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November 01, 2005
This might be the most common mistake people make in basic economics
Students make this mistake all the time. It's got to be one of the most common. It's also one of the more common errors in the media. Phil Miller (Market Power) finds today's example. Phil writes:
I turned on CNN Headline news this morning (Saturday) and watched a item on gas prices. The reporter, who's name I did not catch toed the party line by going after the greedy oilmen. But then he tried to use economic reasoning to make his point. To explain the rocketing gas prices, he said:
"A short supply increases demand...."
This statement is a rather bizarre version of the common error, namely to link changes in demand directly to changes in supply or vice versa (shortcutting the role of price).
How does one make such an egregious mistake? I'll give you one possibility. Supply disruptions in the gasoline production chain (such as those associated with the recent hurricanes) make people think about gas lines from the 1970s. Of course we know that a true shortage happens only when the price is below the market clearing price. In the '70s, this was due to price controls. But old memories die hard. For many the gut-level reaction is to think of gas lines.
The next step in their reasoning is that if gas shortages are on the horizon, then you'd better get in line now. Or, by the same token, if the price is expected to rise, you'd better buy your gas now. Either way, you arrive at the perfectly economically valid argument that an increase in the expected price (or an increase in the probability that the good will be unavailable in the future) causes an increase in demand now. I would be willing to bet that this sort of logic is what drives people to make a statement like that.
But if they are using that logic to explain the higher prices, their efforts are misplaced. The higher prices (as well as the expectation of higher prices in the future) are due to the decrease in supply itself! The fact that prices rise due to the decrease in supply is the reason why there are no true shortages (outside the hurricane's zone of devastation, at least).
So there you have it. Trying to explain higher prices by thinking about what happens in a shortage causes you to miss the real reason fo the higher prices. And I think that also goes to show what a profound impact those gas lines in the '70s had on the way we think about the market for gasoline. We're so mindful of queueing for gas that in the minds of many people the reason for higher prices must be because we are afraid of queues and we're all rushing out to stockpile gas. In reality, that effect, even to the extent that it does happen in a few cases, is small compared to the main reason for the price increase.
Of course, the panicking buyer afraid of shortages does play into the greedy Big Oil mythology a lot better. You don't think that has anything to do with it, do you?
As I said a while back, principles level is all I ask! The direct linkage of changes in supply to changes in demand is a common error, and it's a particularly bad mistake to make because it leaves out the role of price. Our experience with price controls notwithstanding, changes in price are what induces a response in buyers and sellers. Never forget that.
Posted by William Polley at November 1, 2005 09:46 AM
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Comments
Dr. Polley, could one make an argument that there are certain circumstances in which a decrease in supply will lead to an increase in short term demand with minimal interfacing with price due to a commodity being extremely inelastic and information asyemtries about the actual state of supply and demand keeping people from making informed decisions. This is a rare case, but it is an analogue to a run on the bank or a run on gold or a run on currency --- everything is fine and at a s-d equilibrium at Price P, but new information on a shortage leads to a cascading rush.
Posted by: fester at November 1, 2005 01:40 PM
fester,
Yes, you could make that argument. In fact, that argument is perfectly compatible with what I wrote. For example, in the post, I acknowledge that shortages happen in the zone of devastation. That's precisely where the very short run supply is most inelastic and the uncertainties are the greatest. The problem is that people are still apparently trying to spin this story weeks later and on a nationwide level. This article is but one example. I really think that the gas lines of the '70s are so much a part of the general perception of supply and demand in gasoline that people tend to oversell that side of the story and miss the forest for the trees.
Posted by: William Polley at November 1, 2005 01:48 PM