manne and Zywicki 2014).

If the Alchian Thesis is correct, then why do we observe “golden parachutes,” or severance packages paid to the CEOs of corporations, even when that CEO has been responsible for huge corporate losses? For example, in 2018, after a 14-month tenure as CEO of General Electric (GE), John Flannery was paid a severance package worth more than $10 million, even after GE’s stock plummeted under his watch, falling roughly 50 percent.

 

The objection that could be raised here is that, consistent with the Alchian Thesis, GE was approximating the conditions of profit maximization, given the constraints it was facing. This may be the case, but approximating compared to what? The conditions of perfect competition? Given this benchmark, GE would have known to pick another CEO, or for that matter anticipate the mistakes made by Flannery’s predecessors, Jack Welch and Jeff Immelt. The point here is not to argue who should be blamed for the GE’s tragic decline. Rather, it is precisely because firms cannot approximate the conditions of profit maximization ex-post by picking a profit-maximizing CEO that explains why they will adopt golden parachutes to insure against potential losses ex-ante. Under conditions of perfect competition, and hence perfect foresight, there would be no transaction costs associated with potential post-contractual litigation. Analogous to the purpose it serves for a marriage, the golden parachute serves like a prenuptial agreement for firms, which allows the firm to terminate its relationship with its CEO in a quick and cost-effective manner.  Without a golden parachute, Flannery may have found it worthwhile to sue GE for wrongful termination, attributing the failures to the firm to the situation he inherited from his predecessors or other economic circumstances outside of his control. The expectation of this fact, and the additional costs of legal fees and continued losses under a bad CEO, is what incentivizes firm to adopt golden parachutes, specifically as a contractual arrangement to reduce transaction costs. To simply assume that firms “profit maximize” independent of the subsidiary propositions of time and place does not explain why particular contractual and organizational arrangements emerge, namely the realization of positive profits through the reduction of transaction costs in an open-ended world of uncertainty.

To conclude, the purpose of theory is to abstract from reality, and therefore it is impossible to adopt assumptions that are perfectly realistic. However, this does not imply that attributing realism of assumptions to economic theory is a trivial point. The implication of ignoring the realism of assumptions is to render theoretical concepts, at best, irrelevant to understanding historical facts, or at worst, create a distortion of the interpretation of such facts. Nothing I am arguing here is new, but given the foothold of potentially misleading interpretations of particular concepts in economic theory, their applicability requires constant reassessment by economic educators.

 


Rosolino Candela is a Senior Fellow in the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics, and Associate Director of Academic and Student Programs  at the Mercatus Center at George Mason University

(0 COMMENTS)

Read More

Clear-Cut Price Discrimination

Some economists see price discrimination everywhere.  Others see it nowhere.  Key point of contention: How do you know that alleged “price discrimination” does not in fact reflect cost differences?  First-class airplane seats really are bigger, after all.

Logically speaking, though, mindfulness of cost differences can make you see more price discrimination rather than less.  Why?  Because businesses often charge the same price for manifestly different products – and it’s hard imagine that the input costs of all so equi-priced products are identical.  Some restaurants charges equal prices for chicken, beef, and pork dishes – or equal prices for fries, cole slaw, and apple slices – even though the prices of the ingredients and prep time vary notably.  Looks like price discrimination to me, though admittedly they could vary the portion size to lock total costs in sync.

In any case, here in Austin I came across an especially undeniable instance of price discrimination.  The parking garage across from campus posts the following prices:

The hitch: This garage also offers an early bird special.  They charge only $8 ($7 online) if you are “in before 10:00 AM, and out after 2:00 PM & before 6:00 PM.”  Hence, if you arrive at 7 AM but leave at 1:59 PM, you pay not $8, but $23!  Your “reward” for freeing up garage space a minute early is -$15.

Note the perverse incentives.  A person who values his time at $14 might intentionally waste an hour to save money on parking – and clog up the garage at the same time.  Not the invisible hand I had in mind.

At the same time, however, remember that firms have to cover their fixed costs somehow – and price discrimination is one of the many businesses practices that make this possible.  In economic jargon, though price discrimination often undermines first-best efficiency, it is a vital tool for the promotion of second-best efficiency.

P.S. Happy holidays!

(0 COMMENTS)

Read More

Measurement Costs and Economic Calculation

In a previous post, I attempted to demonstrate how transaction costs—the costs of defining and enforcing property rights—modify and enrich the standard (and important!) Econ 101 analysis. In this post, I want to show how transaction cost analysis benefits from incorporating the most important Austrian contribution to economic science: economic calculation. What follows provides a practical example of how Austrian and transaction cost analysis can complement one another, as many scholars have argued they ought.

 

Measurement Costs and the Organization of Markets

Transaction costs arise when exchanging parties take steps to mitigate the threat of opportunistic behavior. As Barzel notes, a buyer has an interest in inspecting a good’s “attributes”—its size, quality, freshness, color, or similarity to other units—in order to verify that what is given up in exchange is perceived as less valuable than what is gained. (Resources that consumers perceive as having different attributes are different goods in the Mengerian approach). However, “measurement” of a good’s attributes is costly. The “problem” with measurement is that its costliness, unlike the money price, does not accrue to the exchange partner’s benefit. Relative to a perfect, Nirvana world where measurement is unneeded, measurement costs are pure waste! This suggests that buyers and sellers could affect exchanges at a higher net price if they could agree to a low-cost means of rendering measurement activity superfluous. Sellers would gain by receiving a higher money price; buyers would gain if the increase in the money price is less than the reduction in measurement costs. How then can exchange partners reduce measurement costs and enjoy these gains?

One possibility is for sellers to do something which makes it in the buyers’ best interests to refrain from expending resources on measurement. Perhaps counterintuitively, one way to achieve this goal is to raise a buyer’s cost of measuring, so that less of it is undertaken. Barzel offers a few illuminating examples. DeBeers, once the owner of a large majority of the world’s diamonds, interacts with its distributors only on a somewhat curious, “take-it-or-leave-us” basis. After having assessed a potential diamond dealer’s request, DeBeers will present the distributor with a package of diamonds that roughly matches the description. Next, the buyer is asked to make a choice: Make the purchase or forgo dealing with DeBeers ever again. Instead of seeing nefarious market power inherent in the “take-it-or-leave-us” offer, Barzel argues that this practice reduces the sorting and negotiation costs that buyers would otherwise incur. To convince buyers to consent to such seemingly slanted terms, sellers invest in brand name capital which they forfeit should they behave opportunistically toward buyers. The discipline of continuous dealings therefore constraints potential opportunism. Similar arguments can make sense of the way that perishable food items, such as tomatoes, are packaged and sold.

Barzel extends this analysis by noting that, in some markets, sellers will tend to be the least cost “measurers,” while buyers will tend to be so in other contexts. Under large-scale production of durable goods, for example, buyers will tend to be the least-cost inspectors, since each unit tends to be examined only once—by the buyer when he attempts to use it. In such contexts, sellers usually offer warranties, which reduce the costs associated with each buyer being forced to measure separate units at the point of sale. This lowers the overall costs stemming from measurement and allows the seller to receive a higher money price.

Calculation and the Organization of Markets

During the Socialist Calculation Debate, first Ludwig von Mises and then F.A. Hayek convincingly demonstrated that a consumer-satisfying allocation of resources is impossible under pure socialism, a system where the state owns all factors of production. Without the exchange of productive factors, there are no market prices for them, and without market prices, there is no way to perform profit and loss calculations. Lacking measures of profit and loss, there is no non-arbitrary means of assessing whether a production process has created or destroyed value. According to this argument, an institutional environment characterized by private property rights is necessary and sufficient for capital goods to be continuously re-allocated to their highest valued uses.

Since the original contributions of Mises and Hayek, the calculation argument has been extended (including by Mises himself), most notably to argue that interventionism’s fundamental flaw is that it causes “false” prices to inform economic calculation. More recently, Piano and Rouanet have extended the calculation argument into the organization of markets themselves. Without re-hashing their argument, they show that “primary calculation” occurs within a given set of institutional rules, but that “secondary calculation” governs the decision of what institutional arrangement to adopt. For example, the fundamental Coasean question about whether to use a market or a firm is regulated by secondary calculation.

Along the same lines, in free markets, the decision about whether to implement a measurement cost reducing arrangement is also subject to economic calculation. Certainly, the opportunity to participate in exchanges where the distribution of goods’ attributes is narrower is a benefit to buyers who can spend less time and fewer resources inspecting. Just because something is a benefit, however, does not mean the benefit exceeds associated costs. You may consider an anti-theft device to be a beneficial ad-on when purchasing a car. But if you live in a low-theft region and rarely drive your car into other areas, you may view the benefit of the ad-on to be less than the cost.

Private versus Public

The most important implication of integrating economic calculation with a theory of market organization is that transaction cost arguments do not apply with equal weight to both private and public institutional arrangements. To illustrate this point, I draw on an example that Barzel offers in his 1985 paper, “Transaction Costs: Are They Just Costs?” In discussing institutions which serve to reduce the variance of goods’ attributes and therefore to reduce measurement costs, Barzel writes: “Occupational licensing may serve a similar purpose. Consumers will view licensed professionals as more uniform when some minimum qualifying criteria are imposed. They would spend less on search and would be willing to spend more on the service itself,” (p. 15).

Barzel is contending that licensing necessarily reduces the quality variance among sellers. Buyers, knowing this, expend fewer resources sorting between labor sellers, and therefore pay higher prices for the laborer’s service. Of course, virtually all economists believe that licensing leads to a higher money price, but Barzel here argues that it is lower than the full price, inclusive of measurement costs, that would be incurred without licensing. In Barzel’s approach, the higher price is a boon to consumers because they are simply paying a premium to avoid sorting. Elsewhere in the paper, Barzel makes similar remarks about government interventions which would force grocery stores to remove expired milk from the shelve. Similarly, for Barzel, the American Medical Association’s regulation of doctors reduces physician variance and thus may confer net benefits on consumers.

However, we might wonder if there is there truly symmetry between private institutional arrangements that reduce measurement costs and public institutional arrangements purported to do the same. Barzel moves seamlessly from examples of sellers voluntarily suppressing expiration dates to government occupational licensing. A key difference between the two cases, though, is that private institutions designed to lower measurement costs are subject to profit-and-loss discipline, while publicly imposed constraints are not.

The reduction of measurement costs is itself a goal that demands someone expend resources to achieve it. When resources are devoted to this task, we must ask whether the resources used to achieve this goal might have been used to satisfy other, more intensely desired ends. For example, suppose that the measurement costs associated with buying tomatoes are minimized when they are sold in a specialized plastic carton. Further, suppose the benefits that exchange partners receive from this reduction in measurement costs are trivial, but that the plastic used to make the cartons is intensely demanded in some other use. The profit-and-loss system assures that the plastic is bid away from its measurement cost reducing role to satisfy some other end.

This logic is also applicable to the labor market example that Barzel supplies. In an unhampered labor market, there would likely be a larger range of quality among labor sellers than in a market restricted by licensing. Yet, an entrepreneur who perceives gains from reducing measurement costs could introduce a new institutional configuration in the form of (say) an association which certifies the quality of its members’ work. Another solution is individual certification by a third-party. In both cases, measurement costs are reduced, as buyers can come to rely on the brand name of the association or the third-party certifier. However, such arrangements will only arise if consumers value the reduced variance in seller quality sufficiently to pay the higher price that comes with “association” or “certified” labor.

Additionally, the reduction of measurement costs is clearly not the singular objective of exchange parties. Yes, some sellers may find it profitable to suppress information about expiration dates, while relying on reputation to assuage suspicions of their opportunism. Other sellers, of course, find that the benefits consumers derive from knowing this information outweigh the gains associated with reducing measurement costs. Which consideration ultimately prevails in any given context can only be determined in the presence of profit and loss feedback.

It follows that a persistent private institutional arrangement that reduces measurement costs can be taken as evidence that it confers net benefits. If it did not, firms employing this technique would earn losses and be forced to implement an alternative arrangement. The same cannot be said of public policies that reduce measurement costs. They may confer net losses on market participants yet persist because the public agency operates in the absence of disciplining losses. For examples of persistent public institutions, which nonetheless failed to achieve even their stated ends, see here.

Ultimately, the notion that occupational licensing works to benefit consumers by shrinking labor market variance is a subset of the idea that the state’s primary role is to reduce a society’s transaction costs. Certainly, more exchanges will occur should the state depress transaction costs. This is because transaction costs are a “brake” on the number of mutually beneficial exchanges which can occur. To point this out, however, is only to note that transaction costs are like all costs in this regard. Costs are barriers to action. If the state subsidized steel production, we would doubtless consume more steel, yet no economist reasons from this fact alone to conclude that steel subsidies are therefore justified. By the same token, transaction cost reducing innovations ought themselves to be left to the realm of economic calculation—if our goal is the most efficient use of society’s scarce resources.

 


Caleb Fuller is an assistant professor of economics at Grove City College and a faculty affiliate at the Program on Economics and Privacy.

(0 COMMENTS)

Read More

Zico and Ammo under Price Controls

In the current shortage economy, why are some goods are in shortage (in the economic sense: none available at the on-going price), others are simply not produced (intensifying the shortage), and some others (I’ll consider the case of ammunition) are produced as needed and sold at higher prices in violation of the states’ “price gouging” laws or the federal Defense Production Act?

To answer this question, it is necessary to understand the economic concept of shortage, as opposed to a blob intuition (I call it “smurfage”) encompassing all situations where somebody does not have something that he would like to have, but not necessarily more than something else.

In another post, I mentioned many ways in which producers—incentivized by consumers who bid up prices instead of having nothing—can stealthily increase prices (see “Why Shortages Are Not More Widespread,” August 17, 2020). One way is for producers to limit the diversity of their offerings, reallocating production to higher-margin products. Another example of that was provided by the Wall Street Journal a few days ago (“Coca-Cola to Discontinue Zico, May Drop Coke Life,” October 4, 2020).

Like many social planners at heart, Bernie Sanders and Donald Trump don’t understand how product diversity is efficient when it corresponds to consumer demand backed with money. Sanders declared:

You don’t necessarily need a choice of 23 underarm spray deodorants or of 18 different pairs of sneakers…

In the same mode but for other reasons, Trump said, in his typical baby talk:

I see people buying five dolls for their daughters, maybe buy two dolls for their daughters…

Ways of satisfying consumer demand when government edicts (price controls or political allocation of available supplies) interfere include the black market or, when repression is haphazard and irregular, the grey market. This appears to be the current situation in the retail market for ammunition. As one can easily check online, established ammo retailers charge prices close to pre-control levels but, most of the time, the products are “out of stock” and the shelves, even online shelves, are bare. This market, however, is very competitive with many online competitors who are apparently willing to risk government suits or prosecutions, don’t have a politically-correct reputation to maintain, and charge what the market will bear. Consumers who need ammo for self-defense, shooting, or hunting can thus get some at higher prices—but, needless to say, they remain free to benefit from low government-capped prices and have nothing to buy.

To give an example of the phenomenon, take 9mm cartridges, the most popular caliber for semi-auto pistols. You can easily check at any large retailer that 9mm ammo is still priced at roughly (or discreetly more than) pre-control prices: around $12 for a box of 50 cartridges used mainly for target shooting and twice that price for 20 premium self-defense cartridges. You can also check that on the grey online market, these prices are now much higher—typically about five times more, when they do have the ammo in stock. It is not perfect but it’s better than to have no choice at all.

Note that there is less diversity on this grey market than there used to be on the white market. One reason is that the established manufacturers of ammo are still forbidden to “price-gouge” the retailers and thus have presumably reduced the diversity of their production.

One interesting question is, Why do government prosecutors close their eyes to gray-market suppliers who offer ammunition at market-clearing and illegal prices? One hypothesis would that the government loves gun owners and rednecks, on whom the electoral fortune of the current administration may hinge. By allowing ammo prices to rise up to their market-clearing level, government prosecutors at least allow gun owners (and hunters) who need ammo more urgently to bid up prices; otherwise, long and haphazard queues would be the only hope. Of course, this hypothesis does not make sense as these same governments claim that laws against “price gouging” favor the consumers! Moreover, there are more than 40 state attorney generals who are supposed to enforce “price gouging” laws, a sizeable proportion of whom don’t like private gun owners at all.

The opposite hypothesis—that governments hate private ammo buyers and do not mind throwing them in the jaws of price gougers—does not make more sense.

One explanation of this strange government tolerance for the grey ammo market is consistent with what classical liberal and libertarian theorists have demonstrated. When a government tries to control prices and allocate goods (like in the current emergency), it cannot respect the abstract and impartial rule of law; it has to arbitrarily discriminate among people and treat them unequally. Moreover, government planners are seldom efficient because they have little incentives to be and because they lack the knowledge necessary to control a vast, diversified, and complex economy. Arbitrary interventions and prosecutions also come from the difficulty and cost of going after everybody breaking the law: the personnel of state attorney generals is not infinite and their employers are broke.

We are getting a glimpse at why, in a government-controlled economy, nothing works. The less government-controlled the economy is, the better things work.

(6 COMMENTS)

Read More

Zico and Ammo under Price Controls

In the current shortage economy, why are some goods are in shortage (in the economic sense: none available at the on-going price), others are simply not produced (intensifying the shortage), and some others (I’ll consider the case of ammunition) are produced as needed and sold at higher prices in violation of the states’ “price gouging” laws or the federal Defense Production Act?

To answer this question, it is necessary to understand the economic concept of shortage, as opposed to a blob intuition (I call it “smurfage”) encompassing all situations where somebody does not have something that he would like to have, but not necessarily more than something else.

In another post, I mentioned many ways in which producers—incentivized by consumers who bid up prices instead of having nothing—can stealthily increase prices (see “Why Shortages Are Not More Widespread,” August 17, 2020). One way is for producers to limit the diversity of their offerings, reallocating production to higher-margin products. Another example of that was provided by the Wall Street Journal a few days ago (“Coca-Cola to Discontinue Zico, May Drop Coke Life,” October 4, 2020).

Like many social planners at heart, Bernie Sanders and Donald Trump don’t understand how product diversity is efficient when it corresponds to consumer demand backed with money. Sanders declared:

You don’t necessarily need a choice of 23 underarm spray deodorants or of 18 different pairs of sneakers…

In the same mode but for other reasons, Trump said, in his typical baby talk:

I see people buying five dolls for their daughters, maybe buy two dolls for their daughters…

Ways of satisfying consumer demand when government edicts (price controls or political allocation of available supplies) interfere include the black market or, when repression is mild or irregular, the grey market. This appears to be the current situation in the retail market for ammunition. As one can easily check online, established ammo retailers charge prices close to pre-control levels but, most of the time, the products are “out of stock” and the shelves, even online shelves, are bare. This market, however, is very competitive with many online competitors who are apparently willing to risk government suits or prosecutions, don’t have a politically-correct reputation to maintain, and charge what the market will bear. Consumers who need ammo for self-defense, shooting, or hunting can thus get some at higher prices—but, needless to say, they remain free to benefit from low government-capped prices and have nothing to buy.

To give an example of the phenomenon, take 9mm cartridges, the most popular caliber for semi-auto pistols. You can easily check at any large retailer that 9mm ammo is still priced at roughly (or discreetly more than) pre-control prices: around $12 for a box of 50 cartridges used mainly for target shooting and twice that price for 20 premium self-defense cartridges. You can also check that on the grey online market, these prices are now much higher—typically about five times more, when they do have the ammo in stock. It is not perfect but it’s better than to have no choice at all.

Note that there is less diversity on this grey market than there used to be on the white market. One reason is that the established manufacturers of ammo are still forbidden to “price-gouge” the retailers and thus have presumably reduced the diversity of their production.

One interesting question is, Why do government prosecutors close their eyes to gray-market suppliers who offer ammunition at market-clearing and illegal prices? One hypothesis would that the government loves gun owners and rednecks, on whom the electoral fortune of the current administration may hinge. By allowing ammo prices to rise up to their market-clearing level, government prosecutors at least allow gun owners (and hunters) who need ammo more urgently to bid up prices; otherwise, long and haphazard queues would be the only hope. Of course, this hypothesis does not make sense as these same governments claim that laws against “price gouging” favor the consumers! Moreover, there are more than 40 state attorney generals who are supposed to enforce “price gouging” laws, a sizeable proportion of whom don’t like private gun owners at all.

The opposite hypothesis—that governments hate private ammo buyers and do not mind throwing them in the paws of price gougers—does not make more sense.

One explanation of this strange government tolerance for the grey ammo market is consistent with what classical liberal and libertarian theorists have demonstrated. When a government tries to control prices and allocate goods (like in the current emergency), it cannot respect the abstract and impartial rule of law; it has to arbitrarily discriminate among people and treat them unequally. Moreover, government planners are seldom efficient because they have little incentives to be and because they lack the knowledge necessary to control a vast, diversified, and complex economy. Arbitrary interventions and prosecutions also come from the difficulty and cost of going after everybody breaking the law: the personnel of state attorney generals is not infinite and their employers are broke.

We are getting a glimpse at why, in a government-controlled economy, nothing works. The less government-controlled the economy is, the better things work.

(0 COMMENTS)

Read More

Impoverishing Economic Illiteracy

Last week, for the Nth time, the Wall Street Journal had a story about shortages of Covid-19 tests ( “Covid-19 Testing Is Hampered by Shortages of Critical Ingredient,” September 25). An important topic. The journalist notes:

According to a survey last month by the American Association for Clinical Chemistry, which represents commercial, hospital and public-health laboratories, 67% of labs are having issues getting both reagents and test kits—the highest level since the group started querying labs in May.

Shortages of test kits have persisted for seven months. And there is apparently no explanation in sight. The president of the Riverside Health System in Virginia, Dr. Michael Dicey, echoes the general puzzlement:

This is a big country, and we still haven’t been able to settle the testing issue. It doesn’t make any sense.

In fact, it makes a lot of sense for anybody who knows something about economics—and does not push it under the rug for ideological reasons. During these seven months, prices of most goods produced in America have been under the legal threat of states’ “price gouging” laws and of the federal Defense Production Act. The latter does not formally control the prices of testing supplies, but the federal government has been doing it indirectly through the FDA, the CDC, and a few commissars who control the allocation of many Covid-19 related products. Among them are Peter Navarro, the so-called “equipment czar” (“‘This Is War’: President’s Equipment Czar to Use Full Powers to Fight Coronavirus,” Wall Street Journal, March 28, 2020), Admiral Brett Giroir, the “testing czar” (“Trump’s Covid-19 Testing Czar Claims Administration Is Doing ‘Everything That We Can Do’ to Increase Testing Capacity,” CNN, August 14, 2020), and Moncef Slaoui, the “vaccine czar” (“Trump Vaccine Czar Will Not Be Required to Disclose Pharma Ties, IG Rules,” The Hill, July 17, 2020).

The Soviet Union was also a big country and they too were unable to settle similar issues, such as shortage of automobiles, pharmaceutical products, or bread. It took between 8 and 12 years for an ordinary citizen to take delivery of a car after he ordered it. Shortages also hit pharmaceutical products; a New York Times story of 1977 (“Soviet Medicine Mixes Inconsistency with Diversity”) gives many examples. Another New York Times story, published a few years later, focussed on food shortages (“Soviet Food Shortages: Grumbling and Excuses,” January 15, 1982; OCR errors corrected):

The situation in late summer looked so bleak that the Kremlin began a nationwide campaign for the conservation of bread, and there are many cities and towns where bread purchases are restricted. …

In Moscow there is de facto rationing, limits set by store managers on the quantities that shoppers can buy. …

For years, top Soviet officials have attributed the nation’s poor agricultural performance to bad weather, and the leadership’s official New Year greeting to the people this year again stressed the climatic blight.

Legion of examples are available.

Strangely—for those who ignore standard price theory—shortages persisted until the whole system crashed. It was not because of a lack of commissars. Could the situation, by any chance, have something to do with the substitution of government allocation for free-market prices? And is it possible that what does not work in the United States right now is also, on a lower scale, the consequence of government interference in prices and allocation? Economic theory and observations strongly point to a positive answer.

The efficiency of decentralized markets and free prices in the allocation of resources was first clearly demonstrated by Adam Smith in his 1776 classic The Wealth of Nations. The invisible hand of voluntary cooperation works better than the visible fist of the state. (The featured image of this post shows Smith’s statue in Edinburgh.)

The well-known story reported by Philip Coggan in his recent book More (which I review in the current issue of Regulation) illustrates the incapacity of the collectivist mind to understand or to acknowledge that decentralized and free markets are more efficient than government price controls and allocation:

In the aftermath of the Soviet Union’s break-up, the economist Paul Seabright was contacted by a Russian official who was keen to learn about the workings of the markets. “Tell me, for example,” he asked “Who is in charge of the supply of bread to the population of London?”

(0 COMMENTS)

Read More

Do Externalities Matter for Economic Analysis?

In the analysis of market processes, the concept of externalities has long invoked strong public policy implications among economists regarding the role of government in addressing their alleged presence, or lack thereof.

It is for this reason that analyses of externalities have preoccupied economists, at least since A.C. Pigou. The more important question, however, is how do they matter for economics?

 

In an excellent and thought-provoking article recently written by Don Boudreaux and Roger Meiners (2019), they provide a comprehensive overview of the origins of the concept of externality, its evolution, and its classifications. Boudreaux and Meiners put forth a subtle though sophisticated argument that transcends how economists generally arrive at particular public policy implications regarding externalities. My goal here is not simply to summarize their point, but also to provide my own interpretation of their argument.

To summarize the concept briefly, an externality refers to a spillover cost borne by third parties to an exchange. Externalities arise when the market price at which a good is exchanged fails to account for the full cost (in the case of a negative externality) or benefits (in the case of a positive externality) of producing a good. Such costs or benefits are, therefore, not only involuntary, but more importantly, unexpected by third parties to the exchange. Externalities are indicative of a deviation from the ideal of perfectly competitive equilibrium, in which all potential gains from trade have been exhausted. Thus, the resulting “market failure” associated with externalities arises from the fact that “there exists a reallocation of resources, such as a change in the structure of market activities that will enrich society” (Boudreaux and Meiners, 2019, p. 21). This restructuring not only includes an adjustment in market prices to more fully concentrate the costs and benefits of exchange upon the relevant trading partners, but also, more importantly, an adjustment in the assignment of property rights, the exchange of which gives rise to exchange ratios, or market prices, in the first place. I will return to this last point later.

 

The fundamental aspect on which Boudreaux and Meiners focus is not the involuntary nature of externalities, but the degree to which they are expected or not. As they put it, “Externalities exist only when another party’s actions create unexpected spillover effects” (emphasis in original, 2019, p. 29).

Building on Alchian (1965) and Demsetz (1967), Boudreaux and Meiners make clear that property rights “are a bundle of expectations” (emphasis in original, Boudreaux and Meiners 2019, p. 31) about how individuals can choose to use, exclude, and exchange resources. The expectation in a market economy is that property rights allow “harm” to the exchange value of a good or service, but not to its physical characteristics.

Consider a barber who sets up shop in midtown Manhattan, assuming well-defined and enforced property rights, physical impediments to his expected ability to utilize his physical and human capital for providing haircuts constitutes an externality. For example, theft or other physical damage to the barber’s property rights are assumed to be prohibited. But, under these assumptions, he also has – or, as a reasonable person, should have – the expectation that a competing barber may “steal” away his clientele by providing a better haircut, thus reducing his income and the resale value of the capital he employs.

Here is where the concept of externality gets a bit tricky, and why “the term has become nearly meaningless due to its ubiquity,” according to Boudreaux and Meiners (2019, p. 3). Returning to the previous example, suppose that building construction is taking place on 5th Avenue, requiring the use of jackhammers. These jackhammers, no doubt, are a nuisance to the barber, and therefore might impede his ability to provide haircuts in a safe and productive manner. A bad haircut or the slip of a razor blade while shaving a client will result in a misallocation of resources in terms of “too much” building construction and “too few” haircuts and shaves than would otherwise be optimal. Is this indicative of a negative externality? Does this example prove that building construction should be taxed in order for contractors to take into account the noise pollution resulting from construction?

Not necessarily.

The key here is the role of expectations. No doubt, incurring the noise pollution from jackhammering was involuntary if the building contractors did not get the barber’s consent beforehand. However, we can reasonably conclude that when the barber chose to locate his shop in midtown Manhattan, one of the most densely populated islands on earth, he would have expected and anticipated such occurrences. The fact that he nevertheless located there implies that he expects the cost to him of this particular “externality” to be sufficiently low as to not overwhelm the prospect of greater expected monetary income derived from serving a larger and wealthier clientele than if he located in a less populated area outside the city.

 

What does this way of looking at externalities reveal about the welfare implications of the market process?

The fundamental point that Boudreaux and Meiners raise, as I understand it, is twofold. First, market processes are imperfect, meaning always in disequilibrium, and therefore imply that the expectations of individuals will never fully mutually coincide. If economists start in a world of disequilibrium as their analytic point of departure, then expectations about the costs and benefits of individual decision-making are never perfect (see Hayek 1937), in which case the concept of externalities, in an abstract sense, means everything and nothing. This implies, I would argue, that if the concept of externalities is to have any meaning and tractability, it must be grounded in an analysis of the particular expectations that individuals have in time and place. In doing so, it will provide the economist with a richer understanding of the public policy implications that follow from his or her analysis.

Secondly, to admit or to deny the presence of externalities is not analogous to admitting or denying the presence of market imperfection. Admitting the presence of externalities does not necessarily imply the necessity of government intervention. But, the absence of externalities does not necessarily imply Pareto efficiency in the allocation of resources either. It therefore does not follow that embracing one analytical point of departure or the other implies the dismissal of or appeal to government intervention as a corrective.

 

As I’ve written elsewhere, imperfect markets do not imply suboptimality or an inherent flaw as compared to the ideal of equilibrium. Rather, imperfection implies “incompleteness” and therefore that markets are processes incessantly moving towards completion. That completion process is facilitated by greater mutual coordination of expectations, requiring corrections in expectations, which makes market processes necessary to addresses misallocations of resources in the first place! As Boudreaux and Meiners make clear, “nothing said here suggests that the absence of spillovers implies a Pareto-optimal allocation of resources” (2019, p. 30). It simply implies the failure of the conditions of the market process to exist, not the existence of market failure (see Candela and Geloso 2020). “The problem, if one asserts there is a problem, is the structure of property rights” (Boudreaux and Meiners 2019, p. 30).

If I have correctly interpreted Boudreaux and Meiners, the question is not whether or not externalities matter for economists, but when they matter for economics, and how they matter for our analysis.

 

As an example to illustrate and conclude this point, let’s take the example of the solution devised by Julian Simon to the problem of airline overbooking (see Simon 1968). Generally speaking, airlines tend to overbook flights on the expectation that there will be a certain number of cancellations. Airline overbooking can then be reframed as problem of assigning property rights, since it creates a situation in which more than one individual has a claim on an assigned seat. When an airline involuntarily “bumps” an individual to another flight, can we conclude that represents an externality? Again, we must take into the context of time and place.

Indeed, the airline has generated a misallocation of resources through its decision-making. It exchanges a claim to a seat for money with a customer, but by assigning more than one customer to the same seat, there is a potential spillover cost on an individual bumped to a future flight, the full cost of which is not borne by the airline. However, we must conclude in this case that though bumping individuals to a future flight may be involuntary, it is not completely unexpected. Prior to the introduction of Simon’s auction proposal, an individual booking a flight could not rule out the possibility that a flight is overbooked. The anticipation of this possibility by individuals implies that this is not an example of an externality. However, to conclude this is not an externality does not imply this is a Pareto-optimal situation. There is indeed a misallocation of resources, since there are too many claimants to the available seats on a flight. Therefore, there is a profit opportunity to devise an institutional innovation to realize such potential Pareto improvements.

The introduction of the auction solution to the problem of airline overbooking can be understood as private property right solution, and therefore introduces new expectations between the airline and its customers about allocation of property rights. Given the transaction costs associated with correctly estimating the number of cancellations by customers, the introduction of the auction system (whether through a voucher or cash payment) grants all existing claimants to airline seats the ability to exchange, in effect creating private property rights in seats (Alchian 1965). Customers, in effect, not only become buyers of seats, but the auction system allows them to become potential sellers back to the airline in the case of overbooking. This exemplifies the point made by Phillip Wicksteed, namely that the supply curve for a good or service (in this airline seats) is part of the total demand curve for a good or service (see Wicksteed 1914, p. 13). More importantly, the exchange process generated through the auction system not only reduces the transaction costs associated with discovering the individuals with the lowest opportunity cost of moving to another flight (at a particular price that reflects such opportunity cost), it also reduces the transaction cost of economically calculating the minimum price necessary to pay an individual to be moved to a future flight. Such knowledge only arises in the context of the exchange of property rights (see Mises 1920 [1975]), which creates more consistent dovetailing of expectations between individuals.

Thus, the ability to assign private property rights in seats with the introduction of the auction system thereafter creates an expectation that individuals will be compensated if an airline mistakenly overbooks a flight. This brings me to the case of the United Airlines 3411 incident that took place on April 9, 2017, in which a passenger, Dr. Dao Duy Anh, was involuntarily dragged off the flight for refusal to give up his seat. This would seem to be a case of an externality, since the situation represents not only an involuntary cost borne unfortunately by the individual, but also because it was unexpected. Given the expectation that, through the auction system, an individual more willing to give up his or seat could likely have been discovered and paid a lower price than what Dr. Anh would have probably demanded as compensation for the airline’s error in overbooking.

 

Connecting this example back to Boudreaux and Meiners, the point here is that however one approaches this analysis, the existence or non-existence of externalities does not eliminate the fact that airline overbooking was representative of a misallocation of resources. And, the fact that this imperfection in the market process facilitated an institutional innovation to erode an existing inefficiency in the allocation of airline seats did not depend upon whether or not there existed an externality. And yet, the presence of an externality does not automatically presume a market failure, requiring government intervention, but a failure to secure the conditions of the market process, namely the voluntary exchange of property rights, due to government intervention. We can therefore conclude that the unfortunate circumstances that transpired during the United Airlines 3411 incident indicated the presence of a negative externality, but that this was a result of government failing to provide clear expectations about the security and enforcement property rights in airline seats, not a market failure.

 

The focus of analyses for economists, therefore, should not be to look backward at a presumed consistency or inconsistency in expectations between individuals, and then to pass normative judgment on it in terms of its conformity with Pareto-optimality or an efficient allocation of resources. Rather, the economist must always approach each analysis of any state of affairs as “nothing but a seething mass of unexploited maladjustments waiting to be corrected” (Kirzner 1979, p. 119), and focus on the constant adjustments that market processes facilitate in an open-ended world of uncertainty.


Rosolino Candela is a Senior Fellow in the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics, and Associate Director of Academic and Student Programs  at the Mercatus Center at George Mason University

 

Further References

Candela, Rosolino A., and Vincent J. Geloso. 2020. “The Lighthouse Debate and the Dynamics of Interventionism.” The Review of Austrian Economics 33(3): 289–314.

Hayek, F.A. 1937. “Economics and Knowledge.” Economica 4(13): 33–54.

Kirzner, Israel M. 1979. Perception, Opportunity, and Profit. Chicago, IL: University of Chicago Press.

Mises, Ludwig von. 1920 [1975]. “Economic Calculation in the Socialist Commonwealth.” In F.A. Hayek, ed. Collectivist Economic Planning (pp. 87–130). Clifton, NJ: August M. Kelley.

 

 

 

(0 COMMENTS)

Read More

Repression of Economic Freedom: The Case of Eggs

There exist some people, usually called “economists,” who have a theory that explains why price ceilings create shortages. Most other people believe that there is no relation between prices and whether shelves are bare or fully stocked. Within this last category, there are those who insist that prices should be prevented from rising when supply decreases or demand increases.

In a recent post (“Why Shortages Are Not More Widespread,” August 17), I wondered why, despite the “price gouging” laws on the books in more than two-thirds of American states (including virtually all the largest ones), shortages were not more widespread; and why prices of meat, poultry, fish, and eggs had been allowed to rise, thereby preventing shortages of them. I wondered if farmers are more immune to the heavy and arbitrary hand of the state.

An article in the Wall Street Journal by agricultural economists Richard Sexton and Daniel Sumner, both at the University of California at Davis, just shed more light on this issue (“New York AG Lays a Rotten Egg,” August 30). At least one large egg producer has been sued. Small farmers, even if they are official favorites of the state, may now yield before the threat they may have thus far ignored.

On August 11, New York Attorney General Letitia James sued Hillandale Farms, a large producer and supplier of eggs based in Ohio, for having “exploited hardworking New Yorkers” and “made millions by cheating our most vulnerable communities and service members.” It committed these horrible sins by letting consumers bid up the price of eggs instead of finding none on what would otherwise have been bare grocery shelves.

New York State’s “price-gouging” law (General Business Law, Section 396-R) states:

During any abnormal disruption of the market for goods and services vital and necessary for the health, safety and welfare of consumers or the general public, no party within the chain of distribution of such goods or services or both shall sell or offer to sell any such goods or services or both for an amount which represents an unconscionably excessive price. …

This prohibition shall apply to all parties within the chain of distribution, including any manufacturer, supplier, wholesaler, distributor or retail seller of goods or services or both sold by one party to another when the product sold was located in the state prior to the sale.

The was amended in June and, as the astute reader may guess, not in order to make it less liberticidal but instead to extend its reach. In the quote above, “or services or both” was added after “goods.”

The petition against Hillandale Farms is presented to the Supreme Court of the State of New York on behalf of “the People,” as if it were some sort of super individual à la Jean-Jacques Rousseau. A few quotes:

The People of the State of New York (“the People”) …

The NYAG [New York Attorney General] on behalf of the People, alleges upon information and belief …

The People repeat and re-allege paragraphs 1 through 67.

In their Wall Street Journal piece, Sexton and Sumner report that “price gouging”—which is part of the economic freedom to respond to price signals—motivated egg suppliers to expand their production capacity, with the result that by late-April, “though demand remained high, prices in New York and nationally returned to pre-pandemic levels.” According to the Bureau of Labor Statistics, egg prices at the retail level are still about 6% higher than in February, but they are down 11% from their April peak. This is what we would expect: if prices are not effectively capped, they will soar in an emergency and, as suppliers try to profit from these higher prices, more production will be forthcoming, which will eventually push prices back down—although not necessarily to their original level if demand remains higher and long-term marginal production cost increases.

The efficiency of letting prices respond to conditions of supply and demand is involuntarily confirmed by the Attorney General’s own charts, one of which is reproduced below, representing the invoice prices of eggs sold by Hillandale to Stop & Go.

One would think that, in “the country of free enterprise” as we used to say, the president would give the Medal of Freedom to Hillandale Farms and other egg producers who made this happen by increasing their production to profit from high prices. (Let’s keep our dreams under control. The current president understands economics as little as the framers of price-gouging laws: he invoked the Defense Production Act precisely to be able to cap the prices of medical goods and PPE, which is why they remain in shortage, contrary to eggs.) The New York Attorney General shows that economics was not her strong field in college or that she has an illiberal conception of the state or that she is willing to say anything—as can be double-checked in two sections of her petition:

50. Hillandale informed the NYAG that its customers have “agreed to” [sic] Hillandale’s pricing practices.

51. To the extent that any such agreements with its customers purport to allow Hillandale to charge unconscionably excessive prices for eggs during an abnormal market disruption, such provisions are illegal, in violation of public policy, and unenforceable under New York law.

The Attorney General might reply that the New York price-gouging law does not forbid a supplier to charge higher prices if his own suppliers charge him more. She claims that Hillandale faced no such higher cost and she is asking the court to force the company to pay her office all egg sales revenues in New York State over and above what they would have been at the prices prevailing in the 30 days preceding its “price gouging.” She is also asking the court to force the company to “disgorge all profits” (among other penalties). How any profit could be left if her first request is granted is another mystery.

She obviously ignores there is always a cost of doing something, which is the opportunity cost of not doing the next most profitable thing instead. The farmer who caters to more hens could instead work elsewhere or take more leisure. And consider that if everybody is forbidden to charge higher market prices (what purchasers are willing to pay) except those who are faced with higher accounting cost, the ones at the beginning of the supply chain—the farmers in our case—will not increase production and shortages will appear and move the chain up to the final consumer. Finally, who trusts government bureaucrats to calculate a private producer’s costs?

Except to those who prefer allocation by government instead of by the market (despite the experience of Venezuela or the Soviet Union), price controls make no sense. (See also my Econlog post “Good Government Greed, Bad Economic Freedom,” August 12.)

(0 COMMENTS)

Read More