Tuesday, July 29, 2008

Free Market Economics: Demand Destruction

The recent drop in gas prices - nearly $.50 / gallon in the past few weeks - is an interesting case study in free market economics. What we're seeing is a natural process called demand destruction. There's nothing magical about it - high prices lead to lower demand which leads to lower prices - but the lower prices are exactly what a lot of us needed. These lower prices were achieved without government regulation or interference, and in fact, could only be achieved without government interference.

Miles driven in the U.S. from November - May were down almost 41 billion from the previous year, in spite of an expanding population and an expanding number of cars. That means the miles driven per person were down even more significantly.

This is a record drop...higher gas prices achieved what no government project, program, or tax ever has. No doubt we like to think of ourselves as noble creatures who would willingly cut back on our driving for environmental causes, or to reduce our nation's dependence on foreign oil. But evidence clearly demonstrates that economic incentives are far more effective than moral ones.

Reduced demand, triggered by higher prices, is demand destruction. It can be a brutal process for some, as the pain of increased fuel costs are not spread evenly across the population. In spite of the inherent inequity, it's necessary for government to get out of the way and let it happen. If government subsidizes the cost of gas, demand is kept artificially high, so prices don't decrease. The "summer gas tax holiday" which was bandied about my multiple politicians, would have reduced the price of gas by 18.4 cents, much less than the $.50/gallon that the free market achieved on its own.*

Of course the transition is painful - I don't envy truckers one bit - but eventually the escalating prices drive changes in behavior, which in turn helps to regulate the demand and reverse the price increase. It doesn't happen right away, but at $4/gallon, carpooling and public transportation starts to look a lot more attractive. That Prius suddenly seems more practical than the Escalade. Your next house may be a little closer to work, or you might negotiate harder for the right to work from home for a few days. The sum of all these little decisions, over time, creates less demand for gas and lower prices for everyone. Lower consumption is also good for the environment, reduces congestion on our roads, and a boon for the U.S. politically, as we send less of our hard-earned money to countries that are trying to kill us.

So which would you prefer? A government-induced decrease in prices, which keeps demand artificially high, reduces tax income (means higher taxes elsewhere), and continues to burn oil at a higher rate...or a larger reduction in price, caused by more efficient consumer decisions? This is a no-brainer, but government needs to be willing to get out of the way and let the markets do their job.

No one likes higher prices, but fair prices for limited resources are the best way to encourage conservation, bar none. Notice during a drought how ineffective 'voluntary restrictions' are on water usage. We all have those neighbors who continue to water their lawns and wash their cars...but what if the cost of water was not regulated, allowed to move higher, accurately reflecting its scarcity? Would a finanical incentive be more effective than a moral one? The answer is clear.

Markets aren't perfect, and they aren't always fair, but they are by far the most efficient way to distribute resources. The more bureaucrats you have mucking around in the system, the more time it takes for imbalances to correct themselves. It might not make you feel any better when you pay $75 to gas up the SUV, but try to take some comfort in the fact that higher prices are forcing us to make choices that are more efficient and less wasteful. Choices that are better for the country economically, politically, and environmentally. And run screaming from any politician who thinks the government can redistribute resources more effectively than the marketplace.

*Correction 07/31/08: Originally I wrote that the gas tax holiday would have been $.50/gallon.


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