Let's use price to allocate resources

Last updated 08:42 16/09/2010
water
WHO GETS WHAT?: What's the most efficient way to apportion scarce resources?

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OPINION: Price-gouging by tradespeople and others following the Canterbury earthquake is not necessarily a bad thing, argues ERIC CRAMPTON.

Far from being the scourge of Christchurch's recovery, as construction economist John Jackson suggested in yesterday's Press, price gouging may be the best mechanism for ensuring a speedy recovery. Understanding why requires thinking a bit about the role prices play in the economy.

Let's start by thinking back to the morning of the earthquake. Some of us had planned ahead and had water reserves stored in the garage; others didn't. Some people had pressing needs for water - people who needed clean water for mixing infant formula - and others of us wanted to be able to do the dishes.

When the stores opened that morning they had only a fixed supply of bottled water available. How should they have allocated that very scarce supply among all the potential customers?

The method they chose, by and large, was first-come, first-served. But is that the method most likely to ensure that the woman needing clean water for mixing baby formula would get some while folks like me, who only needed it for doing dishes, didn't? That seems pretty unlikely.

Instead, it went to the people who were best able to queue. The folks with the most pressing demands might have worked harder to get to the front of those queues, but it's pretty unlikely that those who wound up getting water were the ones who needed it most. Instead, it would have been the folks living close to grocery stores who didn't have pressing property damage to deal with.

Now, imagine that prices had been allowed to do their work. A litre of water might have risen from about a dollar to perhaps even $10, noting that there's no reason a shop can't take IOUs when the eftpos is down.

With the price hike, folks with less pressing needs would have left water on the shelves for those whose needs were more pressing. The guy who needed the water only to do the dishes would have left it on the shelves for somebody who needed it more - not out of the goodness of his heart, but out of concern for his wallet.

It would be a fine world if we could rely solely on the goodness of folks' hearts - and we've seen an awful lot of such goodness in response to the quake. But I didn't see any water on any shelves of any stores we went into that morning.

Now, maybe that's because a bunch of folks came in early who needed the water to mix up infant formula, but I don't really think so. There's only so much goodness to go around.

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Economists say that prices induce allocative efficiency: goods go to the person valuing them most highly. Critics would highlight that the poor do worse than the rich with a price hike, but empty shelves hardly help anyone, poor or rich, other than those first in line.

Thinking about reconstruction, some of us have really pressing construction needs while others of us have minor property damage such that waiting for repairs isn't overly burdensome.

If nobody raises prices, then scarce builders are allocated on a first-come, first- served basis.

If prices rise, then folks like me with minor cracking on a few interior walls will wait until prices come down again to have things fixed.

The most pressing needs get first attention when prices allocate scarce supply; that doesn't work as well under first-come, first-served.

Price increases also draw in supply from further afield. We've heard a lot over the last couple of years about skilled tradespeople moving to Australia in pursuit of higher wages. Right now, their services would really be appreciated here in Christchurch.

But if the prevailing wages prior to the quake were enough to send them off to the West Island, a price freeze here is unlikely to draw them back. If they look back across the Tasman and instead see hourly rates double what they'd been earning prior to moving to Australia, they might consider spending a few months back home helping out.

John Jackson and Canterbury Employers' Chamber of Commerce chief executive Peter Townsend argued that some grand supremo might be needed to ration out scarce tradesmen, ensuring that resources go to the most critical areas first.

But how can any such supremo decide how much I value having my wall fixed as compared to how much my neighbour values having her chimney fixed, let alone weighing up priorities across different damaged factories and retail outlets?

Economist Friedrich Hayek proved back in 1945 that it's impossible for any supremo to be able to do that accounting; prices, by contrast, do it automatically by forcing each of us to weigh up how much we value having a job done now as opposed to waiting for prices to drop.

And no supremo can order Kiwi tradesmen working in Australia to come home.

We were very lucky in this earthquake. Damage was relatively minor and the water came back online, for the vast majority of us, very quickly.

When and if a bigger one comes, I'd happily take a bit of price-gouging over empty shelves. Because I'd sooner a mother trying to get clean water for infant formula gets to complain of high prices than of a hungry and angry kid. And, again, for those who worry about bad effects for the poor, is it worse that a poor mother has to find $10 for bottled water for formula, or that the price stays at a dollar and she gets none unless she managed to queue up early enough?

In this economist's view, it's rather a shame that everyone heaps plaudits on the dairy owner who gave away his stock for free and ran out of everything by 8am. I'll instead save my praise for the price-gouger who ensured there was something left on the shelf for those who didn't come first.

* Eric Crampton is Senior Lecturer in Economics at the University of Canterbury. He blogs at http://offsettingbehaviour.blogspot.com/ 

- The Press

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