Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't (3 page)

We should remember the gasoline shortages of the 1970s that accompanied government price controls. People may complain about paying a lot for gas today, when the market determines prices, but at least we know that we’re unlikely to find a gas station completely out of gas or, as we often saw during price controls, a lack of gas in all the gas stations in an entire area.

Central planning has its appeal. After all, it’s hard for many people to comprehend how the seeming chaos of markets, with millions of separate decision makers, can somehow translate into economic efficiency. But economic freedom has its advantages. The key is to allow firms to set prices that accurately reflect all their costs and their customers’ preferences. Analysts and politicians can study trends for years without being able to account for all the factors that go into a single price. Planning accurate prices is near-impossible, and when the government
gets them wrong, the results are shortages, black markets, or other harmful market distortions. Simply put, freedom better ensures that people get what they want. As Adam Smith noted, prices create incentives for people to meet the needs of others. Despite all the various guises in which central planning has been attempted, it is no real surprise that free economies work best.
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“My constituents think someone rigged the price [of oil] and someone—them—is getting ripped off.”
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So thundered Republican Senator Pete Domenici at one of two Senate hearings convened to grill oil company executives about the steep rise in oil prices following Hurricane Katrina. Accused of price gouging and “unconscionable profiteering,” oil executives faced the “bipartisan wrath” of furious senators, which surely reflected the genuine anger felt by many of their constituents at rising gasoline prices.
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Some senators offered half-hearted objections that the oil companies might not really be the pillaging Mongol hordes as they were described. But no one on the panel seems to have made the really vital argument—what if, by dramatically raising prices during Hurricane Katrina, the oil companies were doing a good thing?

Many people cite corporate greed or monopoly power as the only possible explanation why gas prices began rising even before Hurricane Katrina hit land and disrupted oil production in the Gulf of Mexico.
After all, why should prices at the pump increase before a company’s costs have gone up? Some take this argument even further, claiming that prices should not have risen even after Katrina hit.

Let’s consider the more difficult questions—why would prices rise before Katrina’s effects were actually felt? And how can this possibly be a good thing? Before analyzing the behavior of oil companies, let’s look at the motivations of individual consumers and speculators. If a powerful hurricane is forecast to hit land in a week, and people expect that gas prices are going to rise after the storm hits, then the difference in the price today and the expected post-hurricane price creates the opportunity for consumers to save money today by filling up their tanks when gas is cheaper. Speculators do the same thing. They profit by buying gas when it is cheap and selling it for a higher price after the hurricane. What’s more, by doing so, these speculators are performing a valuable economic service—they are removing gas from the market at a time when it’s plentiful and adding it at a time of shortage later.

Oil company executives reason the same way. By raising gas prices before a hurricane, they reduce the demand for gas and are left with a bigger supply, which they can sell after the hurricane for a higher price. The downside of this action, of course, is that everyone has to pay more for gas before a hurricane hits. But no one talks about the upside—after the hurricane, when gas supplies are severely reduced due to the damage to production and supply lines, oil companies are sitting on increased inventories resulting from the pre-hurricane price hike. These inventories then hit the market right when they’re most needed. And this extra supply at such a crucial time helps minimize the overall price increase.
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In other words, by raising prices before the hurricane hits, oil companies keep the post-hurricane price hike much lower than it would be otherwise. So, from an economic perspective, oil companies should raise prices before a hurricane until the price reaches the expected post-hurricane price. At that point, there will be no more profits to be made
from this speculation, and there will also be additional inventories to help cover the expected post-hurricane shortages.
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If the damage from the storm is worse than anticipated, prices will continue to rise. But in the long term, the higher prices will help accelerate the affected area’s energy recovery. After a hurricane, gas prices rise because the supply shrinks, and prices will begin falling once the supply improves. Rising prices in the short term actually help reduce prices in the long term by increasing supply. They do this in two ways. First, higher prices create a strong profit incentive for companies to find whatever ways they can to rush supplies into the area. The more profit to be made in a given area, the harder and faster people will work to transport gas there.

Secondly, temporarily high prices reduce demand. They encourage people to car-pool, use public transport, and take other unusual steps. Indeed, this kind of economizing was seen throughout the country as gas prices rose nationwide after Katrina.
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Naturally, the poor will feel more pressure to take these kinds of steps than the better-off. This, at first glance, seems unjust. But the poor, like everyone else, will benefit when temporarily high prices result in increased gas supplies, ultimately leading to a faster reduction in prices.

Temporarily higher prices assist energy recovery in other ways as well. The prospect of higher prices after a hurricane gives oil companies an incentive to set aside more gas as a reserve for such a contingency even before a specific hurricane is forecasted. Storing gas is costly, and if we want gas companies to bear those costs, we had better compensate them.

Thus, we see that one need not resort to corporate conspiracy theories in order to explain Katrina’s effect on gas prices. The U.S. oil industry was no more monopolistic when gas prices rose just before Hurricane Katrina than it was two weeks earlier when prices were lower. Neither did the companies suddenly become greedier. They were simply reacting to the ever-present forces of supply and demand. Some
may argue Katrina was merely a pretext for U.S. oil companies to raise prices, and that they jumped the gun by hiking prices before the storm actually hit. But if there were really no justification for the higher prices, then why did oil prices rise worldwide after the hurricane? The simple, non-conspiracy explanation is that we live in a world market for gas and the loss of Mexican Gulf production means less total oil for the world to spread around.

But the senators who conducted hearings about gas prices seemed more interested in finding a politically-attractive scapegoat than evaluating the complex factors involved in determining gas prices. In fact, Senator Byron Dorgan freely admitted this, declaring, “None of us knows much about pricing . . . .But we see the pain of the consumers, and we see the gains of the companies.”
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So the senators considered various measures to put an end to “price gouging;” that is, to stop the temporary rise in prices during disasters that is so crucial to helping energy supplies recover.

One such proposed measure was used to ill effect during the oil crunch of the 1970s—price controls. But instituting government price controls would have the precise opposite effect of the one intended. Without the prospect of high prices and high profits after a disaster, gas companies won’t store as much gasoline. Thus when disasters hit there would be much bigger shortages. The end result is easily predictable: artificially cheap gas available only to those people willing and able to wait all day in line to get it. Ironically, the cost of this waiting (in terms of the money people could have made if they had been working during that time) would probably more than wipe out the savings that consumers would reap from the controlled gas prices.

The argument for “price gouging,” and against price controls, also applies to other goods and services. For example, stamping out price gouging by hotels would simply result in a larger number of people being left homeless after fleeing a storm. No one wants people to pay more for a hotel, but we also want everyone to find some place to stay
during emergencies, when hotels quickly reach capacity. As the price of a hotel room rises, some people will inevitably decide to share a room with others. A family that usually gets one room for the kids and another for the parents may choose to crowd together in one room rather than pay for another expensive room. At high enough prices, friends or neighboring guests may share quarters as well. The more people double up in this manner, the more rooms are freed up for other families and people who otherwise may be left with no place to stay.

We economists may dispute many theories amongst ourselves, but we all agree on two things: first, that when demand rises or supply decreases, prices will rise; and second, that price controls result in shortages. This, of course, was the outcome of the gasoline price controls instituted in the 1970s. Americans waited in lines for hours to fill up their tank due to chronic shortages, which instantly disappeared as soon as the price controls were removed. So why does this debate over price controls never end?

One problem is time lags. People see the short-term effects of controls in keeping prices low, but it is only later that the pernicious effects of shortages set in. People naturally find it easier to make connections between events that occur closely in time. Imagine if a day elapsed between the striking of a match and the resulting fire. Some people would fail to associate the two incidents. Many other events would have occurred during the intervening twenty-four hours that could seem to explain the fire.

Suppose that tomorrow the government capped gasoline prices at their current price. Surprisingly, the controls would temporarily increase the amount of gas for sale. As previously mentioned, gas companies hold extra supplies because of the possibility that prices will rise in the future. The greater the chance of future higher prices, the more gas that companies will store. But when price controls are imposed, firms no longer have any expectation that prices will rise. In turn, they no longer have any reason to hold these inventories and thus begin selling them off.
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When controls are imposed on gas prices, consumers quickly see that prices are kept low and supply increases. It’s only once those extra supplies are used up—and this could take months or even a year—that shortages set in. Companies do not instantly dump all their gasoline on the market when controls are instituted because prices would then fall even below the controlled price.

Because of this delayed effect, companies—not price controls—are blamed for later shortages. This is evident in the coverage by the three television networks of the gas shortages of 1973-74 and 1978-79. The U.S. government was discussed as a cause of the first oil crisis 18 percent of the time and 19 percent in the second, while the oil industry was discussed 32 and 41 percent of the time, respectively.
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And gas isn’t the only product facing constant calls for price controls. The current debate over pharmaceuticals is another example. This industry is subject to price controls in every industrialized country in the world except for the United States. For years, Americans have enviously eyed cheap drugs just over the border in Canada, where strict price controls and a socialized healthcare system allow for the sale of drugs at nearly half the U.S price.

Americans are now demanding access to these cheap drugs, and many state governments, such as those in Illinois and Minnesota, have pushed to have these price-controlled foreign drugs resold in the U.S. This essentially exports the Canadian price controls to us.

U.S.-based drug companies spend vast sums to develop new drugs, and Americans pay high prices for them. Once developed, drugs are reasonably inexpensive to manufacture, and companies are willing to sell the medicines abroad at a price that merely covers the cost of manufacturing and distribution.

Meanwhile, Americans cover the research and development costs through our high prices. Incredibly, Americans, who comprise just 5 percent of the world’s population, account for 50 percent of the world’s spending on drugs. In effect, the U.S. is underwriting the cost of a critical
chunk of the world’s R&D on drugs. Perhaps this is not “fair,” as many other industrialized nations could bear to pay higher prices and thus help cover these costs. But if U.S. drug prices dropped sharply as a result of re-importation, drug companies would simply stop making many new drugs.
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Allowing price-controlled drugs to be sold in the U.S. would instantly lower the price of drugs, causing pharmaceutical companies to cut back on inventing new medicines.
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Those that just started to be developed will be shelved, but many close to completion will be finished. It may take some years before new drugs completely stop being introduced. And when it becomes apparent that there are few new drugs being produced, who will people blame? Most likely, the harmful role of government price controls will be overlooked. Instead politicians, editorialists, and much of the public will rush to vilify drug companies for allegedly not doing their job.

Here is another prediction: it will be unusually difficult to get rid of any pharmaceutical price controls.
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Abolishing future price controls would mean that people would have to accept higher prices for drugs as soon as controls are removed, but it would only be years later, perhaps a decade or more, before brand-new drugs start reaching the market again. Drug companies may even have to reconstitute their laboratories. Worse, pharmaceutical companies may not be willing to start new research out of fear that price controls will be re-imposed in the future.