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Gasoline, crack cocaine and health care
Price coordinates and facilitates the activities of the marketplace.
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What do gasoline, crack cocaine and health care have in common? Answer: They all obey the law of supply and demand. They all have a price.
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Have you ever thought about price and the critical role that it plays? Price is actually the language that we use to communicate in the marketplace. This marketplace is not necessarily a place but rather a the process whereby buyers and sellers come together to exchange goods and services. This exchange can be as simple as purchasing an item at a yard sale with “cash on the barrelhead” or it can be as complex as buying sophisticated puts and calls or derivatives on margin in the New York Stock Exchange.
It is price that coordinates and facilitates the activities of the marketplace. That hair brush that you purchased was made in China. This apple was grown in Chile. That wine was made in France. Think of the incredible myriad of activities that were needed to produce, ship and then market these items. And for every activity someone had to be paid. At each step along the way it was price that coordinated these activities and then summed them all up in the form of a few digits, the final retail price.
Understanding pricing
To better understand prices and how the marketplace works let’s start with the classic story by Leonard Read titled I, Pencil. In it, Read contemplates a simple wooden pencil and considers how truly complex the process is to produce it. It takes literally thousands of people scattered around the globe to bring it to the shelf in your store. But not one of these people know how to make it. In fact there isn’t a one in those many thousands who contributes more than a tiny, infinitesimal bit of knowledge. Each does his or her part in coordination with others to make the pencil. Think about it. The entire process of manufacturing a simple wooden pencil involves many thousands of people and it is price that holds them all together.
Even more amazing, as Milton Friedman pointed out, is that none of the thousands involved in producing the pencil performed his task because he wanted a pencil. In fact, some among them had never even seen a pencil in their entire lives. But each saw his work as a way to get the goods and services he wanted. As he explained, “no one sitting in a central office gave orders to these thousands of people … These people live in many lands, speak different languages, practice different religions, may even hate one another — yet none of these differences prevented them from cooperating to produce a pencil.” None of us, as Read stated, even the wisest among us, would know how to direct and coordinate all of the activities needed to produce this pencil by so many individuals scattered across so many countries and continents. Yet in spite of this, it was produced.
But how were the activities of all of these people coordinated? It was all done via the price system. Prices communicate information. People then act based on this information. Prices help workers determine what type of work would be most profitable for them to do and which employer it would be most profitable to sell their labor to. Likewise, prices of workers help employers determine who to hire and for how long. Prices of products also help producers determine what to produce, how to produce it and in what quantities. Meanwhile, prices help consumers determine what to buy and how much.
For example, in Phoenix when one of the main pipelines that brought gasoline into the city ruptured there was an immediate drop in the supply of gasoline. The price of gasoline tripled overnight. These prices sent a very strong message to not only consumers but also producers. Prices literally shouted out to consumers: We have a shortage, don’t drive if you don’t have to, car pool if you can! This decreased the demand for gasoline. Simultaneously, prices cried out to producers: Because of a shortage Phoenix is paying top dollar for gasoline, maximize your profit by selling your fuel here and not elsewhere! In response, oil tanker trucks began driving fuel into Phoenix from the surrounding states. The result was an increased supply. Price had done its job to alleviate the crisis. It decreased demand as it simultaneously helped to increase supply.
But what if Phoenix had laws controlling the price at which gasoline could be sold? Quite simply the reverse of the above would have occurred.
With laws keeping prices artificially low, drivers would not have cut back on their driving. Consumption thus would have been higher. And with artificially low prices, oil tankers would not have been bringing fuel to the city at all hours of the day and night. Thus supply would have been less. Had price controls been in effect, the crisis would have been much worse and more prolonged.
Supply and demand
The laws of economics are universal. No one is immune from them. They even apply to illegal activities. Last year it was reported that significant progress had been made in the war on drugs. Because of this the supply of drugs on the streets had decreased. The result? Price did its job of conveying this information. The price of crack cocaine went up considerably. In accordance with the law of supply and demand, decreasing the supply without decreasing demand resulted in an increase of price.
When buying or selling, it is critically important that market prices be used. Such prices are real and reflect the true state of the marketplace. With real prices, all types of voluntary mutually beneficial relationships can be formed in order to most efficiently provide for the exchange of goods and services. To be successful in business, these prices have to be low enough to attract buyers but high enough to pay the costs.
Unfortunately, prices can be controlled by legislation but costs can not. When third party payers apply price controls unintended consequences occur. Because prices established by the market are true prices they are always in a in a constant state of flux as they respond to the many changes occurring in the market place. But prices set up by third parties and unable to respond to the many vicissitudes of the market place. Because of this they do not reflect the true state of the market and lead to miscommunication which ultimately results in misallocation of precious resources and shortages. Because they obey the law of supply and demand, price controls cause shortages.
Although we would wish otherwise, health care, like crack cocaine and other goods and services, is not immune to the laws of economics. Thus, as price controls on health care have increased, shortages have begun to occur not only in the services being provided but also in the number and type of health care professionals who have continued to provide them.
Richard Dolinar, MD, is a Senior Fellow in Healthcare Policy at the Heartland Institute, Chicago, a Clinical Endocrinologist in private Practice, Phoenix, Ariz., and is a member of the Endocrine Today Editorial Board.
For more information:
- Read, L. I, Pencil. My Family Tree As Told to Leonard E. Read. New York:The Freeman;1958. Accessed on the web www.fee.org/library/books/ipencil.asp.