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

supply shrinks, and prices will begin falling once the supply improves. Rising prices in the short term actually help reduce prices in the long term by increasing supply. They do this in two ways. First, higher prices create a strong profit incentive for companies to find whatever ways they can to rush supplies into the area. The more profit to be made in a given area, the harder and faster people will work to transport gas there.
Secondly, temporarily high prices reduce demand. They encourage people to car-pool, use public transport, and take other unusual steps. Indeed, this kind of economizing was seen throughout the country as gas prices rose nationwide after Katrina.5 Naturally, the poor will feel more pressure to take these kinds of steps than the better-off. This, at first glance, seems unjust. But the poor, like everyone else, will benefit when temporarily high prices result in increased gas supplies, ultimately leading to a faster reduction in prices.
Temporarily higher prices assist energy recovery in other ways as well. The prospect of higher prices after a hurricane gives oil companies an incentive to set aside more gas as a reserve for such a contingency even before a specific hurricane is forecasted. Storing gas is costly, and if we want gas companies to bear those costs, we had better compensate them.
Thus, we see that one need not resort to corporate conspiracy theories in order to explain Katrina’s effect on gas prices. The U.S. oil industry was no more monopolistic when gas prices rose just before Hurricane Katrina than it was two weeks earlier when prices were lower. Neither did the companies suddenly become greedier. They were simply reacting to the ever-present forces of supply and demand. Some may argue Katrina was merely a pretext for U.S. oil companies to raise prices, and that they jumped the gun by hiking prices before the storm actually hit. But if there were really no justification for the higher prices, then why did oil prices rise worldwide after the hurricane? The simple, non-conspiracy explanation is that we live in a world market for gas and the loss of Mexican Gulf production means less total oil for the world to spread around.
But the senators who conducted hearings about gas prices seemed more interested in finding a politically-attractive scapegoat than evaluating the complex factors involved in determining gas prices. In fact, Senator Byron Dorgan freely admitted this, declaring, “None of us knows much about pricing . . . .But we see the pain of the consumers, and we see the gains of the companies.”6 So the senators considered various measures to put an end to “price gouging;” that is, to stop the temporary rise in prices during disasters that is so crucial to helping energy supplies recover.
One such proposed measure was used to ill effect during the oil crunch of the 1970s—price controls. But instituting government price controls would have the precise opposite effect of the one intended. Without the prospect of high prices and high profits after a disaster, gas companies won’t store as much gasoline. Thus when disasters hit there would be much bigger shortages. The end result is easily predictable: artificially cheap gas available only to those people willing and able to wait all day in line to get it. Ironically, the cost of this waiting (in terms of the money people could have made if they had been working during that time) would probably more than wipe out the savings that consumers would reap from the controlled gas prices.
The argument for “price gouging,” and against price controls, also applies to other goods and services. For example, stamping out price gouging by hotels would simply result in a larger number of people being left homeless after fleeing a storm. No one wants people to pay more for a hotel, but we also want everyone to find some place to stay during emergencies, when hotels quickly reach capacity. As the price of a hotel room rises, some people will inevitably decide to share a room with others. A family that usually gets one room for the kids and another for the parents may choose to crowd together in one room rather than pay for another expensive room. At high enough prices, friends or neighboring guests may share quarters as well. The more people double up in this manner, the more rooms are freed up for other families and people who otherwise may be left with no place to stay.
We economists may dispute many theories amongst ourselves, but we all agree on two things: first, that when demand rises or supply decreases, prices will rise; and second, that price controls result in shortages. This, of course, was the outcome of the gasoline price controls instituted in the 1970s. Americans waited in lines for hours to fill up their tank due to chronic shortages, which instantly disappeared as soon as the price controls were removed. So why does this debate over price controls never end?
One problem is time lags. People see the short-term effects of controls in keeping prices low, but it is only later that the pernicious effects of shortages set in. People naturally find it easier to make connections between events that occur closely in time. Imagine if a day elapsed between the striking of a match and the resulting fire. Some people would fail to associate the two incidents. Many other events would have occurred during the intervening twenty-four hours that could seem to explain the fire.
Suppose that tomorrow the government capped gasoline prices at their current price. Surprisingly, the controls would temporarily increase the amount of gas for sale. As previously mentioned, gas companies hold extra supplies because of the possibility that prices will rise in the future. The greater the chance of future higher prices, the more gas that companies will store. But when price controls are imposed, firms no longer have any expectation that prices will rise. In turn, they no longer have any reason to hold these inventories