What price supply and demand?

16th January, 2014

‘Recessions might be shaped by our desire for prices that move in line with ethical norms’

I recently had cause to visit Ambleside – a pleasant tourist-trap at the head of England’s largest lake and a perennial parking nightmare. I drove at a crawl once around the town and twice around the town’s largest car park without success. Finally I found a spot in a privately owned parking lot. I trudged to the ticket machine through the rain and on seeing the price, my first thought was not economically rational. It was, “That’s a rip-off.”

We have a complicated emotional relationship with prices. To the rational utility-maximiser of the economics textbook, a price is an exchange rate between different possible products. Outside the textbook a price can be a signal of quality (“reassuringly expensive”) or a desperate bid for attention (“FREE shipping”).

A price can also feel like a slap in the face. The simple logic of supply and demand suggests that front-row seats for the Wimbledon final should be expensive. So should bottled water after a hurricane, snow shovels after a blizzard and Ambleside parking spaces over the Christmas holiday. And yet a vendor who tries charging a price high enough to eliminate the shortages will be accused of despicable greed.

That is why the latest electronic gizmos tend to sell out when first launched. Demand is high, supply isn’t infinitely flexible and the logical solution – sell at a high price, then discount once the rush is over – causes outrage. Technology companies conclude they would rather ask their customers to queue or wait than ask them to pay the market-clearing price. Evidently most parking providers in Ambleside have adopted the same policy. The one that did not received my ingratitude.

The psychological wing of the economics profession has known this for a while – Jack Knetsch, Richard Thaler of Nudge fame and Nobel laureate Daniel Kahneman researched the issue in 1986. They found people strongly objected when wages or prices shifted sharply, even if the market logic behind the shift was clear to see.

There are obvious microeconomic consequences of this pigheaded insistence on the appearance of fairness: ticket touts, empty supermarket shelves in unseasonal weather and restaurants at which one cannot get a seat.

But what is less obvious is that the course of recessions and booms might also be shaped by our desire for prices that move in line with accepted ethical norms rather than the laws of supply and demand.

If prices adjusted swiftly and smoothly, “Say’s Law” would always hold true. The gnomic law, named after a Napoleonic-era French economist, is that “supply creates its own demand”. The implication is that recessions can only be due to supply shocks, not simple lack of demand, as Keynesians claim. Prices and wages should adjust to ensure that supply and demand are always equal. In the world of Say’s Law, monetary policy should have little or no effect. Quantitative easing would be of scarcely more significance than a new set of commemorative postage stamps.

Yet prices and wages sometimes fail to adjust. Occasionally this is for psychological reasons; at other times the hassle of changing the price tags, reprinting the menus and so on can delay price adjustments. The price of parking in Ambleside was painted on to a metal sign, after all, and it did not vary by season or (much) by the time of day. Of such inflexibilities are born substantial economic fluctuations – the intellectual descendants of John Maynard Keynes often look to price rigidities to explain why recessions happen at all.

It might seem absurd that consumer irritation at a price hike, or the cost of repainting a sign, could add up to enough price rigidity to cause a recession – and not every economist buys the idea – but it is possible, and an influential school of thought. Economic frictions, just like real friction, may seem trivial. They are not.

Also published at ft.com.

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