Gasoline Rationing: Another Economic Fallacy Rears Its Ugly Head

On the free market, the price of a particular economic good is set by the subjective valuations of the marginal (least eager) buyer and the marginal (least eager) seller. The market price will be a price that is low enough such that the least eager buyer values the good more than he values the money surrendered and is high enough such that the least eager seller values the money received more than the good surrendered.

If an outside force violently intervenes in the market to establish a maximum price that is higher than the market price what must occur? The person who was previously the marginal buyer is now an enthusiastic buyer as he can obtain the good at a lower price than he was previously willing to pay. Price suppression must result in evermore people willing to purchase the good. In other words, demand will increase. If the maximum price is introduced suddenly, there cannot be an immediate increase in supply, thus demand and supply are no longer in balance, the market ceases to function. Then how will goods be distributed? Some form of rationing must emerge. It can be implemented by the sellers or by the agency that imposed the price ceiling. Either way will leave some people dissatisfied regardless of their willingness to pay.

Now let us consider what happens if the supply of a good suddenly decreases and the free market is permitted to operate. As in the situation described above when a maximum price has been imposed, we are in a situation in which demand is greater than supply. On the free market, this is a clear indication that the market price is too low and thus prices should rise. To what extent? They should rise to the height at which our original situation has been reestablished, namely that at which the marginal buyer and marginal seller agree to an exchange. Here, there is no arbitrary or enforced rationing system to distribute the given good. If prices are permitted to move freely, the market discovery process must move in a direction such that the market clears. Unlike in the case with rationing, a buyer who is ready to pay any price is always satisfied.

The great tragedy of our times, is that such basic lessons are apparently unknown to either the public or government officials.

Hurricane Sandy unveiled two of the most preposterous economic fallacies: the broken window fallacy and the belief of the efficacy of price controls and rationing. Despite unassailable theoretical arguments as well as repeated empirical evidence against such fallacies, they never seem to die.

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