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Sub-optimal Optimality

For my 60th birthday last week, my son, Thomas – in addition to surprising me by driving home for the weekend – gathered into a bound volume printed copies of all of the posts that I wrote for Cafe Hayek during its first year (April 2004 through April 2005). This gift is creative, lovely, and very much appreciated. (To Thomas: Thanks again, my son!)

Flipping through this volume, I stumbled upon this post from August 27th, 2004, titled “Down with Blackboard Literalism!” It deals with a retired-economist’s objection to a letter of mine in the New York Times on the benefits of so-called “price gouging” when natural disasters occur. In short, this economist denied that such high prices are beneficial by asserting that they are monopoly prices.

I’ll not repeat here the reaction that I shared in my long-ago blog post, save to say that, even if these high prices are explained by economists’ textbook theory of monopoly, this fact does not by itself justify government-imposed price ceilings. Let me further explain.

Suppose that on the day after hurricane Stormy wreaks massive destruction on Miami each and every surviving hardware store and supermarket in Miami possesses what economics textbooks today describe as “monopoly power.” Further suppose that all of these merchants fully exploit this monopoly power as predicted by the textbooks. That is, the quantities of (say) hourly sales volumes will be such as to equate each merchant’s marginal costs with its marginal revenues. And as every economist knows, if each of these merchants’ demand curves slopes downward – as they do if these merchants each possesses monopoly power – then each of these merchants will maximize his or her profits by selling a sub-optimally low quantity of outputs and charging excessively high (“monopoly”) prices.

A fully informed and apolitical government could then impose price ceilings that cause each merchant to sell that amount of output that each merchant would sell if he or she were in a “perfectly competitive” market. And these government-ceilinged prices would mimic “perfectly competitive” prices. The blackboard literalist would cheer this outcome. Yay state!

But notice what the blackboard literalist does not notice. While these government-ceilinged lower prices achieve optimality in the moment, they prevent the achievement of better conditions in the future. As the truly competent economist would explain matters, when suppliers are prevented from charging prices above marginal costs and from earning super-normal profits, there is no incentive for new suppliers to enter the market in competition with existing sellers. And yet, in a region devastated by a natural disaster, having new suppliers enter the market is especially beneficial. Government-imposed price ceilings drain away all incentives for such entry.

As a sensible non-economist would put it, because what is needed most when a natural disaster strikes is a large infusion of new supplies – more potable water, more blankets, more canned food, more propane, more plywood, more first-aid products. But by pushing today’s prices down, government-imposed price ceilings discourage rather than encourage suppliers and potential suppliers from bringing more supplies into the devastated region.

Here’s Joseph Schumpeter writing in 1942 (in Capitalism, Socialism, and Democracy, p. 83):

A system – any system, economic or other – that at every given point of time fully utilizes its possibilities to the best advantage may yet in the long run be inferior to a system that does so at no given point of time, because the latter’s failure to do so may be a condition for the level or speed of long-run performance.