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Econ 101: gas is too cheap

Posted by Richard on September 6, 2005

QandO’s Jon Henke apparently took a road trip this past weekend, and he wasn’t happy about all the service stations that were selling their gasoline too cheaply:

On my way back from Georgia, approximately 1/4th of the gas stations I encountered were completely out of at least one grade of gasoline. As we all (ought to) know, shortages (aka "excess demand") are caused by prices set below the equilibrium (market clearing) price. That is to say, if we’re seeing shortages, then prices aren’t too high…they’re too low.

If the Federal government wants to correct the "problem":

The federal government is also taking complaints about gouging at

…we might as well report gas stations who limit access to gas by under-pricing their fuel and causing shortages.

Henke bemoaned the widespread ignorance of basic economics, as evidenced by all the wailing and teeth-gnashing over gasoline "price-gouging":

This really is simple Econ 101 stuff. It’s hard to believe our major newspapers and politicians really can’t put 2 and 2 together and explain this to people.

Jon, Jon — why in the world would newspapers and politicians want to explain supply and demand to people when they can instead rail against the evil oil companies? BusHitler! Cheney! Halliburton! Aaaaaaaaaarghh!

Seriously, though, econ seems to be hard for many people to "get," as evidenced even by some of the comments to his post by people on Henke’s side:

…  "They have all that gasoline they bought at $2.50 a gallon, they should have to sell it at $2.50 a gallon." I tried, briefly, to explain the concept of replacement cost to him, but that just set him off.

 I suppose we’re into Econ 201 at this point, but "replacement cost" is irrelevant. For any given supply, the price is determined entirely by the demand for that supply. Cost of production doesn’t matter; if it did, I could make a good living selling carefully hand-crafted mud pies.

The "right" price for anything is always what the market will bear, just as the "right" acceleration of a falling object is 32 ft./sec.2 — it’s a law of nature. Any attempt to change it is as foolish as Canuck’s attempt to hold back the tide. Worse, because the market-clearing price conveys vital information to both producers and consumers — it signals how much demand there is for the product.

If politicians and bureaucrats — or even well-intentioned oil companies "holding the line" on prices as a gesture of public spiritedness — artificially force the price of gasoline below the market-clearing level, then in effect everyone is being lied to about how strong the demand is for gasoline. Producers and consumers both end up making decisions about their future behavior based on false information.

That’s bad in the short run because, as Henke noted, it leads consumers to miscalculate, causing shortages. But it’s worse in the long run because it leads producers to miscalculate, causing less than optimal allocations of capital and thus less than optimal economic growth. We will all be poorer as a result.

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