Demand, Supply And Fairness

Economics is all about supply and demand. Textbooks are full of examples of these two balancing each other out. However there is a third factor that is forgotten. That is fairness. People are guided by how fair they think something is or is not. Businesses often don’t raise their prices even when demand rises because it is seen as being unfair. Similarly customers often resent higher prices if they feel there is no justification for it. Economists obey the laws of supply and demand, sometimes ordinary people don’t.

Imagine if there is a heat wave and shops respond by raising the price of ice cream. An economist would see no problem with this, after all the shop is just responding to an increase in demand. Yet most people would see it as cynical exploitation. The cost of making ice cream hasn’t gone up, but the shop is getting extra money despite not doing any extra work. There is even a name for this, it’s called “Price Gouging” and it’s illegal in some parts of the world. It violates our sense of fairness. In fact Coca Cola once came up with a vending machine that raised its prices when the temperature rose. An economist could easily justify this. Hot weather increases the demand for a cold drink and its utility so raising prices is logical. However there was an outcry as people saw this as an example of a greedy company taking advantage of thirsty people. The plan was dropped.

I once heard of something similar. A friend told me that a nightclub he knew raised its prices after midnight, the logic being drunken people are willing to pay more for alcohol. My friend told the story in a tone of shock and horror at the thought of something so terrible. This reaction is probably why more clubs don’t do this.

This can have a serious side. Imagine if there was a natural disaster. This would lead to an increase in demand for building materials, but would companies raise their prices? I’m sure that if they did there would be absolute outrage. Their actions would be denounced as greedy exploitation of victims. Sanctions and boycotts would probably follow. Regardless of what economic theory and its graphs would predict, this violates our sense of fairness. In this case fairness, not supply and demand would guide our actions. Compassion and basic decency may be written out of economics, but it still exists in the real world. If anything some businesses will sell their goods cheaper during an emergency. This is what happened during Hurricane Andrew when Home Depot not only refused to raise prices but actually cut them to the point where they would not make any profit.

(In case you think I’m making this up, there are economists who defend price gouging. They argue that it ensures goods go to those you need it most while increasing supply. It is an argument only an economist could make.  Actually it ensures the good goes to those who have the most money and has little effect on supply.)

One of the first fire fighting service was in Ancient Rome. It was run by a man named Crassus who would show up at the scene of a fire and charge the inhabitants an exorbitant amount to put the fire out. He would also deliberately start fires to keep himself in business. This model of private enterprise made him the richest man in the city. He was also one of the most powerful partly running the city with the help of Pompey and Caesar. I’m sure there are libertarians somewhere who can somehow justify this.

When there is a recession and a business gets into trouble economists argue that it should cut wages. Yet this rarely happens. Why? Again it is due to our sense of fairness. Employees find wage cuts to be very unfair seeing as they work just as hard and it’s not their fault the business is in trouble. Managers therefore do not cut wages for fear of what it will do to morale. They will only accept a pay cut if the business is in serious trouble. If wages are cut when the firm is profitable there will be uproar (and strikes if there is a union) regardless of what demand and supply suggest.

Humans are social creatures. We are not computers guided solely by money. Instead we take our concepts of right and wrong into account. We will not accept something that is seen as unfair. Economists will defend price gouging at their peril for ordinary people will not stand for it.


Filed under Economics

16 responses to “Demand, Supply And Fairness

  1. oliver17wood

    Great blog post. I love the example of Crassus! However, I’m not always sure that in the real world ‘fairness’ is able to make its influence felt, maybe if we look at oil/gas prices for example (although I have to admit my knowledge here is incredibly limited).

    I’d love your readers to check out my blog post on re-thinking economics:

    • How much it affects us is a matter of debate but it certainly plays a part. I agree with your post, we need an economics that takes account of other factors such as fairness that matter in the real world.

      I really like your blog and look forward to your future posts

  2. “They argue that it ensures goods go to those you need it most while increasing supply. It is an argument only an economist could make. Actually it ensures the good goes to those who have the most money and has little effect on supply.”

    Firstly, I would disagree with the premise that goods would only go to those who have the most money; why would someone, even a very rich person, buy something they didn’t want or need? The only reason to purchase a good or service would be if the purchaser gained some utility equal to or greater than the price OR believed they could re-sell at a higher price, in which case the market has not reached equilibrium and the price of the good will rise (via arbitrage).

    I was going to try and explain why price gouging is not NECESSARILY moraly wrong, or indeed a bad thing (in many cases, it’s prohibition does far more damage to those who need help) but this video explains it so perfectly:

    An alternative view on the wage issue would be that it’s very difficult to coordinate wage reductions. Consider an example where you trust your employer is not trying to screw you over but the economy is tanking. If you were offered a wage cut you would almost certainly refuse it because it’s hard to be sure that everyone else would accept one too, in which case you would be individually worse off for no real benefit to the firm or economy.

    Would you rather take a 2% wage cut at 0% inflation or a 3% wage rise at 5% inflation? Your purchasing power goes down by 2% in both cases but almost everyone would take option 2. It’s technically irrational but it’s the real reason wages rarely fall in nominal term

    • First of all I agree with you on wages. Free riding and the money illusion are definitely a cause of rigid wages. I talk about the money illusion here

      On price gouging, let’s say there’s enough water for everyone to have a little if it was rationed. But instead a few rich people buy a lot of water leaving nothing for the poor. So they can wash but others can’t drink. Its rational from their point of view and they are certainly gaining utility, but at the expense of the poor.

      There is also the moral argument that it is unethical to make money on other people’s suffering, especially if it is undeserved and an abuse of power. (The technical term would be windfall profit)

      • Flipside of that though is that water isn’t scarce everywhere (especially in places with the sort of income inequality you’re talking about, rich people would move away from drought stricken areas) and anti-price gouging laws interfere with (and often prevent) reallocation of that water from an area where it is less useful. So someone in the neighbouring State might be able to provide water that would otherwise have been used for watering his garden to those who are thirsty. You seem to be advocating that because there is a scenario in which a rich person does something that we perceive as selfish we should outlaw the practice entirely. The implications of this precedent are pretty draconian.

        The moral argument is fine, but even if you think it immoral to charge a higher price because the good is scarce, outlawing it is a dangerous reaction precisely because of the harm it can cause to those who are suffering from the disaster. So yes, some profiteering individuals don’t get to capitalise on others’ misfortune but on the flip side, the people who are affected by the disaster don’t get the choice as to whether the increased price is ‘fair’ (if they don’t think it is, then they will not buy the good). The decision is taken for them, in advance, by someone else who cannot possibly account for their preferences and situation.

        Also, how does anti-gouging legislation help with the scenario you describe above? If the price is artificially pegged to a lower rate then the rich can still buy up all the water, in fact they can buy even more of it as the price has been prevented from rising. In the absence of formal rationing or the price mechanism as a rationing tool, something else will take its place (like first come first served and nuts to the latecomers).

        I’m not saying it’s morally right to charge huge prices for necessities in times of crisis but (a) it’s far better than imposing a law which AT BEST will not improve the situation for those worst affected and at worst will actively harm them and (b) in all but the most apocalyptic scenarios you won’t get away with charging too high a price as other people will smell profit, enter the market and drive the price down to the (new) market rate.

        • I think decisions over whether ‘price gouging’ regulation would improve consumer welfare is a decision that must be taken market-by-market.

          In some cases, Costy750’s (b) will happen – charging high prices and earning super-normal profits will not last long, new supply will come into the market, and prices will be driven down by competition. Regulation would be pointless in such a situation. Red Bull is a good example, very expensive when it first came out but competitors soon appeared. You can now buy energy drinks for about the same price as a normal soft drink.

          In other situations, risk to reputation prevents companies charging high prices. Home Depot’s pricing strategy during Hurricane Andrew is a good example. They could have taken advantage of the situation, raised their prices and earned super normal profits, but would have gained a reputation as the company that didn’t care about people in a crisis. People would have said for years, “remember when Home Depot ripped us all off during the hurricane?”

          In other situations, companies can charge high prices for an extended period because of barriers to entry or barriers to competition. The price of international calls is a good example in the telecoms industry. Regulation might be needed – indeed, the EU has intervened in this situation.

          My point is that economic theory doesn’t provide a blanket answer.

          • I personally feel uneasy about government controlling prices (probably due to 3 years of free market economics being hammered into me). There is a difference between the problem and the solution. I see the problem, I’m not so sure about the solution.

            Another thing to be remembered is that natural disasters are by their nature short run events. So by definition supply isn’t changed.

            I completely agree that we should not have a rigid economic doctrine that does not take account of local factors

        • Perhaps I didn’t make it clear, but I am particularly focusing on the aftermath of a natural disaster. Therefore supply is fixed as is movement, neither the rich nor the poor can migrate. While I would not be comfortable with price controls, that does not mean speculation or exploitation is acceptable.

          “the people who are affected by the disaster don’t get the choice as to whether the increased price is ‘fair’ (if they don’t think it is, then they will not buy the good).”
          Actually they don’t. The problems I discuss above are about necessities, the point is that people have to buy it. So we are talking food, water and electricity. So regardless of whether they think the price is fair, they have to pay anyways.

          • Supply is only fixed in the IMMEDIATE aftermath of a disaster. Especially in developed economies, this short run is generally a matter of hours, and barring major (and sudden) disruption to transport links, goods which are relatively plentiful in neighbouring regions can begin to flow into the affected area quickly. The price mechanism is almost certainly the best way of encouraging this, and it is certainly the best option ex-ante.

            The crucial point, though, is that even if the disruption is extensive, price controls are STILL a bad idea. They don’t change the fundamental problem (i.e. that there are not enough goods to go around). With necessities, price controls will result in hording and over-consumption by the lucky few (i.e. rich people, or those who happened to get to the front of the line first). If you expect the problem to last for a while, and you happen to be in a position to stock up, it would be stupid not to. The result is that more people end up with nothing, a few end up with more than they need, and the shortages bite even harder.

            There is a real issue with the speed of response, especially in less developed regions, but price controls exacerbate the problem rather than solve it. Natural disasters involve issues of supply, attempting to keep the price low is merely attacking the symptom (with substantial negative side effects) rather than seriously considering the problem.

            • We seem to have gone off the original point. You’re making an argument from an economists point of view and it is logical on its own terms. My point was that no one outside of economics would see this as fair or acceptable. If I sold drinks and raised my prices because the weather was hot, an economist would see this as a perfectly acceptable response to an increase in demand. However, pretty much everyone else would be outraged at this “exploitation”. They would not accept it and it would probably damage sales in the long run. Its a good example of the gulf between economics and the rest of society.

              • Just because most people believe something is true doesn’t mean that informed study and analysis isn’t worth doing. I agree, most people do not see the logic behind such price changes, hence the populism of anti-price gouging legislation. It is up to people like you and me to walk through the reasons why such legislation not only doesn’t address the problem but is in fact harmful. I also agree with you on the sales-damaging impact of price hikes in response to disasters; it’s why many firms don’t do it even when there is no legislation preventing them from doing so. The outcomes are the same: hording, overconsumption and amplified shortages.

                Economics is less a science than a way of thinking problems through. The majority of people don’t have the time or inclination to think past the first stage, but I don’t accept that they don’t have the capacity to analyse the conclusions of those who do. We surely have a moral imperative to inform as many people as possible about the harmful unforseen consequences of well-intentioned actions.

                • While just because the majority believes something doesn’t make it true, but they can affect the outcome. (There’s a fancy impressive term for this but I can’t remember it). So if most people think it is unfair for prices to rise on hot days, then they will not buy them and prices will not rise. The original point of my post was that we cannot simply think of things in terms of supply and demand. There is a third factor, fairness, that must be taken into account. In a way you could say I am describing the world, rather than changing it. I’m not proposing any law or campaign to change it, (which is why I’m not getting too caught up on price gouging laws) but merely pointing out that this is the way things are.

                  • Well, there we agree. I don’t dispute that this is the way things are for now but I don’t think they will last much longer. The Sandy coverage gave a lot more credence to the idea that prices have to rise in response, otherwise you worsen shortages of crucial goods such as food. This is also the way things are, if prices don’t rise and there’s a chance of a shortage, people will overconsume for fear of running out, making the shortage worse. Most firms don’t raise prices for fear of being labeled exploitative. The sooner people realise that this ain’t necessarily so, the sooner firms can raise prices in response, thus tempting outside competition to arbitrage their profits back down, increasing supply and wiping out the shortage. I don’t believe fairness is the thing on most people’s mind at the time of a natural disaster; it’s to help those in need.

                    • You really won’t let go of the arbitrage dream will you? Listen, I’m only going to say this one more time, prices rise because there is a lack of competition more than a lack of supply. Businesses can charge exhorbitant prices but only for the duration of the storm as soon as the roads reopen, prices drop back to normal. There is no arbitrage.

                      There is a serious problem of hoarding and panic buying which leads to inefficiencies. In their panic people buy things they don’t really need, can’t use or simply too much. This is why rationing is often used in times of disaster.

                      I don’t think people’s view of disasters will change nor do I think it would be a good thing if they did. You have to have some morality, some principles. Economics has to avoid the temptation to be soulless money whores. There is more to life than money and not every problem can be solved by charging more for it. For example if I asked you to plant a bomb in England in exchange for a large amount of money, there is no economic reason why should oppose my offer. In fact I could imagine an economic argument along the lines of “If you are paid £10,000 but only cause £9,000 then the bomb is pareto efficient . . . ”

                      The video below of Milton Friedman is an example that horrifies me, but I’m pretty sure it was repeated in our textbook. The fact that Ford knowingly made defective cars that killed people is glossed over because the company made more money. Its disgusting to see Friedman bargaining with lives and pretending its dignified.

                      (I know its slightly off point, but the video annoyed me so much that its hard to get out of my head)

                      Let me finish with an anology. Imagine you are staying in a hotel and plan to go to visit the city. However, a terrible storm strikes, one so bad that you cannot leave the hotel. You are effectively trapped and have nowhere else to get supplies of any kind. Seeing this, the hotel trebles the prices in the hotel restaurant, knowing its guests have nowhere else to go. The guests have no choice but to pay the rip off prices and resentfully eat. In the morning, the storm clears, people can leave and the prices go back to normal. This is price gouging. It is basically an extortion racket based on lack of competition. The storm prevents any arbitrage regardless of price. It flies directly in the face of most people’s sense of fairness (economists being the exception). (My personal solution would be to ration the food between people, but then again everyone thinks I’m a socialist)

                    • Everything has a cost. You know as well as I do that money is just a medium of exchange; it represents material costs. To take your example, suppose the hotel is greedy and does charge extortionate rates to trapped customers. How are those customers likely to respond? You say they have no choice, and in this instance they do not. But they would take an alternative if one was provided at a slightly lower cost. Food is not scarce outside of the disaster zone, therefore it is cheap. Are people and companies who don’t inhabit zones hit by disasters any less greedy? Will they not see a profit opportunity? Will their desire to take this opportunity not lead them to enter the market as soon as physically possible, thus taking those grateful customers in?

                      To claim that lack of competition is the main determinant of price implies that you reject even basic supply & demand theory. It’s also demonstrably not true; there is something other than competition constraining both upper and lower price bands, even in monopoly markets.

                      I think you have missed Friedman’s point. The only question being posed is what value you should place on a human life. If that answer is infinite then we should abolish driving (thousands of road deaths a year) altogether. If you do not believe that it is ‘ethical’ to attribute such a value, then you can’t engage in any meaningful debate on topics of human life. It’s not ‘just’ a question of money, money represents real costs in terms of resources.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s