The Beauty of Prices

Prices! Prices! Prices! It's the only thing I hear on the news today. The price of gas is too high!

I disagree completely! Do I like paying the high price of gas right now? No - I wish it was a quarter per gallon. But wanting the price to lower is one thing and making an argument that the price is too high is another. Saying the price is wrong, whether too high or too low, suggests ignorance about the role of prices. So let's talk about that.

Prices are not high or low because someone is trying to take advantage of you or because someone is evil. Actually, someone is always willing to charge too much for a product - that motivation will never go away. Don't you wish you made twice as much in your job? I sure do, but having that motivation doesn't make it possible. I charge for my labor what the market will pay. Any more than that and the market stops paying me and goes elsewhere for my skills.

The same is true for gas stations. There are about 10 stations within 3 miles of my home. I regularly drive by them all and know exactly which ones charge most and which ones charge least. I typically go to the cheapest unless one of the more expensive ones has a hot dog or something else that I want. Point being, the gas station can’t gouge because I’ll just go somewhere else.

You might say – but the gas companies all work together to keep prices high. Actually dozens of government inquiries (including one going on right now initiated by President Bush) have investigated the oil companies for that very thing, and each time the oil companies were exonerated. They are not colluding! They are competing – just like they are supposed to do.

So what is price? First of all, price is a reflection of market realities. The price a person charges for a product will always include all the costs that went into providing that product to the marketplace. Costs such as research and development, advertising, raw materials, production and labor, transportation, the retail environment – oh and lets not forget – taxes. These all must be paid for by the price charged to the consumer.

Every company is putting its best minds to the problem of reducing all of these costs in any way possible so as to gain an edge on the competition and drive more business to its doors and more profit to its shareholders. They can’t charge less than their costs for long without going out of business. They can’t charge much more than a reasonable profit because they’ll lose to the competition. So the price cannot be whatever the company wants it to be – it is tightly, tightly held in its given place by market realities – natural economic forces that are amazingly difficult to manipulate.

Second, price regulates the disparity between supply and demand. This is such a critical point and I hope you’ll read that sentence again and think about it. Why do we rarely have shortages of fuel in America? Or food, or cars, or TVs, or clothing, or toilet paper? Because prices of all these things are permitted (by the government - let's hope it stays this way) to fluctuate freely, thus regulating the disparity between supply and demand. When prices are controlled artificially, without fail you will have either shortages or surpluses. For example, when rent controls are put in place by local governments, two things happen: 1) People are less willing to provide rental units because they can’t cover their costs (supply goes down), and 2) People line up to rent units the units that are still on the market at artificially low prices (demand goes up). However, there is now a disparity between supply and demand. Less supply, more demand = shortage of rental units. So now we’ve got less housing on the market and more homelessness.

Oh and guess what – something else has to step in to regulate the difference. Getting a rent controlled apartment becomes an issue of “who you know” rather than “can you pay.” Do you think that possibly opens the door to discrimination? By the way, a decrease in discrimination is also a result of free markets – my gas station doesn’t care if I’m white or black, Christian, Muslim, or Jew – “can I pay?” is the only thing they care about. Added to that - I don't really care what ethnic group provided the gas, as long as it works in my car.

When the price of gas rises, people conserve. So without any government program or involvement, without being convinced by the President’s “Addicted to Oil” speech, people choose to figure out a way to buy less gas. I personally traded in my SUV (16 MPG) for a mid-size sedan (30 MPG). Not due to any other social pressure except the desire to save money on gas. Oh, and I also drive a little slower now too.

Okay, back to prices. Third – price allows resources to flow to where they are most needed. Let’s use Hurricane Katrina as an example. People were enraged that there were “hucksters” buying generators in neighboring states, driving them down to the coast and then charging twice as much as retail for those generators. “Those evil price gougers!” They even wanted to pass laws making such behavior illegal. Ok, let’s think this through. People took time off of work to buy and transport some generators that were desperately needed on the coast. There are now generators for sale that weren’t available a few days before – and we want to pass laws to prevent this?! There is so much wrong with that thinking I don’t know where to begin!

Consider this: the “high” price of the generator encouraged people to go out of their way to provide them. The “high” price of the generator kept people from buying them who didn’t really need them at the moment and had other options. Recognize this dynamic? Supply and demand were equalized – AND – resources went where they were needed most (from neighboring states to those most in need). These same principles work for every commodity – gas, water, labor, housing, you name it.

Do you know what the real threat is? Government involvement. The government erects roadblocks at every step for the oil companies. Environmental regulations affect exploration and extraction, limits on where they can drill, regulations about formulations, taxes. Every roadblock affects price by adding costs. If you want to do something about gas prices – tell the government to get out of the way. That is a market reality that we can affect. Freedom works – let’s try it!

So back to our initial point – the price of gas isn’t too high. It is exactly where it should be given market realities and the consumer demand for fuel. More importantly, fuel is exactly where it should be as a result – in the tanks of those who need it most. That is the beauty of prices - they almost magically adjust to prevent shortages or surpluses and at the same time ensure that precious resources go exactly where they are needed most. Amazing.

Subject areas: Oil Prices, Price Gouging, Hurricane Katrine, Addicted to Oil