In my Principles of Microeconomics class, when we’re discussing the role of prices and of speculation, I share with my students the following story (as recounted in this September 2008 letter to the station manager of WAMU radio in DC):

This morning your reporter interviewed a resident of Galveston, Texas, about the effects of hurricane Ike.  The person interviewed said that she went to the gasoline station before Ike hit to “top off” her tank.  But she was angry to find that gasoline prices had jumped 50 cents per gallon from the day before.  “It’s ridiculous,” this woman opined. “Ike hadn’t hit yet!”

Your reporter should have immediately asked this woman: “Well, why were you topping off your tank?  Ike hadn’t hit yet.”

Gasoline became more scarce — more precious — in Galveston the moment Ike’s arrival became likely. Gasoline retailers acted in anticipation of the future no more or no less than did motorists (such as your interviewee) who topped off their tanks.

Sincerely,
Donald J. Boudreaux

While no one has explained the beneficial role played by speculators better than has Adam Smith, I below try a somewhat different way to explain the importance of the fact that market prices accurately reflect not only the market conditions that exist today but, also, the market conditions that are likely to exist tomorrow.

The degree of scarcity of a good (relative to consumer demand for that good) is determined not only by how much of that good is available in the present but, also, by how much of it will be available in the future.  The scarcity of a good (or service) exists in both a spatial and a temporal dimension.

The degree of scarcity, for example, of petroleum cannot accurately be determined by looking only at the amount of that oil that exists in one particular geographical location, such as Texas or Russia.  To get a more accurate assessment of the scarcity of petroleum requires taking account of the amount of petroleum in existence in all geographical locations.  But, again, the spacial dimension is only one dimension in which goods exist.  Goods exist also in a temporal dimension.  So to get today the most accurate assessment of the scarcity of petroleum requires an examination of supplies of oil not only across different geographical locations but also across different temporal locations (today, tomorrow, the next day, and so on).

Just as the marginal value of a barrel of oil located in Texas will be higher or lower the lower or higher are supplies of oil located outside of Texas, the marginal value of a  barrel of oil located in ‘Today’ will be higher or lower the lower or higher are supplies of oil outside of ‘Today’ (such as, for example, in ‘One Week from Today’).  Just as no one with any sense demands that the pricing of barrels of oil in Texas be done in ignorance of the relative scarcity of oil outside of Texas, no one with any sense demands that the pricing of barrels of oil in ‘Today’ be done in ignorance of the relative scarcity of oil outside of ‘Today.’

In short, the value of a good today depends every bit as much upon the relative scarcity of that good in ‘Tomorrow’ as it does upon the relative scarcity of that good in ‘Today.’  Given this reality, we want the price of the good today to depend every bit as much upon the relative scarcity of that good in ‘Tomorrow’ as it does upon the relative scarcity of that good in ‘Today.’  Speculation is by far the best means that humans have stumbled upon to ensure maximum possible consideration of the relative scarcities of goods across time.

….

Imagine an oceanside village whose residents’ only food is shipped in regularly on boats.  Every Monday morning one boat sails into the village’s harbor.  Each boat is packed with enough food to feed the villagers quite generously for seven days.  These food-bearing boats have been arriving regularly, without fail, every Monday morning for the past 100 years.

One Monday at noon, however, just after completion of the unloading of the food cargo on that Monday’s boat, a reliable source brings terrible news to the villagers: the next two food-bearing boats scheduled to arrive – one next Monday, the second on the Monday after that – have sunk. They’re not coming.  The next food shipment, therefore, will not arrive until three weeks from today.

What happens to the value of the food in that village the moment the news about the sunk boats sinks in?  Answer: it goes up.  The value of the food rises despite the fact that nothing yet has changed the villagers’ food supply.  The amount of food the villagers have on hand when they get this awful news is no different from what it would have been had this news not been delivered or had the incoming boats not sunk.

How would any sensible person, upon learning this bad new, advise the current supply of food be treated?  Surely that person would advise that the rate at which the food on hand is consumed be reduced.  For the villagers to survive, they must make the current stock of food last, not one week, but three weeks.  A rate of consuming food that would have been perfectly appropriate if there were no pending disruption in the delivery of food becomes excessively high given that the villagers’ future food supply now is known to be lower than it had been in the past.  Sensible people understand that the rate of food consumption must be reduced now rather than waiting until one week from now before reducing that rate of consumption.

And no sensible person would take seriously any villager who protested that she should await the non-arrival of next-Monday’s food boat before she reduces her rate of consuming food.  No sensible person would give the slightest bit of credence to this woman’s argument that, because no expected food shipments have as of now not arrived, food is no more scarce today than it has been in the past.

The price changes brought about today by speculators are (1) the signal that future supplies will be different than previously expected and (2) the incentives for consumers to start today to appropriate take into account tomorrow’s fall in supply of the good (and (3) both a signal and an incentive for suppliers to put forth greater efforts to increase supplies in the future).

(Scholars of Adam Smith will note that my food-boat example is similar, although not identical, to an analogy used by Adam Smith to make the same point.  See paragraph 42 here.)

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In my Principles of Microeconomics class at George Mason University, my students and I recently discussed the economics of so-called “price gouging” – the signifiant rise in the prices of staple goods (and services) following a natural disaster.  Basic supply-and-demand analysis explains quite well the observed pattern of price changes (prices rise sharply when a natural disaster strikes as demand rises and, at the same time, supply falls; and then prices eventually fall back to their pre-disaster levels as demand and supply both return to their pre-disaster levels).

The most popular alternative explanation – one heard repeatedly from the media, pundits, politicians, and, in general, people who are economically uninformed – is that the rise in prices is caused by greed (implying – although one never hears it said – that the subsequent fall in prices is caused by altruism).  As I’ve said elsewhere, “greed” is no more an acceptable explanation for “price gouging” than “gravity” is an acceptable explanation for plane crashes.  Causal factors far less constant and more variable than greed and gravity are at work in both cases and, hence, must be identified in order to explain the events.

Here’s an essay that I wrote ten years ago on this topic and that I assign each semester to my students.  A slice (where the example used is a government-imposed price ceiling on bottled water):

Fact one: capping the price does not keep the cost of bottled water low. Time spent waiting, time and fuel spent driving to distant towns where supplies are greater, and the anxiety unleashed by the inability to obtain water are all costs. The fact that these costs are not revealed in the price of bottled water does not render them less significant or real.

Fact two: while a higher market price both prompts consumers voluntarily to economize more diligently on water’s use and increases the quantity of water supplied (by giving incentives to suppliers to bring more water to this market), the queues and empty shelve

Fact three: the economization forced on consumers by price caps is ugly and arbitrary. Those obliged to do without are the unlucky ones who couldn’t get into the queue early enough and who have no political or business connections. These unlucky consumers are also typically too poor to pay the high prices demanded on the black market. A fact always missed by proponents of price caps is that black-market prices are higher than the unregulated market prices would be. The reason is that unregulated market prices—being visible and legal—will stimulate a larger inflow of supplies than will black-market prices.

There’s no denying that people dislike the higher prices. What is deniable is that the higher prices are the problem. They are not the problem; they reflect the problem. Because the problem itself is unfortunate, its undistorted reflection will reveal this misfortune. But only by revealing this misfortune as accurately as possible to everyone who can help to minimize its effects will reality be returned as quickly as possible to normal.

(Coincidentally, I learned just this morning that this 2005 essay of mine will be included in a new volume forthcoming from the Foundation for Economic Education – a volume entitled Cliches of Progressivism.)

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Quotation of the Day…

by Don Boudreaux on March 27, 2015

in Economics, Politics, Reality Is Not Optional

… is from page 256 of William Easterly’s excellent 2006 book, The White Man’s Burden:

It is the job of economists to point out trade-offs; it is the job of politicians and Planners to deny that trade-offs exist.

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Carl, a high-school history teacher from South Carolina, writes to ask how, if ever, do I consider the “losers from free trade” in my defense of complete, unilateral free trade.  It’s a good question.  Being busy at the moment, I content myself here with reprising the following blog post from January 2007.

….

Trade and Romance

by DON BOUDREAUX on JANUARY 7, 2007

in TRADE

Talking about winners and losers from trade is much like taking about winners and losers from romance.  Nearly everyone of us has had his or her heart broken at least once.  And yet the typical person, even after enduring genuine pain from the unwanted transfer of The Other’s affections from him or her to some (often despised) rival, returns to action, looking to receive love in exchange for love to be given.

Suppose that Joe’s much-loved wife, Jane, just left him for another man.  We don’t abuse language by describing Joe as “a loser” in the game of love.  But we clearly here refer only to Joe’s immediate situation.  He is suffering now.  He has just endured a genuine and painful loss.

And yet, is he truly a “loser” at romance?  This question isn’t absurd.  After all, when he was dating Jane he likely ousted some other identifiable man or even men from the potential of enjoying her amorous affections.  So if we look at the longer, fuller time span, we see that Joe “won” earlier and “lost” later.  Indeed, only because Joe initially won Jane’s hand was he able to lose it later.

None of the above, of course, will heal Joe’s broken heart as he watches Jane walk, luggage in tow, out of the door, her toothbrush already at Hank’s house.  Joe will likely hate romance at that moment, and for many moments afterward.

But even if Joe fails ever to find another woman to share his affections, it’s inaccurate to describe him unambiguously as a “loser” at romance.  He was once a winner — and he might again win on another go-round.  And, of course, he owes his very existence to romance.

Like all analogies, this one is imperfect.  Dear Readers, be assured that I’m aware of the many imperfections.  Still, the essential similarity remains: not only did romance create each of us, but almost all of us who “lose” at it lose only what we previously won.  And how many of us, recognizing the frequent and deep and undeniable pain that romance often causes, would argue that this downside of romance makes romance a curse that we would be better off, all of us, to avoid?

….

See also this follow-up post.

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Some Links

by Don Boudreaux on March 26, 2015

in Books, Economics, Education, Housing, Immigration, Inequality, Seen and Unseen, Work

In his latest column, George Will’s shares several economic insights from John Tamny’s new book, Popular Economics: What the Rolling Stones, Downton Abbey, and LeBron James Can Teach You about Economics.  It’s a book that I’m especially eager to read!

In yesterday’s Wall Street Journal, Michael Saltsman describes some baneful consequences of minimum-wage legislation.  A slice:

In Oakland, local restaurants are raising prices by as much as 20%, with the San Francisco Chronicle reporting that “some of the city’s top restaurateurs fear they will lose customers to higher prices.” Thanks to a quirk in California law that prohibits full-service restaurants from counting tips as income, other operators—who were forced to give their best-paid employees a raise—are rethinking their business model by eliminating tips as they raise prices.

A new paper by MIT’s Matt Rognlie explains that, because studies of capital’s share of national income typically miss or undercount depreciation, the only capital that is truly increasing as a share of national income is housing.  A slice:

Capital income is not growing unboundedly at the expense of labor, and further accumulation of capital in fact most likely means a fall in capital’s share of total income – refuting one of the main theories of economist Thomas Piketty’s popular book Capital in the 21st Century.

Speaking of inequality, this inequality is truly among the worst and most dangerous.  (HT Robert Rounthwaite)

Here’s my brilliant colleague Bryan Caplan at his brilliant best on immigration and labor markets.  A slice, which helps expose the naive view of many people that running a business successfully is relatively easy, even rather idle, work:

Good managers know in their bones that diverse human beings aren’t built for close cooperation.  Rather than throw their hands up in despair, however, good managers rise to the challenge.  True to their job description, managers manage their workers, forging them into effective teams despite their disparate abilities, personalities, and backgrounds.  It’s an uphill battle, and you have to keep running just to stay in place.  But good managers kindle the fire of teamwork, then keep the fire burning day in, day out.

The critics of immigration are right to insist that people aren’t plug-and-play.  Cultural diversity definitely makes teamwork harder.  Unlike the critics of immigration, however, businesses around the world treat this fact not as a plague, but a profit opportunity.  Sure, some stodgy entrepreneurs mutter defeatist cliches about oil and water and keep hiring within their tribes.  But more visionary entrepreneurs rise to the challenge of diversity every day.  That‘s why even the most unskilled and culturally alien workers rightly believe that the streets of the First World are paved with gold.  Given half a chance, socially adept businesspeople rush to do the paving.

George Leef ponders the future of the university.

Jon Murphy gives the play-by-play of Robert Reich vs. Robert Reich.

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Quotation of the Day…

by Don Boudreaux on March 26, 2015

in Immigration

… is from page 75 of Julian Simon’s 1993 essay “In Favour of Immigration,” as reprinted in the splendid 2000 collection Population: The Ultimate Resource (Barun S. Mitra, editor):

Opponents of immigration seek to persuade us that new immigrants damage society economically, politically, and culturally.  Immigration restrictions are intended to “protect us” in the same way as tariffs and trade quotas.  But like trade barriers, immigration restrictions largely protect us from benefits.  This is not to say that immigration brings no adjustment costs.  But historical and current evidence shows that the costs are exaggerated and the benefits vastly under-appreciated.

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… that if each individual can, on his or her own, choose which offerings of private businesses to accept and which to reject, and all without having to coordinate these choices with other individuals, people are slaves to corporations – but that individuals regain their freedom and dignity only by voting to use government power to regulate businesses, with every individual forced to abide by the ‘will’ of the majority.

As notions go, this one is among the weirdest.

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Quotation of the Day…

by Don Boudreaux on March 25, 2015

in Cleaned by Capitalism, Energy, Environment

… is from page 86 of Alex Epstein’s brilliant and clear 2014 book, The Moral Case for Fossil Fuels:

[T]he natural environment is not naturally a healthy, safe place; that’s why human beings historically had a life expectancy of thirty.  Absent human action, our natural environment threatens us with organisms eager to kill us and natural forces, including natural climate change, that can easily overwhelm us.

It is only thanks to cheap, plentiful, reliable energy that we live in an environment where the water we drink and the food we eat will not make us sick and where we can cope with the often hostile climate of Mother Nature.  Energy is what we need to build sturdy homes, to purify water, to produce huge amounts of fresh food, to generate heat and air-conditioning, to irrigate deserts, to dry malaria-infested swamps, to build hospitals, and to manufacture pharmaceuticals, among many other things.  And those of us who enjoy exploring the rest of nature should never forget that energy is what enables us to explore to our heart’s content, which preindustrial people didn’t have the time, wealth, energy, or technology to do.

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What Power?

by Don Boudreaux on March 24, 2015

in Competition, Myths and Fallacies, Regulation

In my latest column in the Pittsburgh Tribune-Review, I ponder the belief held by many people that corporations in market economies wield dangerous powers – powers that harm ordinary men, women, and children unless and until government acts as The People’s protector.  It’s a belief as mysterious as it is mistaken.  A slice:

A corporation operating in the market can only make offers to consumers and to suppliers. Consumers and suppliers — including suppliers of labor (workers) — are free to accept or to reject these offers. With no coercion involved, consumers and suppliers accept only those offers that they estimate will make them better off. Corporations that consistently have too few of their offers accepted must make their offers more attractive. If they fail to do so, they go bankrupt.

Also, corporations have no power to prevent other corporations and entrepreneurs from competing with them. And as the history of market economies makes clear, such competition is unending and intense. The only “power” a corporation can exercise to enhance or to maintain its market share is to continually produce better mousetraps and offer them to consumers on terms that consumers judge to be better than those of other companies.

Consumers’ and suppliers’ abilities to reject corporations’ offers, along with the incessant struggle of corporations and entrepreneurs to take business away from each other by making better offers to consumers and suppliers, regulates the market. This regulation is far more reliable, objective and fast-acting than are the government edicts and bureaucratic supervision that are today called “regulation.”

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An Open Letter to Robert Reich

by Don Boudreaux on March 24, 2015

in Economics, Education, Health, Seen and Unseen, Work

Mr. Robert Reich

Dear Mr. Reich:

Complaining in a much-viewed recent Facebook post* about the low pay of K-12 schoolteachers, you assert that such teachers should be paid more in order to increase the supply of teachers.  Although you’re right about the great importance of education, your economics is mistaken.

Contrary to your argument, we should celebrate rather than bemoan the fact that teachers are paid less than the likes of CEOs, professional athletes, and movie stars.  Low teacher pay means that the number of people willing and able to work as K-12 teachers is already quite large.  Precisely because education is especially important, we are blessed that so many people are willing to work as teachers that the cost to society of each teacher is relatively low.  Given the number of school-age children, higher teacher salaries would be evidence that fewer people than is actually the case today are willing to work as teachers.  That situation would be one to lament, not cheer.

In case you still don’t see my point, let me ask if you believe that the pay of physicians should rise.  After all, healthcare, like education, is vitally important.  So by your logic, we should artificially raise the pay of physicians in order to encourage more people to become doctors.  Yet, of course, we want healthcare to be more, not less, affordable.  The same is true for education.  Unfortunately, the supply of physicians is so low that the resulting pay of physicians is unusually high.

So let’s be thankful rather than regretful that we don’t suffer the same problem in education that we suffer in healthcare.  Let’s toast the fact that - as the relatively low pay of teachers reflects - a large number of people are today willing and able to work as teachers.

Sincerely,
Donald J. Boudreaux
Professor of Economics
and
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA  22030

* Can be found here.

….

See also this October 3, 2013, Cafe blog post.

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