There’s a lot of discussion about how the computer chip shortage is causing problems for US manufacturers. But I rarely see any plausible explanations of why there is a chip shortage.
Articles on the subject occasionally mention the fact that auto producers did not order enough chips. But why should a reduced supply of chips cause a shortage? In the standard supply and demand model, a reduction in supply does not cause a shortage; it causes higher prices. I am still able to buy apples at the grocery store when there’s an unusually small apple crop; it’s just that the price is higher than usual. Why doesn’t that apply to computer chips?
There could be many reasons, but I suspect one factor is that chip manufacturers and/or wholesalers fear political retaliation if they raise chip prices to market clearing levels:
(Bloomberg) — The Biden administration has concluded that a global semiconductor shortage will persist until at least the second half of this year, promising long-term strain on a range of U.S. businesses including automakers and the consumer electronics industry.
U.S. officials plan to investigate claims of possible price gouging for chips used by auto and medical device manufacturers, Commerce Secretary Gina Raimondo said Tuesday.
Of course formal price controls are very bad. But laws against price gouging are equally bad. Even cultural norms against price gouging are bad. Price gouging is necessary for markets to do their job when there is a steep fall in supply or a steep increase in demand.
Foes of price gouging often assume that it’s a zero sum game. In fact, price gouging serves two important roles. First, it boosts quantity supplied. Supply is almost never completely inelastic over a period of several months or years. Second, it leads to the limited supply being allocated to those who place the highest value on the good.
Why don’t farmers get accused of price gouging? One theory I’ve heard is that the public (and hence politicians) tends to sympathize with producers that appear in children’s stories. Hence politicians favor farmers, teachers, fireman, police, etc.
READER COMMENTS
Fazal Majid
Jan 27 2022 at 7:14pm
Ah yes, the Richard Scarry theory of political congeniality.
Auto chips have to operate reliably in harsh conditions so they use older and more mature fabrication processes than cutting-edge chips like those in your phone, laptop or gaming video card. No one will build a new plant using tech that was cutting-edge 20 years ago, you have to use old fabs that have already been amortized to make the economics work. UMC, Taiwan’s No. 2 offered to build such a fab in exchange for a $1B guaranteed order commitment, but the offer was turned down.
That’s why it is pointless to talk about one chip market, there are several. Nimble and integrated carmakers like Tesla were actually able to substitute different chips, but the legacy carmakers are just too slow and hidebound to do that, instead they opted to lobby the Biden administration to pressure the Taiwanese government to lean on their chipmakers.
David Henderson
Jan 27 2022 at 7:36pm
Excellent post. It helps solve a puzzle I’ve been having. A friend asked me why I wasn’t writing about current price controls that cause these shortages. I told him that I wasn’t aware of such controls.
Fellow blogger Pierre Lemieux has pointed to some and now you have pointed to the Biden administration’s threats. I think the puzzle is being resolved.
Pierre Lemieux
Jan 28 2022 at 12:26am
David (and Scott): I wonder if another factor should not be added: the reputation problem of large firms (with a valuable brand name) who would violate the egalitarian religion of probably not the majority (of Americans, anyway) but the majority of the chattering classes and the SJWs. Take ammo. Despite the end of “price-gouging” emergency measures, you can’t find much ammo at Cabela’s or Walmart, who ration whatever they have because they sell at below-market prices. It’s cheap but they don’t have it. To buy some, you have to go to small, less known online sellers and pay much higher, roughly-market-clearing, prices. Cabela’s and Walmart will probably soon have to stop losing money and rise their prices, but in the meantime, many people observe a localized ammo shortage.
Scott Sumner
Jan 28 2022 at 1:32pm
I agree, and that’s what I meant in my reference to “cultural norms”.
Jose Pablo
Jan 30 2022 at 11:10am
“Even cultural norms against price gouging are bad”
Antimarket biases are a driving force of voter’s choices. Caplan did a great job explaining that.
I bet they are here to (at least) stay and (more likely) to grow.
“Cultural norms” being good or bad seems like a normative position. From a positive perspective they should be a relevant part of any model that try to explain “real reality” and assuming they would just go away does not seem a very realistic improvement.
Rajat
Jan 28 2022 at 2:33am
Early in the pandemic, there were major shortages of toilet paper in Australia because for some reason people were buying much larger amounts than usual (supply was largely unaffected). Supermarkets eventually introduced purchase limits of 2 packs per customer or something. Eventually supply was increased and the situation resolved. Similar, but less severe issues affected grocery staples like pasta, rice and meat. Supermarkets never even experimented with raising prices. There seem to be very strong norms here against ‘price gouging’, reinforced by community pressure via social media and the like.
Interestingly, the Australian government only legalised rapid antigen tests for personal use from the start of November. As omicron took off and the PCR testing system got overwhelmed, people (and eventually state government testing authorities) turned to RATs to meet the demand. But having only just been legalised and with no one anticipating the PCR system would be overwhelmed, Australia began suffering an acute ‘RAT shortage’ from late December that persists to the present day. But unlike toilet paper, which in Australia is largely sold by supermarkets and other established brick & mortar retailers, RATs were being sold at multiples of their former prices by online retailers and individual pharmacists and others who had stocked up. Social norms weren’t strong enough to ‘discipline’ all of these people, so the government introduced measures under the Biosecurity Act 2015 to prohibit RATS being sold at more than 120% of their purchase price. Of course, this reinforces the self-regulatory impulse of larger and more established retailers for the next time a similar situation arises. Your children’s story theory might be right. There aren’t too many fairytales about toilet paper or RAT suppliers. But when Cyclone Yasi struck Queensland in 2011 (and prior to that, Cyclone Larry in 2006), destroying banana trees and pushing prices from $3/kg to $12-15/kg, there were no anti-gouging rules to be seen. While bananas are probably not as ‘essential’ as toilet paper for adults, for many parents with very young children, bananas are a staple.
BC
Jan 28 2022 at 3:24am
“the public (and hence politicians) tends to sympathize with producers that appear in children’s stories”
Maybe, someone should write a children’s story about economists. 🙂
Jose Pablo
Jan 30 2022 at 10:43am
Not even the grown-ups can understand what economist really do …
Warren Buffett once said “If your company has one economist in the payroll it has one too many”
Alan Goldhammer
Jan 28 2022 at 8:05am
As one who tracks this regularly for investment purposes, the story is more complicated than Scott portrays it. Modern cars might have over 100 computer chips that do various tasks. It’s not just a question of having a single chip that does lots of different things. In 2020 when business and recreational travel went way down and close to zero, rental car companies saw their business dry up as well. Fleet sales of cars consequently took a nose dive which then impacted the used care market as rental car companies cycle cars to that market on a yearly basis. All of this led to great uncertainty for manufacturers with Tesla perhaps the lone exception (even so Tesla does not have nearly the sales of major auto/truck makers).
Most major semiconductor companies are moving into higher value added products and legacy chips mainly used by automakers are suffering. Intel is looking to move into some of these markets (disclosure – I have been an Intel shareholder for a lot of years) but it takes time to build new plant capacity and they don’t want to alter existing plants that may be running at capacity, producing other types of chips. In Intel’s case, they have recently been producing chips for computer graphics cards which have been in very short supply and are being rationed by retailers right now. The market has responded by seeing price increases of double or triple the introductory price of the GPU.
Chip shortages are multi-factorial and not amenable to easy solutions.
Jon Murphy
Jan 28 2022 at 10:03am
Your point is correct, but doesn’t quite answer the conundrum of “why aren’t prices rising?” Even if supply cannot be changed from a certain quantity, prices would rise until the shortage is eliminated given the Law of Demand.
Aaron W
Jan 28 2022 at 11:49am
I can’t speak for the cost of chips used by auto manufacturers, but the price of GPUs as sold by retailers (not just resellers) has definitely increased by quite a lot.
Fazal Majid
Jan 28 2022 at 5:06pm
GPU prices are being bid up by cryptocurrency miners, and are not caused by Covid shortages.
Aaron W
Jan 28 2022 at 7:59pm
Why would crypto miners bid up GPU prices if there was adequate supply?
Scott Sumner
Jan 28 2022 at 1:36pm
Alan, You said:
“the story is more complicated than Scott portrays it.”
The rest of your long comment provides absolutely no evidence that it is more complicated than I suggested.
Here’s what I actually suggested:
“There could be many reasons, but I suspect one factor is that chip manufacturers and/or wholesalers fear political retaliation if they raise chip prices to market clearing levels:”
Alan Goldhammer
Jan 28 2022 at 4:14pm
Jon Murphy
Jan 28 2022 at 5:14pm
Manufacturers are only part of the story. Scott also brings up wholesalers (not to mention retailers).
Further, I disagree with the contention that politics doesn’t play into firms thinking. Rather, the opposite is quite true, especially here in 2022. Pre-pandemic, firms devoted tons of resources to government compliance and lobbying. No reason to think that’s changed at all as the governments have seized more power.
Scott Sumner
Jan 29 2022 at 1:23pm
Perhaps you didn’t read the article, which suggested that wholesalers were being targeted.
Kenneth Duda
Jan 28 2022 at 10:57am
Scott,
When companies design products that include chips, they wind up locked in because changing to a different chip is very expensive (new PCB design, has to be validated, creates product variants that have to be serviced differently, can involve software changes too, etc.). So, companies buying chips frequently negotiate price at design time, when they have leverage. Chip suppliers sign long-term contracts guaranteeing a certain level of supply at a certain price. Historically, continuing tech improvements mean chip suppliers can expect falling costs — and will sometimes count on that, agreeing to a price that isn’t even profitable in the short term, relying on future cost improvements to make the contract profitable in the medium term. Now, imagine what happens when there are fundamental supply bottlenecks. Chip makers are contractually prohibited from raising prices. They’re losing money on a per-unit basis anyway. So, instead they raise lead times. We ration via queueing instead of via price, because price flexibility has already been negotiated away.
Sometimes, you can get more chips sooner by paying “expedite fees” that cut the lead time. Whether these are legal depends on contract details.
But my larger point is that there is no mystery why prices don’t rise in the face of chip shortages. We have price controls already — not as a matter of law, but embedded in thousands and thousands of supply contracts.
Kenneth DudaMenlo Park, CA
Scott Sumner
Jan 28 2022 at 1:39pm
Ken, What’s to stop wholesalers from buying chips from those who receive them, and then reselling them to firms willing to pay more? The article suggests that it is wholesalers who might be charged with price gouging.
steve
Jan 29 2022 at 8:34pm
You have an economic theory. People who know the industry well are trying to tell you why you are probably wrong. Since number one son is in the industry let me give you an example based on his knowledge of the industry. There has been an increase in demand for nearly all kinds of chips because we all want more computers, more laptops, more TVs, more cars, etc. The demand is for more chips than the industry can produce. They can retool to make more chips for cars, but only at great cost, lots of time and then having shortages in the chip they tooled away from. That would include as noted in an earlier comment breaking contracts.
Better price signals might redirect chips, in a while, away from video game consoles to cars, but then we would have a shortage in video game consoles. Samsung, TSMC and one other major producer I cant remember (Global Foundries, Intel?) are building major plants but wont come on line for a few years.
The US govt may have played a role in reducing capacity, which is her problem right now. In 2020 the US placed some restrictions on SMIC, the large foundry In China so that they could not obtain chip making equipment.
https://www.cnbc.com/2020/09/28/us-sanctions-against-chipmaker-smic-hit-china-tech-ambitions.html
Steve
Steve
Dale Doback
Jan 28 2022 at 11:12am
I have seen a lot of food shortages at grocery stores and little or no price gouging, so I don’t buy the premise that agriculture is allowed to price gouge more than other industries. I think the main reason suppliers, particularly in semiconductors, are not raising prices is many are contractually obligated under past negotiations. For those not under contract, raising prices has the potential to alienate future customers after what is expected to be a temporary supply disruption. Fear of political retribution certainly could play into that as well, though I don’t see it as a main cause.
Aaron W
Jan 28 2022 at 11:58am
While I normally would be sympathetic to this kind of narrative, I am really skeptical that “fear of political retribution” is anything but a very small effect on the supply problems in this market. For more consumer-oriented chips like GPUs, manufacturers have definitely increased their prices (for products such as the NVidia RTX 30 series, sometimes 4-5x the original MSRP from 2020), and “price gouging” is common. The shortages in that particular segment are still problematic but seem to be alleviating with falling demand since crypto prices crashed.
It’s also worth noting that in that same article you shared the Commerce Department is aware that they have limited ways to “fix” the shortage:
‘The Commerce Department report all but concedes that the government is powerless to resolve the bottlenecks.
“The private sector is best positioned to address the near-term challenge posed by the current shortage, via increased production, supply-chain management to minimize disruption, and product design to optimize the use of semiconductors,” it says.’
Philo
Jan 28 2022 at 3:19pm
This looks like an endorsement of Bryan Caplan’s point, that we would be better off with even higher prices for many items.
Scott Sumner
Jan 29 2022 at 1:24pm
Yes, I agree with Bryan.
Jose Pablo
Jan 30 2022 at 10:54am
“Second, it leads to the limited supply being allocated to those who place the highest value on the good.”
Not sure if this is true (not at least in any meaningful way).
Price gouging leads to supply being allocated to companies that can afford an increase in working capital and/or that have clients inelastic to price increases.
For instance, an increase in gas prices could lead to gas being allocated to South Florida’s boaters and away from Alabama, Louisiana or New Mexico’s low income commuters. To say that this is “allocating goods to those who place the highest value on the good” is, maybe, true but an economic meaningless tautology (I think) … and a “market optimization mechanism” very dificult to sell politically
Scott Sumner
Feb 2 2022 at 2:02pm
It’s always true in all markets that the rich have more ability to buy goods than the poor. It’s not clear why the price becomes the wrong way of allocating resources when there is a disaster, but not otherwise.
In fact, the opposite is likely to occur after a disaster if price gouging is allowed, gas is likely to be redirected from boaters to those with a greater need.
Thomas Strenge
Feb 1 2022 at 7:13am
Anti-price gouging laws are terrible. I also believe they are responsible for the slow hurricane recovery in Florida. Hurricanes are nothing new, but in the 90s they were just a brief interruption. Now they are an apocalyptic event that takes months to normalize.
Eric Hammer
Feb 2 2022 at 2:18pm
The standard supply and demand model as described here is incorrect. A reduction in supply will cause a shortage, however it won’t be a long term shortage as prices adjust. Price do not adjust instantly, however, nor does the increase in supply happen instantly. Supply and demand models say nothing of the time period over which things happen, so shortages can still exist, just not in the long term, where “long term” is “past the point where normal market prices adjust”. Persistent shortages should not be possible, but short term ones are.
In this case, based on the comments here and my experience in industrial supply chains, it does look like long term contracts are holding down prices where they can, capacity switching costs are high and so slowing down an increase in production, as well as hopes that things will get back to normal soon leading decision makers to try and grit through it instead of incurring all the costs of force majeure breaking contracts. There is probably a healthy dose of “and the administration will jump down your throat at the behest of lobbyists if you raise prices” too.
Anecdotally, a company I recently worked for had a similar problem, where costs shot up over the past two years but we couldn’t get customers to agree to change pricing rates on contracts. Some we considered just dropping all together but decided that the court costs might be worse than just operating at zero or negative returns for a few more months if things go back to normal. I doubt we were alone in this, although damn, those were some awful contracts even when signed.
Eric Hammer
Feb 2 2022 at 2:19pm
Sorry, the first two sentences there were supposed to be a quote… not sure how I messed that up.
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