Today’s Quote of the Day…

…is from Page 10 of Ludwig von Mises’ 1949 treatise Human Action (emphasis added):

It is true that economics is a theoretical science and as such abstains from any judgement of value.  It is not its task to tell people what ends they should aim at.  It is a science of the means to be applied for the attainment of ends chosen, not, to be sure, a science of the choosing of ends.  Ultimate decisions, the valuations and the choosing of ends, are beyond the scope of any science.  Science never tells a man how he should act; it merely shows how a man must act if he wants to attain definite ends.

Far too many economists, both in Mises’ day and today, make the very mistake Mises warns against: treating economics as a science of the choosing of ends.  They consider themselves enlightened for building models that can maximize this or minimize that, and then call for said models to influence policy.  But building models like such, as Jim Buchanan said in his 1964 paper What Should Economist Do?, is the purview not of economics, but of applied mathematics.  Indeed, anyone with even an elementary level of calculus would find such a task trivially easy.

But economics is not this; it is not merely optimizing some constrained function with some universally desired “social goal.”  Economics is the study of exchange; Of competing interests for scarce resources and the institutions that arise to deal with these issues.  In short, the study of human action.

Economics as a Positive Science

Following a natural disaster, one can count on two things in the opinion pages and blogosphere: economists of all stripes decrying price-gouging legislation in a disaster and proponents calling economists immoral for questioning such legislation.

The conversation/disagreement between these two is a microcosm of a much larger discussion: the difference between the normative (subjective) and the positive (objective).

Economics is a positive science.  It deals with what is, not what ought to be.  When economists argue that price ceilings (like price-gouging legislation) cause shortages, that is a positive claim: it is a claim of what is.  This claim can be empirically tested, but it does not reflect the moral positions or suppositions of the economist.  In fact, the claim carries with it no moral implications whatsoever.  The claim price-gouging legislation causes shortages carries with it no more or less moral weight than the claim the sky is blue.

Conversely, morality is a normative science.  It deals with what ought to be, not what is.  When moralists argue that raising prices during a disaster is immoral, that is a normative claim: it is a claim of what ought (not) to be.  This claim cannot be empirically tested (although it can be tested to see if it falls into various moral criteria).  It reflects the belief structure of the person making the claim.  The claim raising prices during a disaster is bad carries with it no more or less empirical weight than the claim the sky is blue is good.

Allow me to elaborate, lest I give the mistaken impression that normative and positive sciences are opposed.  Normative and positive are not opposed; in fact, they compliment each other quite well.  Normative can prevent positive from becoming abusive (think, for example, our modern sensibilities against eugenic human breeding [normative] despite knowing certain traits are genetic [positive]).  But positive can also keep normative from being “pie in the sky,” by explaining how the world is.  For example, normative claims like “one should not kill his neighbor,” are all well and good, but the positive claim that “murder happens,” is important to know, too.  Knowing the two together brings us to the conclusion that police are needed for the few who do break the law.

To apply this reasoning to disasters, knowing price-gouging legislation makes the logistical system worse is important to know, as it can help inform better forms of aid and legislation.

In short, answering a positive claim with a normative claim will get us nowhere, but the two must be given, and understood, concurrently.

Price Gouging Legislation Means Fewer Resources for Search & Rescue

Police, like any resource, is scarce: there simply is not enough to satisfy every want and need.

Because of this simple fact, anti-price-gouging legislation has two perverse effects on a disaster.  The first, and the one economists tend to focus on, is what I discussed the other day, namely that price controls create shortages.  The other, as the title of this post would suggest, is even more of an immediate threat to life and limb.

If police resources are diverted toward price-gouging enforcement, then that means there are fewer police resources for search and rescue operations!  A cop who has to spend his time making sure merchants don’t charge too much is not spending his time looking for people, or preventing looting, or distributing goods.

Just your daily reminder: scarcity is a thing

The Short-Sightedness of Anti-Price-Gouging Legislation

Columnist Michael Hiltzik wrote a piece in the LA Times the other day calling economists’ opposition price-gouging legislation wrong “both morally and economically.”  By pure coincidence, I addressed the “moral” argument yesterday on this blog.  Allow me now to respond to a very large economic error he makes.

Hiltzik writes:

Another factor commonly overlooked by defenders of price gouging is that natural disasters tend to be (1) short-term and (2) not amenable to rapid response by market forces. If there’s no physical way to get a new supply of bottled water into some part of Houston, then allowing unrestrained price increases won’t produce a larger supply. Retailers lucky enough to have a few cases in the back room when the crisis hits, however, will reap a windfall. But who does that help, except the lucky retailers?

Strictly speaking, he is correct that natural disasters tend to be short-term, at least the disaster itself.  It may also mean that it is not amenable to a “rapid response by market forces.”  But that doesn’t necessarily mean that anti-price-gouging legislation is the way to go.

Take a look at the following diagram:


Source: Price Theory and Applications, 7th Ed., by Jack Hirshleifer, Amihai Glazer, and David Hirshleifer, page 214.

This is just your standard supply and demand chart with price on the vertical axis and quantity on the horizontal.  Let’s assume that curves IS (Immediate Run Supply Curve) and D (Demand) are immediately before Harvey hits Houston.  Immediately after, demand shifts to the dashed D’ curve.  IS doesn’t immediately change because there are now frictions (ie flooded roads) preventing new supplies coming in.  The price level now rises to PI (the intersection where the D’ curve intersects IS).  This increase in price is what people call “price-gouging.”  The “lucky few” retailers who have the inventory on hand may enjoy a brief windfall.  This is where Mr. Hiltzik’s analysis ends.  What he doesn’t consider is what happens as we move away from the immediate period and into the longer run (the days that occur after the disaster).  Higher prices induce more supply to the region, especially as entrepreneurs discover ways to overcome the physical barriers preventing supplies from arriving.  And, as the Second Law of Supply says, the longer prices stay relatively high, the more elastic the supply curve becomes.  We see the development of the LS (Long-run Supply curve) in the diagram above.  If there is no interference in the market, we now see increased supply in the market (represented by the delta-S section in the above diagram).

However, Mr. Hiltzik demands a price ceiling to be imposed to prevent this higher price level.  On the above diagram, that is represented by the original price level, Po.  In the immediate run, there is no deadweight loss to the community stemming from the price ceiling (eagle-eyed readers will notice this is identical to the question from my microeconomics comprehensive exam from three weeks ago).  There is no deadweight loss, but there is a shortage, represented by area H on the above diagram.  However, what is important to note is that with the price ceiling enforced, even as the supply curve becomes more elastic and more supplies can make it into the devastated area the shortage does not disappear!  No additional supplies make it into the market despite the need!  The quantity the market supplies never shifts off of Qo.  Nota bene: This means that, so long as the demand for goods and services are higher than the pre-disaster level (ie, so long as disaster conditions persist), there is a persistent shortage of needed goods in the market! This stands in stark contrast to the increase in supply created when prices are allowed to adjust.

In short, Mr. Hiltzik’s analysis is too short-sighted.  He looks at just the immediate run (which is dire) but fails to account for anything beyond that (including the very next day).  And we are already beyond the IS curve for Harvey; the supply curve is becoming more and more elastic every day.  And it is becoming that way because of the price signal.  Even in the immediate run, anti-price-gouging legislation has major negative consequences.

I’d also like to add that the situation described above is probably a bit optimistic.  In all likelihood, following Harvey, we saw both an increase in demand (D’) and a decrease in supply (a shift from IS to an IS’ curve somewhere to the left of the IS curve).  So the shortage, H, caused by the price ceiling would likely be larger than depicted here.

Where is the Protectionist Love for Harvey?

The damage wrought by Hurricane Harvey has been rightfully lamented by folks all over the spectrum as Houstonians and others suddenly find themselves without food, water, housing, etc (fortunately, according to a report I heard on 106.7 The Fan yesterday, electricity still appears to be available as the storm in Houston has been mainly rain).

However, there is one group who should be out celebrating the scarcity brought on by the storm (and no, I’m not talking about the “disaster relief creates economic growth” people): protectionists scarcityists.

The whole argument for protectionism is that it is scarcity, not abundance, that fuels economic growth.  Scarcity (in this case, preventing the inflow of goods from foreign producers), they claim, promotes growth by giving companies more profits.  This trickles down to us normal people in the form of jobs and higher wages (so they claim), which offsets any price increases.

So, why aren’t scarcityists celebrating Harvey?  The storm has created enormous scarcity of many goods and services, sending prices skyrocketing.  According to the scarcityist theory, this should be quite the boon to the economy!  The profits reaped by those who have the resources will surely trickle down to the rest of the Houstonians and make them all better off than before!  Furthermore, the scarcityists must be denouncing the (metaphorical) flood of bottled water, clothing, and other necessary supplies that charities are sending and distributing to the area (it’s just unfair price competition, you see.  These goods are being subsidized so they can be sold/given away below market price, and some even by the government!).

The scarcityist may object that I am strawmanning his argument, but I refute that charge.  I am not strawmanning, but rather taking it to its logical conclusion.  If the argument applies to trade with China, it also applies to trade with Houston.  Hurricane Harvey is just the scarcityist’s argument writ large and with the scarcity concentrated, and we see the folly of his claims as clear as crystal.  Fundamentally, there is no difference between tariffs erected and a flooded city.

A Smithian Look at Price-Gouging

As Hurricane Harvey hits Houston, Texas has invoked its price-gouging legislation, preventing prices from rising to meet the new levels of supply and demand.  As usual, lots of ink has been spilled by economists denouncing this legislation (for example, see here, here, and here).  On a recent post, Mark Perry asks: “It’s really not that complicated is it, to understand the adverse consequences of anti-price-gouging laws?”

Part of the issue is the price theory arguments against price-gouging are not complicated, but they are subtle.

I think the other issue is people take the positive analysis of economics and try to impute normative analysis onto it. That prices rise when demand rises/supply falls is neither good nor bad. It just is. Just like the sun rising in the East and setting in the West is neither good nor bad. It just is.

However, people will take this positive and try to make it normative. It is “bad” prices rise and people profit off of the suffering of others. Or it is “good” prices rise and lure in profit-seeking individuals and that increases supply.

These normative imputations get problematic because it is trying to answer a different question than the one originally posted. The question is not “how should people act when disaster strikes” (the normative) but rather “how to allocate needed resources to disaster areas” (the positive). Giving a normative answer to a positive question is neither helpful or insightful.

This is not to say that there is no room for the normative. I think that is an important aspect. Should people raise prices during disasters? Should there be discounts for those in absolute need? I think the answers to these two question is “yes.” I think Adam Smith’s “impartial spectator”  would be pleased to see prices rise in order to attract more goods/services to where they are needed, but also to see prices not rise (a discount) to those in absolute need. Indeed, the impartial spectator may frown if prices are “gouged” for those in the most need.

But does the disapproval of the impartial spectator, (“The heart of every impartial spectator rejects all fellow-feeling with the selfishness of his [the price-gouger’s, in this case] motives,” to use Smith’s words [The Theory of Moral Sentiments, page 78.3]), necessarily imply the need to anti-gouging laws? I’d argue “no.” Punitive legislation, Smith (and I) argue exists to serve justice:

“Resentment seems to have been given us by nature for defense, and for defense only.  It is the safeguard of justice and the security of innocence.  It prompts us to beat off the mischief which is attempted to be done to us, and to retaliate that which is already done; that the offender may be made to repent of his injustice, and that others, through fear of the like punishment, may be terrified from being guilty of the like offense.  It must be reserved therefore for these purposes, nor can the spectator ever go along with it when it is exerted for any other.  But the mere want of the beneficent virtues, though it may disappoint us of the good which might reasonably be expected, neither does, nor attempts to do, any mischief from which we may have occasion to defend ourselves (page 79.4).”

And the violation of justice is injury, that is: “it does real and positive hurt to some particular persons, from motives which are naturally disapproved of (page 79.5).” Since the price-gouger’s actions do no real and positive harm or a person, he cannot be punished: “To oblige him by force [ie, by legislation] to perform what in gratitude he ought to perform, and what every impartial spectator would approve of him performing, would, if possible, be still more improper than his neglecting him to perform it (page 78.3-79.3).”*

In short, the anti-gouging legislation both cause economic problems by creating shortages of much-needed supplies when they are already extremely scarce, but also invoke an injustice upon the society by punishing people, by inflicting harm on people, when no real and positive harm has been done.

*Nota bene: This conversation here revolves around price-gouging in general.  We could carve out all kinds of exceptions here that would allow for punitive legislation, but we are discussing the general case, not specifics.

The Uses of Price Theory

I want to go back and discuss more a post I had a few weeks ago on the difference between a model and real life.

As the question highlighted in the post shows, the model and reality can differ.  In the price theory model discussed, there is no deadweight loss from a price ceiling when supply is perfectly inelastic.  However, a more robust consideration tells us there are inefficiencies we need to consider.  A simple observation of the grocery store is another example: if standard price theory were 100% accurate, then supermarket shelves would always be stocked with just enough of each good to meet demand, no more and no less.  But this is clearly not the case.

This difference between the model and reality can lead us to the question: why have models at all?  Indeed, there are some forms of economics that do-away with models and theory altogether preferring to “let the data speak for itself.”

But price theory models serve an extremely important purpose.  Careful study of price theory provides the good economist with strong intuition about the “economic way of thinking.”  Careful study of supply and demand curves can reveal a lot.

Even if these price theory models do not model the world perfectly (and it is my opinion that they do not, although do provide a pretty decent approximation), then the models can still provide valuable insight.  Even though equilibrium is not a point that can ever truly be reached because the economy is dynamic and thus constantly changing, it provides us a good starting point for economic investigations.

Static price theory analysis (that is, all else held equal, including time) provides us many insights into the effects of monopolies, oligopolies, price manipulations (taxation, ceilings, floors, etc), market misinformation, etc.  But it is just that: static.  Adding a dynamic element to price theory makes it far more robust and interesting.  For example: What happens when there are price manipulations over time?  How do demand curves and supply curves shift over time?

But static analysis has its uses, namely that it provides strong intuition.  Intuition that can help answer questions like:

-Does minimum wage help the poor?

-Do anti-discriminatory laws protect women and minorities?

-Will tariffs “make America great again”?

Price theory intuition extends well beyond just the narrow world of “material” well-being.  Jack Hirshleifer has used price theory to explore conflict theory.  Terry Anderson and Donald Leal have applied price theory to environmental issues.  Armen Alchian and Harold Demsetz used price theory to explore discrimination and the development of property rights.  More famously, Gordon Tullock and Ronald Coase used price theory to explore the law and externalities.

Price theory is an extremely powerful tool, even in its static form.  It merits careful study and consideration because there are a lot of subtleties to it, but the logic of price theory is straight forward (unlike macroeconomics).