Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't

neither the authors nor the referees nor the journal editors really understood the institutions they were discussing.7
Focusing so intensely on theory, economists too often take on the role of central planners. They identify the “right” prices that companies should charge and the “right” policies they should adopt without considering why market incentives haven’t encouraged firms to take these measures on their own. A greater problem, though, is that some economists try to pinpoint the subsidies or taxes that should be applied to goods to ensure that the “right” amounts are sold.
But as Milton Friedman noted, a tax that might work in theory is difficult to make succeed in practice. Friedman and his wife Rose observed: “Government is one means through which we can try to compensate for ‘market failure,’ try to use our resources more effectively to produce the amount of clean air, water, and land that we are willing to pay for. Unfortunately, the very factors that produce the market failure also make it difficult for government to achieve a satisfactory solution . . . .Attempts to use government to correct market failure have often simply substituted government failure for market failure.”8
We should remember the gasoline shortages of the 1970s that accompanied government price controls. People may complain about paying a lot for gas today, when the market determines prices, but at least we know that we’re unlikely to find a gas station completely out of gas or, as we often saw during price controls, a lack of gas in all the gas stations in an entire area.
Central planning has its appeal. After all, it’s hard for many people to comprehend how the seeming chaos of markets, with millions of separate decision makers, can somehow translate into economic efficiency. But economic freedom has its advantages. The key is to allow firms to set prices that accurately reflect all their costs and their customers’ preferences. Analysts and politicians can study trends for years without being able to account for all the factors that go into a single price. Planning accurate prices is near-impossible, and when the government gets them wrong, the results are shortages, black markets, or other harmful market distortions. Simply put, freedom better ensures that people get what they want. As Adam Smith noted, prices create incentives for people to meet the needs of others. Despite all the various guises in which central planning has been attempted, it is no real surprise that free economies work best.9

1
Are You Getting Ripped Off?
Speculators, Price Gougers, and Other Good People
“My constituents think someone rigged the price [of oil] and someone—them—is getting ripped off.”1 So thundered Republican Senator Pete Domenici at one of two Senate hearings convened to grill oil company executives about the steep rise in oil prices following Hurricane Katrina. Accused of price gouging and “unconscionable profiteering,” oil executives faced the “bipartisan wrath” of furious senators, which surely reflected the genuine anger felt by many of their constituents at rising gasoline prices.2 Some senators offered half-hearted objections that the oil companies might not really be the pillaging Mongol hordes as they were described. But no one on the panel seems to have made the really vital argument—what if, by dramatically raising prices during Hurricane Katrina, the oil companies were doing a good thing?
Many people cite corporate greed or monopoly power as the only possible explanation why gas prices began rising even before Hurricane Katrina hit land and disrupted oil production in the Gulf of Mexico. After all, why should prices at the pump increase before a company’s costs have gone up? Some take this argument even further, claiming that prices should not have risen even after Katrina hit.
Let’s consider the more difficult questions—why would prices rise before Katrina’s effects were actually felt? And how can this possibly be a good thing? Before analyzing the behavior of oil companies, let’s look at the motivations of individual consumers and speculators. If a powerful hurricane is forecast to hit land in a week, and people expect that gas prices are going to rise after the storm hits, then the difference in the price today and the expected post-hurricane price creates the opportunity for consumers to save money today by filling up their tanks when gas is cheaper. Speculators do the same thing. They profit by buying gas when it is cheap and selling it for a higher price after the hurricane. What’s more, by doing so, these speculators are performing a valuable economic service—they are removing gas from the market at a time when it’s plentiful and adding it at a time of shortage later.
Oil company executives reason the same way. By raising gas prices before a hurricane, they reduce the demand for gas and are left with a bigger supply, which they can sell after the hurricane for a higher price. The downside of this action, of course, is that everyone has to pay more for gas before a hurricane hits. But no one talks about the upside—after the hurricane, when gas supplies are severely reduced due to the damage to production and supply lines, oil companies are sitting on increased inventories resulting from the pre-hurricane price hike. These inventories then hit the market right when they’re most needed. And this extra supply at such a crucial time helps minimize the overall price increase.3
In other words, by raising prices before the hurricane hits, oil companies keep the post-hurricane price hike much lower than it would be otherwise. So, from an economic perspective, oil companies should raise prices before a hurricane until the price reaches the expected post-hurricane price. At that point, there will be no more profits to be made from this speculation, and there will also be additional inventories to help cover the expected post-hurricane shortages.4
If the damage from the storm is worse than anticipated, prices will continue to rise. But in the long term, the higher prices will help accelerate the affected area’s energy recovery. After a hurricane, gas prices rise because the