Real prices can be about more than supply and demand

(featured image via Twitter)

How to turn an unfair price rise into a fair one

This last week, the UK has been experiencing a freak petrol* crisis. A handful of filling stations on the south coast had run out of fuel because of minor supply issues. The news led to a vicious circle of spreading panic buying, dozens more stations running dry, even more panic buying with demand up to 5 times its normal level, and so on. Why did such a demand-supply imbalance not push prices up?

The law of supply and demand in economics is much like the laws of thermodynamics in physics: it describes a natural phenomenon. The market price of a good is largely determined by how much there is on offer (the supply) and how much is required (the demand). Whatever its price is right now, if there is more than needed (i.e., supply exceeds demand), it will come down. Some suppliers want to get rid of their surplus, which they need to offer more cheaply in order to attract more buyers, and this raises demand. The price reduction may also lead to some producers halting production, thus reducing supply. Once supply and demand are matched, the price stops moving: every unit produced is sold, and every unit demanded is fulfilled – “the price is market clearing”, economists say.

Conversely, if there is not enough of a good to meet the demand, the price will rise: buyers who value it the most will offer a higher price, at which other potential buyers will drop out, and demand will fall. The price rise may also encourage producers to make more, or new producers to enter the market, thus increasing supply. And again, this will happen until supply and demand are in balance.

The market to the rescue… if we let it

So, whenever something happens that pushes the supply-demand equilibrium out of kilter, markets enable human behaviour to affect the price, which in turn affects behaviour, and so on, until rest is restored. In a splendid video, part of the equally splendid Marginal Revolution University’s course in micro-economics, economist Alex Tabarrok explains that a price (or perhaps more accurately, a price movement) is a signal wrapped up in an incentive. It signals that something becomes more (or less) scarce, and gives an incentive to act upon this signal to both buyers and sellers. Magic.

How would such a ‘natural’ price rise in the case of this specific petrol crisis work out? It is hard to see how it might boost supply. There is enough fuel in the depots, so producing more would not help at all. The problem is that there are not enough drivers to replenish the petrol stations at the rate drivers are filling up. But using a higher price at the pump to increase their pay is obviously also not a practical solution to peak demand. What higher prices would very likely do, though, is dampen demand, and thus facilitate a quicker return to normality. Yet, the prices did not budge.

See what happens when you overcharge customers? (image: Jeffrey Rolinc/Flicker CC BY NC ND 2.0)

This is one of the situations where rationalist economics clashes with real life economics – as economics Nobel laureate and behavioural economist Richard Thaler would say, ‘econs’ (reasoning, emotionless creatures) versus humans (complex bags of contradictory emotions, motives and preferences). The boss of the British Petrol Retailers Association put it pithily: “The one thing we do not condone is profiteering in situations like this.” Customers have long memories, he argued, and would remember how their local filling station offended them by overcharging them. Thaler himself alludes to the problem of profiteering – regardless of how much economic sense it makes – in Misbehaving: together with Jack Knetsch and Daniel Kahneman, he explored how people perceive fairness in economic transactions. One of the questions they asked concerned a hypothetical hardware store selling snow shovels at $15, but the morning after a snowstorm raises the price to $20, as the demand outstrips the supply. Unfair, 82% of the respondents found. (I wrote about this phenomenon a while ago here.)

Still, a situation where supply cannot meet demand and prices cannot rise is not ideal. Long queues at the pump, but not everyone needs fuel equally badly. Some people’s tanks are genuinely nearly empty; others are simply topping up or even bring along a collection of jerrycans to stockpile. Some people need their car to get to patients, pupils or to their job as an ambulance driver, or to drive to the hospital for important medical consultations; others only to take the dog for a walk in the woods. There are calls to give certain categories of key workers priority to fill up to avoid this problem, but that is easier said than done.

A fair allocation through an unfair price hike?

A market in which the price can freely move to bring demand and supply in line with each other could help. In a recent episode of the Rationally Speaking podcast, host Julia Galef discussed the practice of price gouging (or profiteering) with two economists, Raymond Niles and Amihai Glazer. Along with the other effects of pricing (the signal and incentive), they also considered the related aspect of the allocation of scarce goods: who gets what?

Niles argues that not allowing the market to set the price leads to inefficient allocation: people will buy more than they need, and so inevitably some people end up with less than they need. He also points out that rationing does not ensure that the scarce good goes to those people who value it most. (Here, for example, the person who just wants to fill up their car but leaves it on the drive for days gets as much as the person who needs their car to go to work every day and earn a living.) Glazer observes that misallocation (which can become full-blown hoarding) when prices are kept low is primarily a problem for goods that can practically be stashed – and that is indeed the case (at least in the short term) for petrol.

If there is no practical mechanism to ensure the efficient allocation of a scarce good during short term peak demand other than allowing the price to rise, and at the same time such price rises are considered hopelessly unfair by the consumers, is there nothing that can be done? Richard Thaler hints at a way to circumvent the aversion apparent profiteering: the perceived fairness of a transaction can depend on how it is framed.

What if a price hike did not, as is assumed by default, take extra money out of the buyer’s pocket only to add to the seller’s profit, and was framed differently? Sure, it would then not act as a signal and an incentive to the supply side, but since that is not where the problem is, that is just fine. It would send a signal and an incentive to the demand side, though: dearer fuel discourages those buyers who value petrol the least, and ensure that what is available can go to the drivers with the highest need. Yes, dearer fuel would also irk people, but arguably, wasting time frantically searching for petrol, and wasting more time queueing when you’ve finally found some is also not without irksomeness.

“Move on, you pillock, so I can fill up with cheap fuel too!” (image: John Greenfield/Flickr CC BY 2.0)

That leaves the question what to do with the surplus income that cannot go to the seller. What if that went to a good cause? In Britain, the national treasure of the NHS would be a most suitable recipient of these funds, and it would make many drivers a lot less irked at having to pay more.

One way to implement this could be a special levy imposed by the government, but my inner curious libertarian would prefer leaving the setting of the price to the market, and limiting the government’s role to creating the legal framework for raising prices in emergencies and funnelling the proceeds. Not only would this ensure it is market forces rather than bureaucrats or, heaven forfend, politicians setting prices, but it would also leave the decision whether or not to engage in this mechanism to the retailers. That might create diversity in the market, and provide drivers with a true choice between cheaper petrol that is hard to find and costly (in time) to obtain, more expensive, “NHS+” fuel… or simply staying put and waiting until things calm down.

What an interesting economic field experiment that would be!

(Between writing this article and publishing it, I noticed that none other than the FT’s undercover economist, Tim Harford, proposed something very similar on Twitter. Modesty stops me from saying that great minds think alike :-).)

* ”gas” if you are in America

About koenfucius

Wisdom or koenfusion? Maybe the difference is not that big.
This entry was posted in Behavioural economics, Cognitive biases and fallacies, Economics, Psychology and tagged , , . Bookmark the permalink.

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