Prices Are Signals

Paul Gift, PhD
Paul Gift, PhD

With all of the recent turmoil in the financial markets, the impact of hurricanes Ike and Gustav on gasoline prices in certain U.S. markets did not get the normal amount of attention it otherwise would have.

Immediately following hurricane Ike, motorist Fred Hamilton paid $4.87 per gallon for regular unleaded at a gas station in Miami, Fl. He claimed it was “price-gouging.”

In a video posted on YouTube on Aug. 27, rapper, music producer, and businessman Sean “Diddy” Combs complained that “gas prices are too high.” According to CNN.com, he stated:

I’m actually flying commercial,” Diddy said before walking onto an airplane, sitting in a first-class seat and flashing his boarding pass to the camera. “That’s how high gas prices are. I’m at the gate right now. This is really happening, proof gas prices are too high. Tell whoever the next president is we need to bring gas prices down.”

The previous examples reference the fact that many people seem to think of a price as a number set by a greedy business owner that should always be low and should not have to react to market forces, except possibly for costs of production. That could not be more nonsensical.

In a free market, capitalist system (a.k.a. the price system), prices are nothing more than signals. They signal what consumers in the marketplace reveal about the value of the next additional unit and what the supply side of the market is revealing about scarcity. Economists call this signaling value and scarcity on the margin.

For a quick example, consider the Diamond/Water Paradox of Adam Smith. We all know that given a choice of only diamonds or only water, we would choose water as it is absolutely necessary for survival while diamonds just look pretty. However, the price of diamonds is much higher than the price of water. This is because price does not signal the overall value of diamonds or water, it signals the market’s valuation of one additional diamond or one additional gallon of water. This is determined by a combination of scarcity and consumers’ revealed willingness to pay.

When a hurricane roars through an area, it is going to affect the consumer value and scarcity of oil/gasoline. If consumers rush to the pumps, it’s because their current valuation of gasoline has changed. Likewise, if drilling, refining, or distribution processes are impacted, then scarcity has changed. Prices will adjust to signal these changes. When prices rise, they are signaling consumers that they need to strongly consider conserving. Additionally, higher prices signal sellers to consider shifting resources in order to bring more gasoline into the area. There’s now an incentive for gasoline that was going to a low priced part of the country to be diverted to the higher priced region. Why? Because sellers generally like money.

If prices aren’t allowed to adjust, you’re creating perverse incentives and attempting to deny scarcity (which is the economic equivalent of denying gravity). If you restrict price signals to remain low, you’re effectively telling consumers that, in the midst of a hurricane, there’s no need to conserve, consume all you would have anyway. You’re also signaling sellers to take their time and not take additional measures to bring extra gasoline into the region, hitching your wagon to benevolence instead of self-interest. These are not the incentives of a properly functioning economic system.

The same article that ran the Fred Hamilton price-gouging quote also contained this quote: “’I saw this one [gas station] at $5 and thought, this is ridiculous,’ Mike Stajdel, 60, said at the 2522 NE Second Ave. station. ‘But it’s the only place that has gas.’ This should not need further explanation. Price signals value and scarcity on the margin. Pretending to deny scarcity and value changes is like denying the existence of gravity.

With all due respect to Diddy, the price system is doing its job correctly. It’s signaling that he should re-optimize and potentially change his methods of travel. After all, if denying scarcity actually worked, I’d be flying in a private jet, too!

Paul Gift, PhD, is an assistant professor of economics at the Graziadio School of Business and Management of Pepperdine University.

 


Related in the GBR

The Tie-In Decision by Paul Gift, PhD

Electricity Price Gouging in California? by Terry Young, PhD and David M. Smith, PhD

Author of the article
Paul Gift, PhD, Assistant Professor of Economics
Paul Gift, PhD, Assistant Professor of Economics
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