Using Price to Control Demand

The core principle of economics is the law of supply and demand. Raise the price and demand will go down and vice versa. Common experience tends to confirm this, although with a fudge factor called "elasticity". If the demand doesn't go down as much as one would expect then it is said that demand is inelastic.

As the world enters into a period of fossil fuel limits, and as demand increases due to developing countries and overall population growth, discussions of using pricing to control demand have become popular.

This is all part of the "magic of the market" and "invisible hand" that has been standard fare since the rise of mercantilism in the 16th and 17th Centuries. The sensible economists are pushing for an increase in the cost of fuel through distinctly non-free market mechanisms. The most common idea being some sort of new tax plan.

The thing that doesn't exist in these economic discussions is any sense of morality. Economics claims to be value neutral, which means in actuality that it favors the haves over the have-nots. Let's take fuel as an example. There is a segment of the market that is relatively poor, but lives far from their job and in an area with no mass transit. So they drive and use an older, less efficient vehicle. The economists say raise the price of gas, what happens?

The wealthy, SUV-driving, suburbanite complains a bit, but can easily absorb the increased expense. The poor person suffers. Whatever their choices it is not value neutral. They can cut back on some other expense, like food or health care or they can attempt to drive less, perhaps by leaving their job and finding work elsewhere. Those in the middle can cut back on discretionary driving - a few less trips to the mall. The net effect will be a drop in demand. The economists are once again proved right, but they ignored the uneven distribution of hardship. This is not the "optimum" solution when ethical considerations are given some weight.

Governments know that using pricing is not a realistic solution which is why it is used so little in practice. For example, in the US West there are water use compacts between states and regions. Water is sold below "cost" to farmers while water is rationed to homeowners who want green lawns. Many agricultural products have subsidies which keep the price down for consumers. In parts of the world fuel is subsidized by the government as well.

Even in standard commercial settings pricing is only loosely used. When a hot new consumer item is released the maker sets the price, he doesn't leave it to the "market". He may be guessing that the price is the optimum for demand, but he doesn't take the risk of finding out. If he did then why not use an auction? When Apple sells its latest Iphone it doesn't sell to the highest bidder, it sells first come, first served.

So we see alternatives to using pricing to control demand being used all the time. There is the theory and there is the real world. So what could be done to control demand for fossil fuel that won't make the poor suffer?

The most common idea in times of shortage has been to ration supplies. The public generally supports this because it is seen as "fair", everyone gets an equal amount. Making ration coupons tradable also allows for demand to be better adjusted to supply and avoids the rise of a black market. Those who need less can sell their coupons or barter for something else. The free-market ideologues see no contradiction with proposing this for pollution credits, but can't conceive of it for gasoline.

Another technique that governments have used is price controls. The US did this during WWII (when it worked reasonably well) and under Nixon (when it didn't). Setting prices doesn't control supply, supply is limited in the first place - hence the need for controls. It is an effort to mitigate unfairness.

Subsidies can, in addition to being provided to producers and consumers, be provided to competitors. Right now there is a debate about providing incentives to alternative fuel efforts, such as wind and solar energy. Ethanol is currently receiving a subsidy to the producers.

If the item is not a necessity, but is highly prized, then a lottery can be used. Theater tickets frequently use this scheme when demand exceeds supply. They seldom raise the price to cut demand, fearing resentment from the less well-healed. The new sports arenas have started to get away from keeping ticket prices reasonable and this has caused a lot of fan resentment. It will be interesting to see if new sports arise to capitalize on this dissatisfaction. In the US there has already been a small increase in minor league baseball as a result.

So we see that in the real world we have subsidies, rationing, price controls, social compacts and encouragement of rival products as ways to control supply and demand. None of them use market-based pricing, because they all acknowledge that there are other factors beside "efficiency".

It is time for economics to shed its false claim to having value-neutral theories and recognize that people are not averages. We need a new school of ethical economics, devoted to minimizing harm, not maximizing growth.

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Copyright © 2008 Robert D Feinman
Feel free to use the ideas, but the words are mine.