Happy Hogging!

Price hikes in anticipation of shortages can lead to re-allocation of scarce resources to higher-valued uses.

A day before Katrina hit the Gulf coast, every bay in a Memphis Sam's Club gas station had a line of at least 2 cars waiting to get gas. The pumping machines no longer printed out sales receipts probably because they ran out of paper. There was an air of frenzy in the gas station. My car still had half a tank of gas. But anticipating shortage, I topped my tank off. I bet most other drivers thought the same way. So, more cars were carrying more gas than they did normally. Because this sudden jump in demand is unanticipated by the supply chain, it inevitably leads to shortage. The only way to discourage such panic hoarding is to greatly increase the price. When prices are high enough, buyers would buy only the amount they currently need. As a result, there is enough left over for those who cannot do without. But such a preemptive move on the part of vendors is often condemned as "price gouging".

To be fair to the condemners, vendors probably do not raise their prices because they intend to lead to a better collective outcome. Their intention is more likely to capitalize on the sudden jump in demand. But the market system does not require its participants to be altruistic or mindful of the greater good. Indeed, Adam Smith (Wealth of Nations) thinks that it is exactly the single-minded pursuit of one's self interests that inadvertently leads to a greater collective good. In fact, greater good could be achieved if prices of potentially short-supplied goods are raised ahead of time.

Since most people are fixated on the prices of gas, a different good might be useful to illustrate the importance of raising prices to properly rationing short-supplied goods. After power was knocked out by Katrina, thousands of people used battery-powered radios to stay informed. Radio was the best means to reach employees and customers. As a result, the demand for radio ad spots shot up. If the ad rates stayed the same as before Katrina, there would be a shortage of ad spots. How should the scarce resource be allocated to maximize its utility? First come, first served? Or let higher prices filter out causal buyers?

As it turned out, the 60-second spots at WIBR, a Baton Rouge, LA news-talk station, went up to $100, up to 5 times the normal rates. The higher rates did serve to reallocate the spots to higher-valued uses. Light-hearted ads were pulled. Higher-valued users such as insurers and power companies scrambled to get on the air. The higher rates were also justified by the increased number of listeners as the population in towns like Baton Rouge saw a large influx of evacuees.

In fact, the reallocation could have been more thorough if ad spots that had already been contracted before Katrina at the previously lower rates were allowed to resell their spots to higher-bidders. No such secondary market was reported.

This story shows that unexpected shortages can often be solved by valuing scarce resources at their opportunity costs instead of their historical costs.