So why is it that people will buy all of the gasoline when the prices are lower than the “market clearing” price? Why don’t people evaluate the situation and think to themselves, “Gee, there’s not much to go around, I better cut back?” The answer is one of the more misunderstood, and I think one of the more interesting aspects of price. Many, if not most, people view prices as being fairly arbitrary and motivated out of greed. Prices are much more complicated than that. As a matter of fact, accurate price setting is critical to the proper functioning of the economy.
Prices are a reflection of the incidence of supply and demand. Even without going into the details, it should be pretty obvious that when prices are low, either there is a ton of supply, not much demand, or both. On the other hand, when prices are high, demand is high, supply is low, or both. Nobody goes around trying to calculate relative supply and demand for every item they purchase to make sure they aren’t doing something they shouldn’t be doing like taking gas from a hospital or ambulance. The reason is because price tells us everything we need to know. Accurate prices are the quickest, easiest, and most efficient way of communicating the relative supply and demand of anything. If the gas is very expensive, we know that there is a lot of demand and/or a low supply. The beauty of this is that no one needs to make that insightful leap, it is enough that when it gets too expensive, we no longer buy it and others with higher demands can then have access to it.
This explains why price controls (like anti gouging laws, rent control, minimum wage, price supports for dairy, etc.) are so dangerous. If there is a disaster someplace and gasoline is in short supply, the price needs to go up in order to signal the smaller supply to consumers. If the price is held down at “regular” prices, there isn’t any signal that things are now different and that consumption should be different as well. Assuming a modicum of competition (and there always is with gas stations no matter where you are in the US), prices will come back down as the supply comes back to normal. The lower price signals to consumers that it is OK (and maybe even desirable) to consume more.
It works the other way too. If prices are made artificially high, producers will make more than is necessary. Not only are the higher prices a hit on the pocketbooks of the consumers, but the extra production is a waste of resources that could have been used for something whose actual demand is higher (i.e. is something that people actually want.) A perfect example is price supports for the dairy industry. They are allowed to set a higher price than what the market would bear (and a higher price than would occur if imports were allowed to freely compete). This causes us to not only spend more than we would otherwise, but they make too much milk. Luckily for the dairy industry, they also had the connections to make sure that they could not only set higher prices, they have Uncle Sam buy the excess…. Any other price floor (like the minimum wage or mandatory union hiring) or subsidy (like ethanol) has the same effect. Too much is made, more than the demand requires. It’s a huge waste of resources.
In a market with competition and minus government interference, prices will adjust to balance out the supply and demand for that product. Gum, labor, gas, homes, and even babysitters will have their prices determined by the constant feedback of market prices. The thing to remember about this is that there is no one person, group, or company that can determine prices. That’s right, you can’t set whatever price you want on your home and expect to sell it. WalMart cannot set wages arbitrarily low and expect to get the people they want to fill the positions they want. It also means that you shouldn’t be able to buy gas at $2.50 gallon right after a hurricane with no supplies coming for a while. If you can’t get paid what you want, it’s because either people don’t particularly want what you have to offer or there are many people offering the same skills.
Price is a critical indicator of relative supply and demand and it is the prime determinant of weather someone decides to buy (or sell) something. You can’t screw around with that without consequences….