At the end of last year, I quipped that 2022 had felt like the year of the shortage. It hasn't finished yet. In the wake of Cyclone Gabrielle, many parts of the North Island lost electricity service, increasing the demand for generators. As the New Zealand Herald reported this morning:
The cyclone has also seen Northlanders without power rushing to stores and buying generators to power their homes.
Donovans Trade Supplies manager Scotty Brown said his business sold 200 generators in four days, which was more than they would usually sell in a year.
“One person looked after only generators, and it was mental, really mental. And the person was me,” Brown said.
On Monday last week when the storm was in its early stages, Brown sent a truck and a driver down to a supply branch in Auckland to pick up 60 generators,
“We unloaded them out the back and by lunchtime Tuesday, they were all gone,” Brown said.
On Wednesday, the team went to Auckland again to pick up 120 generators and “within a day and a bit” they had sold them in Whangārei.
When demand increases, we would expect prices to increase, as shown in the diagram below. When demand increases from D0 to D1, the equilibrium price increases from P0 to P1, and the quantity of generators traded increases from Q0 to Q1.
Indeed, that appears to have happened in some cases:
Christchurch company All Trade also flew 50 to 60 generators up to Donovans Trade for Northlanders to purchase when the other supplier ran out.
Brown said customers were thankful to receive generators and get power to their homes back, and they have only 20 generators left in stock.
He said unlike Donovans Trade, he’d heard some places had been increasing the prices of generators due to the demand.
“We didn’t want to take advantage of the situation.”
That last point, that All Trade didn't want to take advantage of the situation, is surprisingly common among sellers. It is inconsistent with what we would expect from the demand and supply model shown above, but it is consistent with how consumers perceive price changes.
In a famous study (ungated), Nobel Prize winner Daniel Kahneman (along with fellow Nobel Prize winner Richard Thaler, and Jack Knetsch) found that when a hypothetical hardware store raised prices for snow shovels following a snowstorm, consumers felt strongly that the price increase was unfair. In contrast, it was perceived as fair for stores to raise prices when their costs increased. Raising prices to increase profits in the short run, taking advantage of market conditions like a snowstorm (or a cyclone), may actually be inconsistent with long run profitability. If a firm develops a reputation for price gouging, the negative image among consumers may actually harm the firm overall.
But keeping prices low creates a different problem - a shortage. In the diagram above, if firms kept the price at the original level of P0, the quantity of generators demanded would be QD, but there would still be only Q0 generators supplied. The difference between QD and Q0 is the shortage. More buyers want generators at the low price P0 than there are generators available. Some willing buyers will miss out on a generator.
The Northland sellers have solved this problem partly by increasing the supply of generators (by bringing in stocks of generators from elsewhere in the country). However, if the shortage is large enough, even that approach would not entirely solve the problem. Most likely the limited number of generators will go first to whoever is quickest to call a supplier, or to whoever knows a supplier personally. Everyone else will miss out.
So, we face an economic problem when disaster strikes. Either prices rise in the wake of the increased demand for generators, or there is a shortage of generators. It might be tempting to think that the government can provide a solution here that keeps prices low (for example, by passing laws against price gouging), while imposing a better way of allocating the limited number of generators. Maybe, instead of going to whoever knows a supplier personally, the government could allocate the generators to those most 'in need'. But, such a subjective approach is open to all sorts of abuse. That is why most economists favour letting the market solve the shortage, by allowing prices to rise. Generators would then be allocated to those that need them the most, without anyone having to decide who has the greatest need. That's because those with the greatest need should be willing to pay the most for a generator. So, when prices increase, the buyers who have the least need for a generator, will be the first to drop out of the market, leaving the generators for those with the greatest need.
There is one final problem here, which is that willingness-to-pay for a generator is not only determined by need. It is also determined by income, because those with highest incomes generally tend to be willing to pay more for goods. The final distribution of generators determined by the market would tend to result in generators going to higher income recipients in a way that many people would consider an unfair allocation. At least, that is if generators were being bought by households. The highest income buyers of generators, with the highest willingness-to-pay, are actually likely to be businesses, trying to keep the lights on and serve their customers. An allocation of generators, that sees them going to supermarkets and service stations first, is probably what most people would prefer.
So, there is no perfect solution to the problem that the cyclone generated (pun intended!). Prices can be kept low and there will not be enough generators for everyone who is willing to buy one. Key service businesses may miss out on generators that are snapped up by buyers who have a close relationship with the sellers. Alternatively, the market can allocate generators, which would result in higher prices but no shortage of generators (at least, at the higher market price that would result). And, it is more likely that key service businesses would end up with those generators. All without the government needing to intervene. You can probably see now why economists might prefer price gouging as a solution.
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