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Response to my Mother
My wonderful mother is upset, like pretty much everyone else, at the price of gas. "Well, the hurricane has knocked out a lot of production on the gulf coast," I say. "Yes but there's plenty of gas in the pipes that was produced before the hurricane - the suppliers are gouging." she responds. Arrghhh....must resist, must resist, must be ....nice. "mmm," I say. You and my Econ 101 students (103 actually), however, are not so lucky.
Many people think that price is determined by historical cost. Price is never, ever, determined by historical cost. Price is determined by supply and demand. If supply or demand change then the price changes regardless of historical cost. Last year's fashions? The price falls regardless of cost. Chopped up dead sharks? If demand is high, the price is high regardless of historical cost. If the demand for gas were to suddenly fall, the price of gas would fall too, regardless of cost. In the present situation the supply of gas has been reduced and the price has gone up. Historical cost is always irrelevant.
Is the high price due to supplier gouging? Not at all. If you want to blame anyone for the high price blame your fellow buyers not the suppliers. A high price means that some other buyer is outbidding you to obtain the limited supply. It's buyers who push up prices in a competitive market and it's suppliers who push prices down!
It's true that some suppliers are making big profits but people have the cause and effect backward. It's not the high profits which are causing the high price. It's the high price which is causing the high profits. If you were to tax the high profits, for example, you wouldn't reduce the price. Indeed, quite the opposite because the high profits motivate suppliers to increase the quantity of gasoline as quickly as possible.
The last point brings us full circle because as the situation stabilizes suppliers increase the quantity supplied until price is pushed down towards long-run costs (which are also historical costs). Thus, in the usual situation it appears that price is determined by historical cost. It's only in the brief time period when a shock shifts (short-run) supply away from historical cost that we can see the truth. Price is determined by supply and demand.
Addendum: Is it just me or did Ken Arrow ever feel the need to correct his Mom on economic matters? Did Adam Smith? "Look Mom, I know you're upset about the price of mutton but let me tell you about this new theory I've been working on..."
Posted by Alex Tabarrok on September 14, 2008 at 06:50 AM in Economics, Education | Permalink
Comments
Alex - free advice - upset your mom enough and she'll give you an invisible hand
right across your face.
Posted by: glenn at Sep 14, 2008 7:02:21 AM
That's all very well. But most of the consumer goods that people buy do not have rapid price fluctuations. The can of tuna you buy doesn't go up ten cents on Monday and down five cents on Tuesday in response to how much has been fished. The Samsung TV in the store doesn't go up thirty dollars on Wednesday in response to the exchange rate with Korea.
For most products, there are large enough stockpiles that prices change only slowly. And many companies will sell at a loss for short periods rather than annoy their customers with temporary price rises.
Maybe you should be explaining to your mother why gas is different to everything else she buys. Also, call her more. She gave you the precious gift of life you know...
Posted by: TheophileEscargot at Sep 14, 2008 7:09:16 AM
Why can't you explain this to your mom? Your main points that: someone is willing to pay this price, and profits encourage more gas, are easily understood, even by my grandmother ( I tested this. She used to be a market gardener, and well experienced in auctions).
Your point that shocks cause temporary shifts is not too far away from your mother's point, I think: if there really was lot of gas in the pipes ( say enough for a few months), then you wouldn't see these large price changes.
Posted by: Zamfir at Sep 14, 2008 7:38:29 AM
This blog post seems to be in contrast to a post by Russ Roberts over at Cafe Hayek: http://cafehayek.typepad.com/hayek/2008/09/a-multiple-choi.html#comments
Posted by: verdantique at Sep 14, 2008 7:41:13 AM
"Yes but there's plenty of gas in the pipes that was produced before the hurricane - the suppliers are gouging." she responds.
The tactic that I would take is to point out that the suppliers are charging based on what it costs to replace the gas in their pipes after you buy it, so that they are back in the situation they were before you bought it.
Posted by: John Thacker at Sep 14, 2008 8:44:53 AM
It's "mutton", not "mutten".
It'd be interesting to hear what you have to say about the gas prices in Italy, where there is no hurricane, and gas prices have hardly fallen at all since the highs they hit when oil was expensive too.
Posted by: David N. Welton at Sep 14, 2008 9:02:42 AM
I wouldn't run so quickly from the "gouge" accusation. As near as I can tell, to gouge is to charge a price greater than the cost.
Well, then... Anyone who is employed at a wage that pays more than required to keep himself alive and working -- say rice, beans, vitamins, and a bed in a large dormitory -- is gouging his employer. In the US, that's a mere fraction of minimum wage, so even those earning minimum are completely ripping off their employers.
"Oh, I'm just charging replacement cost," the gouger pleas. Well, no dice. All that says is that you are willing to gouge as much as the next bastard to have your job.
Posted by: MikeP at Sep 14, 2008 9:29:38 AM
i don't subscribe to the gouging claim, but your response to the claim is unsatisfactory from a microeconomic point of view. when was the last time you outbid another motorist at the gas station? the claim that the energy market is competetive is a useful fiction for many purposes but in the presense of a large shock to supply, asymmetric information, and transaction costs, it is not difficult to imagine that suppliers might behave non-competetively and charge prices above the marginal cost.
Posted by: camello at Sep 14, 2008 9:54:33 AM
To paraphrase Feynman, if you can't explain something to your mother then you don't fully understand it ;-)
Posted by: David at Sep 14, 2008 10:07:34 AM
Hasn't demand been decreasing?
Posted by: Karl B. at Sep 14, 2008 10:16:29 AM
"If the demand for gas were to suddenly fall, the price of gas would fall too, regardless of cost."
I'd like to see you perform a real-data analysis of this assertion. My suspicion is that you would at best see an indirect or delayed correlation between domestic demand and cost. It seems that prices at the pump did not start sagging until August despite significantly reduced demand all Spring and Summer.
Posted by: Ben at Sep 14, 2008 10:20:47 AM
This reminds me of my mom. She was an immigrant, small businesswoman who was always complaining about how "big" business used its power to take advantage of the "little" people. When I told her I was going to Wharton, she said, "What's that?" I said, that's where one trains to become one of the exploiters. "Oh, that's great," she replied. "If you have the choice, why choose to remain small?" I miss her.
Posted by: MHodak at Sep 14, 2008 10:30:24 AM
Its not the motorists that are outbidding us, its China and other nations, and their fuel energy infrastructures.
While I agree on the general economic implications the business concerns are being totally ignored in a situation where, because of the VERY HIGH barriers to entry the market cannot easily correct itself by allowing additional participants to enter and undercut the establishment while still making a profit. Expecting the current participants to adjust supply on their own without considering price elasticity shows ignorance; plus the ability to increase supply itself has its own barriers to overcome.
"Gouging" is a purely subjective term so without actually saying: "a gross/net profit margin over 15% is gouging" it is nothing more than a use of poetic license meant to rally people to a cause. In my opinion instead of trying to attack the effect the government should attack the cause of why such price variability and long-term profit margins are able to be sustained without new competitors or new investment.
We already tax income so it isn't like the government isn't getting their share, and unless the owners are stuffing their cash under their mattresses (and profits != cash) then the money is being put into the banking and investment system and thus providing liquidity and assets for others to invest.
Posted by: David J at Sep 14, 2008 10:37:59 AM
I'm obviously missing something fundamental here, but can someone explain (again, perhaps) why if a situation of high demand and strained supply leads to higher prices, (then profits), where is the incentive to open up supply and push price down? I would say competition, but since it all seems to flow from a finite number of fields and refineries, it doesn't seem like that would be too strong of a force. It seems like the Walmart model of making products ubiquitous and cheap as a way of creating profit should apply. Maybe it's the disconnect between the two models that makes it hard for non-economists like me to get it.
Posted by: G.ira at Sep 14, 2008 10:59:11 AM
It's buyers who push up prices in a competitive market and it's suppliers who push prices down! As somebody pointed out its who you include in the buyer pool that seems relevant, not only other countries such as China and India, but also speculators in the market. Mack Frankfurter wrote a 3 part article on The Commodity Conundrum: Securitization and Systemic Concerns. It's in 3 parts so I am giving my post on it http://briandrpm.blogspot.com/2008/07/securitization-doesnt-seem-that-secure.html . It also seems that if there is limited competition in the industrial production sector with relatively more in the buyer pool, that the suppliers could see that greater supply will lower prices and over time not put investment in infrastructure that would increase supply to meet demand. The second concept seems to have some logic though I don't have any real empirical support. Taxing for unrelated purposes is one thing but to tax for other energy sources or to not tax for focused investment seems to be another. While both may discourage greater supply for the second we are hopefully increasing supply from other sources.
Posted by: Brian Dowling at Sep 14, 2008 11:12:55 AM
To paraphrase Feynman, if you can't explain something to your mother then you don't fully understand it ;-)
I was at a party once where someone made this observation, and the target of it said, "Dude, my Mom teaches Physics at Stanford."
Posted by: Kieran at Sep 14, 2008 12:39:57 PM
Alex,
Don't argue with your mom. You won't win either the battle or the war.
Posted by: glh17 at Sep 14, 2008 12:52:44 PM
I tend to agree and disagree. I agree that the price of gas does depend on supply and demand, as we have all seen in the past few days. People were freaking out that we "might" not have a surplus of gas for a few days and suddenly you couldn't even drive on the roads because people were trying to get into the nearest gas station to fill up. The same thing happens when they call for a "chance" of snow, people rush to the grocery store and stock up on un-needed groceries. I disagree when you say that in the past few days the gas station owners have not been price gouging. They most certainly saw an opportunity to inflate prices, and knew that people were so desperate that they would pay whatever the price just to fill up.
Posted by: Ashley Moore at Sep 14, 2008 1:25:14 PM
Oddly enough, I think that Alex got it somewhat wrong here.
The proximal causation step that forces prices up or down is pretty well modeled by supply and demand, but the price curve is the relationship between prices and availability and *that* can change and changes in the way that consumers respond to changes in supply is very much determined based on their recollections of yesterdays pricing.
Having a memory of a low price from yesterday can make consumers today very cranky about increased prices and thus can make demand much more responsive to price changes than it might otherwise be. This means that in a strong sense, yesterday's price determines today's price more fundamentally than a static curve would imply.
Posted by: Ted Dunning at Sep 14, 2008 1:47:07 PM
Never mess with mom, she will get payback, if not overtly then passively - never mess with mom.
There were announcements in the midwest that the supply of gasoline is plentiful and demand is soft, and therefore no reason to gas up quickly - and prices immediately increased by exactly $.40 a gallon at every station I can find. Economics? [chuckle]
Posted by: save_the_rustbelt at Sep 14, 2008 2:21:27 PM
Or, people generally disbeleive "announcements."
Posted by: David at Sep 14, 2008 2:30:23 PM
"It's buyers who push up prices in a competitive market and it's suppliers who push prices down!"
Where do you put people who neither purchase nor supply the product?
Both the supply (firm) and demand (consumer) sides of the market are capable of influencing prices in both directions based upon the cost structure of the firm and the price elasticity of the consumer.
To clarify my previous statement (and please address any of my misconceptions) a competitive market works because both buyers and firms are able to enter and exit at will. Firms will enter to capture economic profits and exit if their economic profits are negative. This ability to adjust the competitive landscape, moreso than consumer demand, affects the margins available to the firms.
Existing firms have an interest in maximizing/increasing their economic profit whereas new firms have an effective ceiling of whatever the existing firms make LESS some percentage that corresponds to the amount necessary to get a buyer to switch from an existing firm to the newcomer. It is this mechanic, not supply adjustments of existing firms, that most effectively causes a competitive market to tend toward zero economic profit.
Posted by: David J at Sep 14, 2008 4:17:34 PM
Gas retailers can more readily pass supply shocks on to their customers than other retailers because delaying the gas purchase is only so much of an option. For the consumer, it's a very short-run market.
Posted by: Cyrus at Sep 14, 2008 5:01:59 PM
I live in middle Tennessee. We've seen a 30 to 40 cents increase in prices since last Thursday in my town. I paid $3.99 yesterday. In other areas prices have gone up much higher. In one small town (Winchester), a convenience store owner claims he purchased gas at around $5.00 per gallon and priced it at $5.29. He received threats, including death. He says he will sell what he's got but not buy anymore until the price falls. Winchester seemed to be a sleepy little town. I guess gas price shocks can wake even the sleepest towns. This doesn't bode well for Mankiw's Pigou Club membership.
Posted by: glh17 at Sep 14, 2008 6:20:00 PM
"Hasn't demand been decreasing?
Posted by: Karl B. at Sep 14, 2008 10:16:29 AM"
This is a common error propagated by the media. The quantity of gas sold has decreased (year over year). Demand is a curve matching different price points to the corresponding quantities sold. Demand may have decreased (i.e. the curve shifted left/down), but that's difficult to prove. It could just be the case that on the demand curve that was already in place, higher prices led to less gas being sold (I suppose the demand curve is constantly changing to some small extent, but this isn't what the media is referring to when they claim "demand is declining").
@ Posted by: Ashley Moore at Sep 14, 2008 1:25:14 PM:
The alternative to higher prices is shortages, which isn't very helpful either. When gas prices go up, driving is reduced by the purchasers of gas. For instance, raising gas prices in a city in the path of a hurricane discourages driving that's less important to the drivers (e.g. driving to see a movie), and leaves more gas available to those who may need it to evacuate. If gas shortages are expected in other areas of the country, it discourages less important driving and leaves more supplies available for those who need to drive to work, hospitals, grocery stores, etc. Purchasing supplies to prepare for the chance of a hurricane or snow isn't "un-needed" or wasteful; in fact, allowing prices to rise in such events is what cuts down on people purchasing things in excess of their needs.
Posted by: Dave at Sep 14, 2008 6:46:55 PM
