It is impossible to understand the economy—that is, the economic consequences of individual actions—without understanding the role that prices play or are prevented from playing. This was a crucial scientific discovery of modern times. For that very reason, microeconomic theory used to be called “price theory.” So it is troubling to observe that many of our contemporaries and even many financial journalists ignore that discovery. Even economists tend to forget it when their moral values or virtue signaling is at stake.
An illustration of the problem was given by a Wall Street Journal feature of August 21 titled “Why Are There Still Not Enough Paper Towels?” The role of prices and price controls is nowhere mentioned. The very word “price” only appears twice, mainly from a management perspective: the competition of “Japan’s low-price cars” in the 1970s and the fact that overcapacity “would not allow you to price in a way that meets customer needs.” This last phrase, from P&G’s chief executive, could be read as referring to prices established on free markets, but it is as close as the story comes to prices. Not surprisingly, the report cannot explain why a shortage of paper towels persists:
The United States of America, heralded as the land of plenty, still doesn’t have enough paper towels. … An average of 21% of household paper products were out of stock at U.S. stores as of Aug. 9
The story’s “economic” explanation is essentially that
[t]he scarcity is rooted in a decadeslong quest by businesses at all levels, handling many different products, to eke out more profit by operating with almost no slack.
In other words, the culprits are bad capitalists who are trying to maximize profits with tricks such as lean manufacturing and just-in-time delivery. The authors do not conclude, but could as well have concluded, that this is why so few shortages exist under communism and socialism, in Cuba or Venezuela, not to mention the former Soviet Union.
The real reason for persistent shortages, as I explained in many recent Econlog posts (including “Why Shortages Are Not More Widespread,” August 17), is that prices are capped under the threat of government prosecution. It is that consumers are forbidden to bid up prices. It is that bad capitalists are forbidden to maximize profits to respond to consumer demand, except sometimes stealthily. Being an obedient government crony is becoming an easier path than serving consumers.
The featured image of the present post is a photograph I took last week of the gun counter at a major retailer in Maine. It illustrates what a “land of plenty” looks like when price adjustments along supply and demand curves are forbidden.
The Wall Street Journal story has some feebly redeeming value. It provides many examples of why marginal cost increases with production. It hints at the fact that reducing product diversity has been a stealth way of responding to consumer demand despite price controls. But as a purported explanation of why shortages persist, it is at best misleading.
READER COMMENTS
Jon Murphy
Aug 24 2020 at 1:35pm
This quotation, I think, highlights the very confusion people at all levels have with economics. They assume there is just some pie and the only question is about distribution.* Even among profession economists, we see this (I’d argue this is the problem with much of Samuelsonian economics). Relatively little attention is paid to the entrepreneurial and production process, save for some invocation of a production function.
“Land of plenty” assumes “plenty” of something already in existence. But there weren’t just paper towels waiting in warehouses. They had to be produced and distributed, not merely distributed.
As a final aside, this confusion is why one should be skeptical about awarding businessmen too much credit for knowing economics even if they are successful. You can be successful without fully knowing why you are successful.
*In a sense, this can be traced back to Lord Robbins’s description of the economic problem as “the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses,” but that is a discussion for another time.
Craig
Aug 24 2020 at 1:38pm
Producers today are very efficient of course. The article is critical inasmuch as companies like the maker of Bounty, P & G essentially doesn’t have sufficient slack in their supply chain to fill current demand for paper towels. The article also notes that they will not expand capacity. They shouldn’t. Right now cleanliness is next to godliness, for sure, but the vaccine is coming and right now you really should not anticipate that the surge in demand is permanent in a way that you should be contemplating expanding production.
In a sense, the authors are Black Swanning. P&G apparently is supposed to look into the future and see the potential for a pandemic and make sure that it can manufacture Bounty accordingly. Now, after the pandemic, it becomes evident that the pandemic should have been planned for. That’s Monday night quarterbacking. There are any number of low probability, high impact events that we could theoretically be preparing for right now.
https://www.forbes.com/sites/stevebanker/2019/11/05/procter–gamble-embraces-continuous-planning-and-execution/#6a54ee83ed1d
2019 article….
“The 2017 hurricane season,” Mr. Herzog said, “was a big event on our journey. We saw Irma coming, a Category 5 hurricane, and its path.” They were able to leverage their digital tools to see what plants, supplier plants, and customer distribution centers were in the path of the storm. P&G activated its business continuity plans and repositioned inventory so that when the hurricane passed, they could supply consumers with what they needed most.”
Impressive actually and today, August 24th, 2020, I can’t say I have difficulty finding paper towels.
Pierre Lemieux
Aug 24 2020 at 10:55pm
Interesting article, Craig, thanks. But note one thing: whether P&G or any of its competitors will increase the size of their production facilities (“increase capacity”) depends on expected future prices. If P&G thought that the price of a roll would jump from $4 to $10 (perhaps after a short-term jump to $40), as opposed to being capped to $4 by law, they would be interested in increasing capacity for when this time comes.
mike
Aug 24 2020 at 11:45pm
Pierre, while agree in general that prices matter, i don’t really think the paper point makes a ton of sense. Fundamentally the amount of paper products, and paper towells in specific will be pretty flat over the next decade. No real reason to think that structurally it will go up much. So why would they build new manufacturing lines? If anything, people already panic bought, so demand may slightly DIP over the next 12 months.
At the margin, I agree they didn’t want to increase prices significantly over the short run, which probably kept them from running a 3rd (night shift) to increase production etc, but if they had to more equipment or buildings i don’t think prices would matter there because those new lines woulnd’t be need for 10+ years for new demand etc.
Jon Murphy
Aug 25 2020 at 9:11am
Mike-
Remember that prices do not affect just production. True, in the short run (if firms do not believe the increase in demand is permanent) existing firms may run 3rd shifts, reduce downtime, etc., (in econo-speak: run down their capital) rather than add new machines.
But the market supply curve does not just look at existing firms. It takes into account smaller suppliers who may be tempted to enter the market if the price gets sufficient high that it covers marginal cost. Other paper good manufacturers may switch from (say) paper bags to toilet paper at a sufficiently high price. Imports can enter (assuming no efforts to block them). Other manufacturers not even in the industry may enter (like distilleries did when hand sanitizer prices shot up).
Furthermore, prices signal to consumers the need to conserve. Relatively high prices mean people no longer use the good that is now relatively scarce for low-valued uses. TP, for example, may no longer be used to kill the spider in the corner. At a sufficiently high price, consumers may begin to switch to other goods like bidets, moist wipes, etc etc.
In short, there are lots of ways people (both buyers and sellers) can adjust, but prices signal the need to adjust. Even if a producer is constrained, prices still matter. Such constraints cannot explain the real shortages of paper products.
Craig
Aug 25 2020 at 10:43am
First off, is P&G even subject to a cap? There are 50 states’ laws on the topic. Yes, FL has a law barring excessive price increases, right?
“The amount charged grossly exceeds the average price at which the same or similar commodity was readily obtainable in the trade area during the 30 days immediately prior to a declaration of a state of emergency, unless the increase in the amount charged is attributable to additional costs incurred in connection with the rental or sale of the commodity or rental or lease of any dwelling unit or self-storage facility, or regional, national, or international market trends.” FL STAT: 501.160
In other words, Publix can sell a roll of Bounty for $8 if P&G is charging $4 per roll.
[Professor] “If P&G thought that the price of a roll would jump from $4 to $10 (perhaps after a short-term jump to $40), as opposed to being capped to $4 by law, they would be interested in increasing capacity for when this time comes.”
That means the profit during the surge demand period will have to compensate for lower margins to carry excess capacity. P&G margin was 15% +/- before falling to 6% in 2019.
The pandemic surge demand just isn’t a compelling enough of a business case to produce a second plant. Because no matter what the price is in the short term, the vaccine comes, the price goes back to a $1 per roll and now they are stuck with two plants operating at 50% capacity. <– you don’t want to be that guy.
Honestly I don’t believe P&G is failing to expand capacity because the government is capping their prices at the retail level. If you said to P&G TODAY that they will perpetually sell 2X the amount of paper towels at the pre-pandemic price, they’d expand capacity even if it cost them twice as much to make them per unit.
Jon Murphy
Aug 25 2020 at 11:38am
See my comment to Mike above on why that point is irrelevent.
Further, see my comment here to Michael Pettengill on why the allowance in the Florida statute does not matter.
Pierre Lemieux
Aug 26 2020 at 10:25am
@Craig: There are about 40 state laws, which means that you can be prosecuted by any one of 40 state attorney generals. It also means that there are different and confusing legal reguirements. If what you are saying is that enforcement is arbitrary, you are certainly right. (To my knowledge, for example, online sellers of ammo have been left alone even if, in some cases, they charge four times pre-crisis prices. Selling ammo is bad, so price-gouging becomes good?) However, when organizers of auctions are prosecuted, anybody can be. If the probability of successful prosecution is 10% and you will have to pay $100,000 (including legal fees) in seizures, legal costs and fines, your expected cost of selling at a price your buyer wants to pay is $10,000; for a large company, the expected cost including PR would be several times that amount. This explains why few small businessmen have made a fortune, which they could, on the newly created black markets.
Daniel
Aug 25 2020 at 12:44am
The funny thing is that they critique capitalism not having enough “slack”.
But no doubt in a few months they’ll critique capitalism for being wasteful and bad for the environment.
Ignoring the fact that you cannot have both slack, and frugal utilization of land and materials.
You either waste material building a factory that produces in excess, and no doubt costs more to heat in winter, or cool in the summer (and shifting factories to more remote locations as land becomes more scarce), or you use rare materials like steel to actually produce something needed now.
Making claims that we should build factories with enough slack to meet the demand of once in a 100 year pandemic that no one saw coming is just the height of arrogance.
You might also be interested in the fact that computer memory price / GB have been mostly stagnant (ignoring inflation) for about 8 years, memory has gotten faster, but the main culprit is that the mobile sector has exceeded expectations, consistently outstripped demand, and a lot of the manufactures are enjoying good profits but even then, building a semiconductor factory is highly risky, and no one wants to drive themselves in to unprofitable spending.
Phil H
Aug 25 2020 at 10:01am
Wait, are there government price caps on paper towels?
Christophe Biocca
Aug 25 2020 at 10:13am
Not price caps per se, but vaguely-defined anti-price gouging laws. Here’s Ontario as an example: https://www.ontario.ca/page/report-price-gouging-related-coronavirus-covid-19
It doesn’t set explicit caps, but if you’re found to be charging a price “that grossly exceeds the price at which similar goods are available to like consumers.”, you’re fined and/or imprisoned:
Jon Murphy
Aug 25 2020 at 10:35am
Yes. Here in the US, paper towels and other paper goods are covered under price gouging legislation.
Pierre Lemieux
Aug 26 2020 at 10:32am
@Phil H: Assuming you were not making a joke, have a look at my previous posts, where I have given many examples over the past few months, including recently. Another way to be persuaded would be to try yourself so sell paper towels on the (online) black market: you can make a fortune.
Thomas Hutcheson
Aug 25 2020 at 10:19am
There is a grain of truth in this post (although I suspect that legal constraints on prices have very much to do with this particular example), but it does not go far enough in looking for more market-friendly solutions to the problem that interference with prices are intended to solve. Reformers need to realize that policy changes have both incentive and distributional effects. To ignore the latter only inures the futility of the effort to reform.
Pierre Lemieux
Aug 26 2020 at 10:43am
@Thomas Hutcheson: In previous posts over the past several months, I have given examples of sellers of many other goods who have prosecuted for selling other goods at illegal prices. Some 36 states have “price gouging” laws, plus the federal Defense Production Act.
Anonymous
Aug 26 2020 at 12:40am
I read the journal article and had much the same thought. Interesting that many restrictions to price fluctuation are not just government imposed. My company sells to all the major supermarkets. When the shutdowns began, we saw raw material prices increase and we in turn tried to raise our prices to the supermarkets who were placing large orders to meet rising demand. These companies refused to honor our prices and pushed back saying they needed 60 days notice of an increase. Without being able to pass along our increased costs, we were forced to short orders and sell to those who accepted the new prices. There was no incentive to increase production without begin able to cover our costs.
Pierre Lemieux
Aug 26 2020 at 10:13am
@Anonymous: I would suspect that the supermarkets did not want to increase prices because of fear of prosecution, with all the financial and PR problems that this could raise. When auction organizers are prosecuted for selling at the highest bidders, anybody can–even if prosecutions or suits are unequal and arbitrary.
Anonymous
Aug 26 2020 at 1:28pm
I wasn’t aware of the extent to which these laws could have an impact, but that makes perfect sense. The desire for these types of regulations seems to be driven by the belief that prices are moral. I would think that the economics profession could disabuse students of this notion. Unfortunately, one of my children, who has taken many economics classes both in high school and college, was incensed when, early in the shutdown, some Amazon sellers had purchased all the sanitizer in their area and were selling it on Amazon for comparably high prices. She was unconvinced when I explained that prices are just information and that the supermarkets should have been charging more in the first place. What was she being taught in these classes?
Pierre Lemieux
Aug 26 2020 at 1:53pm
Very good question! And, indeed, nobody is forced to buy at higher prices: he can be satisfied with having none of the good. In Jonathan Anomaly et al., Philosophy, Politics, and Economics, you and your daughter might be interested in three articles that take different positions on “price gouging”. I reviewed this book in Regulation: “The Handicapper General” (scroll down the review section).
Anonymous
Aug 26 2020 at 6:49pm
Thank you very much! We will be sure to spend some reading time together!
Mike Sproul
Aug 27 2020 at 3:52pm
“microeconomic theory used to be called “price theory.”
The word “microeconomics” makes one think that it is just about individuals and firms, when in fact, micro is also about the big picture.
In a better world, microeconomics would be called “economics”, and macro wouldn’t exist.
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