I live out in the country. Among my few neighbors is a man we like to call “Mr. Mow-it-All.” This guy has the most perfect lawn you will ever see. He mows religiously when the grass is green. We see him almost daily out there on his zero-turn John Deere riding mower, keeping his lawn looking like Pebble Beach.
Another neighbor down the road is a sweet, kindly old lady who is chronically ill. She needs to see different doctors and specialists multiple times each week to keep track of her various conditions, the interaction of several prescription drugs, and so on. Because her health is so poor, we know that when she leaves the house, she is probably going on a doctor visit; sometimes she is so frail and weak that she has to call for an ambulance to fetch her to the hospital.
Then you have my family: ordinary, “live in the country/commute to the city” type folks. We just so happen to have two vehicles: one huge, gas-guzzling SUV and one tiny, gas-sipping economy car.
Normally, our corner gas station has plenty of gas available for everyone in the area to do whatever they want to do—mowing, commuting, motorsports, or whatever. But let’s assume that one day, due to some terrible set of circumstances, the gas supply to our corner station is cut off. It might be a pipeline failure, a refinery explosion, or something along those lines. It really doesn’t matter. The important thing is that, this time, there’s not enough gas for all of us in the neighborhood to go about things the way we have been.
How do we ensure that the limited supply of available gas is going to be used wisely? Or, how do we ensure that gas will only go toward higher-valued uses and be denied to lower-valued ones?
One obvious thing to do would be to ration out a fixed amount of gasoline to everyone. There’s 1,000 gallons left. The manager anticipates 100 customers, so everyone gets 10 gallons each. This is only fair, right?
Mr. Mow-it-All is retired. So between his constant mowing and infrequent trips into town, he needs only, say, 9 gallons of gas each week. He’s perfectly happy with the rationing scheme. While my family normally uses 18 gallons per week making daily trips in both our SUV and subcompact, we could get by on a mere 6 gallons (if we parked the SUV and carpooled in the economy car). This arrangement would involve some hassle for my family. But with only 10 gallons available, we’d have no choice but to at least do some carpooling. The sickly old lady (bless her heart) and her husband, between her doctor visits and his commute, use around 16 gallons of gas per week. A reduction to 10 gallons puts her in serious danger of getting stranded on the way to the hospital, which might well kill her. While Mr. Mow-it-All and my family could manage on the 10-gallon ration, she can’t live with this situation—perhaps literally. We need a better method of allocating gasoline to the most important uses.
How about we bring in a notable citizen to allocate the gas according to her evaluations of whether a given use is worthy? This system might work, so long as she genuinely knew the truth about people’s differing valuations of gas—and as long as we could trust her to judge fairly. But even with a wise, trustworthy judge, this method breaks down once we start involving more than just a few people. Note that there are hundreds of regular customers at our local gas station, and hundreds more might stop in from the highway occasionally. In reality, no single person—not even a committee of well-informed experts—could possibly gather and adjudicate all the “facts” required to make fair decisions about each of these people’s “need” for gasoline.
Maybe we should have our decider simply ask people what they’re going to use the gas for, and only approve those uses she deems worthy, while denying frivolous uses. “I’m driving granny to the hospital” would count. “I’m going squirrel huntin’ on my ATV” would not. Can you anticipate a problem with this arrangement?
Mr. Mow-it-All is so serious about keeping his lawn perfect that he just might use any means necessary to keep his mower running. I can see him pulling into the gas station with granny in the passenger seat, proclaiming: “I’m takin’ granny down for her cancer treatment!” He drives back home on the back roads. Granny (who is fine) is happily watching Matlock reruns and he’s siphoning the gas from his pickup into the mower. Any system that relies on people putting others’ perceived needs above their own is a system bound to fail. It violates the self-interest principle, which instructs us to assume that people will usually put their own interests before others’—even if that involves lying, cheating, or worse.
What we need, then, is a system that induces people like my family to give up some of their gas and transfer it to exactly those who really can’t go without. Crucially, we need a system that does not rely on either:
1. A decision-making authority having perfect knowledge of thousands of different people's uses and valuations of gasoline; or
2. Trusting people to put others’ interests (most of whom are total strangers) ahead of their own interests.
What we need is a price system!
Let’s say the gas price had been $3 per gallon. The supply disruption sets off a chain reaction of market forces that push the price up, let’s say to $4 per gallon. What happens at this new equilibrium price? Will Mr. Mow-it-All cut back on lawn care? Heck no! I honestly think he’d drop his satellite TV service before being deprived of his perfect lawn. Will the sickly old lady (bless her heart) cut back on her doctor visits? Hardly. It’s truly a matter of life and death; a permanently higher gas price might mean fewer presents for her grandkids, but she will endure it.
What will my family do? I reckon that continuing our old driving habits costs us an extra $720 per year when the price of gas rises from $3 to $4 per gallon. (That’s money we could spend on Christmas presents, money we could donate to the church, money we could use to go out to a nice restaurant 10 more times a year, and so on.) We’re switching to carpooling full-time, which actually saves us $2,500 a year, because now we rarely need fill the SUV at all. Informed only by the price change—and nothing more—my family alone goes from using 18 gallons per week to 5 gallons per week, “liberating” 13 whole gallons of gas for others’ uses. Similar choices will be made throughout the market; higher prices will induce those who can more easily forgo some gas consumption to do so, enabling those who really do need to maintain their old consumption patterns to do so.
What the market did that no central planner (however benevolent) could do, and no self-interested people (however nice) would do, is to seamlessly divert resources from lower-valued to higher-valued uses without muss or fuss. All it took was a naturally occurring price change, a process that—if markets are simply left free to operate as we know from both theory and practice they will—happens almost automatically. The strong and swift operation of market forces leads us to change our behavior in changing circumstances. (And to think, we haven’t even addressed the greater incentives that the higher price creates for suppliers to get creative about bringing in extra gasoline to make up for the shortfall!)
You might be thinking, “well, that works for you, Watts, because you’re an economist! We can’t trust the average person to react appropriately to the price changes.” Nonsense, I say. Yes, as an economist who is quite conscious about prices and my own budget, I agree that I will be among the first to react to a price change. But the beauty of markets is that, eventually, everyone in the economy is left with no choice but to respond to price changes. Stubborn refusal to adapt means you’ll quickly go broke.
You can see why Adam Smith marveled at this process, stating that, within the price system, people are “led by an invisible hand to promote an end which was no part of [their] intention.” You can see why Frédéric Bastiat attributed the smooth functioning of inordinately complex world markets to the hand of “Providence.” And you can see why Leonard Read described the market process in terms such as “wonder” and “miracle.”
This is not “market fundamentalism.” Markets work. If only enough people understood this, we might someday rid ourselves of the constant political meddling that, although usually well-intentioned, almost always makes things worse for everyone.