Lesson 2: When Disaster Strikes, What Can Markets Do? Vocabulary



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Lesson 2: When Disaster Strikes, What Can Markets Do?

Vocabulary

scarcity supply demand

price supply shock consumption shock

price controls determinants of supply determinants of demand

price gouging incentive
Content Standards

Standard 3: Different methods can be used to allocate goods and services. People, acting individually or collectively through government, must choose which methods to use to allocate different kinds of goods and services.

Benchmarks: Grade 12



  • Comparing the benefits and costs of different allocation methods in order to choose the method that is most appropriate for some specific problem can result in more effective allocations and a more effective overall allocation system.


Standard 4: People respond predictably to positive and negative incentives.

Benchmarks: Grade 8



  • Changes in incentives cause people to change their behavior in predictable ways.


Standard 8: Prices send signals and provide incentives to buyers and sellers. When supply or demand changes, market prices adjust, affecting incentives.

Benchmarks: Grade 8



  • An increase in the price of a good or service encourages people to look for substitutes, causing the quantity demanded to decrease and vice versa. This inverse relationship between price and quantity demanded, known as the law of demand, exists as long as other factors influencing demand do not change.

  • An increase in the price of a good or service enables producers to cover higher per-unit costs and earn profits, causing the quantity supplied to increase and vice versa. This relationship between price and quantity supplied is normally true as long as other factors influencing costs of production and supply do not change.

  • Scarce goods and service are allocated in a market economy through the influence of prices on production and consumption decisions.

Grade 12:

  • Demand for a product changes when there is a change in consumers’ incomes or preferences, in the prices of related goods or services, or in the number of consumers in a market.

  • Supply of a product changes when there are changes in the prices of the productive resources used to make the good or service, the technology used to make the good or service, the profit opportunities available to producers by selling other goods or services, or the number of sellers in a market.

  • Changes in supply or demand cause relative prices to change; in turn, buyers and sellers adjust their purchase and sales decisions.

  • Government-enforced price ceilings set below the market clearing price and government-enforced price floors set above the market clearing price distort price signals and incentives to producers and consumers. The price ceilings cause persistent shortages, while the price floors cause persistent surpluses.


Standard 9: Competition among sellers lowers costs and prices and encourages producers to produce more of what consumers are willing and able to buy. Competition among buyers increases prices and allocates goods and service to those people who are willing and able to pay the most for them.

Benchmarks: Grade 8



  • Competition among buyers of a product results in higher product prices.

Grade 12:

  • The pursuit of self-interest in competitive markets generally leads to choices and behavior that also promote the national level of economic well-being.



Lesson Overview
Lesson 1 defined the economic impact of disasters as essentially a step backward in the human struggle to satisfy an ever-growing list of wants and needs with limited resources. Having conceptualized the problem in general terms, we proceed to examine the institutional tools available to societies and nations to deal with the blows that nature occasionally deals us. In this lesson we focus on the economic institution of markets, asking what markets can – and can not – do in the event of a disaster. Examples from historical (the Great Chicago Fire of 1871) and recent (the Asian Tsunami and Hurricane Katrina in 2005) disasters illustrate the economic analysis.
To perhaps a greater extent than is common in FTE curriculum materials, this lesson incorporates a traditional tool of economic analysis, supply and demand graphs. Teachers are reminded, however, that graphs are no more than tools. The economic reasoning modeled in supply and demand graphs does not depend on the graphs, nor do we consider the graphs necessary to teaching about the economics of disasters. The economic way of thinking can be modeled just as effectively by written explanation or, as the late economist Paul Heyne advocated, by “telling a plausible story.” Recognizing that graphs are commonly used in economic analysis, we have incorporated them here to provide the opportunity to practice applying the tool to problems other than the fictitious examples in end-of-chapter assignments.
By asking what markets can do, this lesson is also asking, by implication, what markets cannot do and what tasks are better left to other institutions. The disaster-related roles of governmental and charitable institutions are the subjects, respectively, of Lessons 3 and 4.


Activity: Price-Gouging Computer simulation

Key Points


  1. The advantages of rationing by markets are evidenced by the relative wealth of nations with market economies and by their resilience in adversity.

  • Scarcity requires rationing. The basic question an economy must answer is not whether to ration but which method of rationing uses resources in such a way as to satisfy the most wants and needs.

  • Tradition and experience have established markets as the method of rationing most goods and services in developed economies like the United States.

  • The advantages of market-based rationing include:

      1. Markets direct resources to their most highly valued uses, and

      2. Markets encourage the least-cost uses of resources, including human time and effort.

  • Markets’ ability to direct resources to their most highly-valued, least-cost uses is of heightened importance during natural disasters, where conditions produce a sudden increase in scarcity.




  1. Disasters do increase scarcity (as we saw in Lesson 1), but they do not reduce the ability of markets to respond to scarcity.

    • Markets respond to scarcity through decentralized communication of dispersed knowledge, eliminating the problems associated with centralized collection and analysis of massive amounts of rapidly changing information.

    • Austrian economist Frederich von Hayek defined the central task of economic systems as that of “. . . rapid adaptation to changes in the particular circumstances of time and place,” and identified two characteristics that make markets so successful in doing so. (The Use of Knowledge in Society, 524)

  • First, von Hayek pointed out that while information about the “particular circumstances of time and place” is localized and widely dispersed, economic decision-makers actually need only some of that information to be successful producers.

“. . . [T]he ‘man on the spot’ cannot decide solely on the basis of his limited but intimate knowledge of the facts of his immediate surroundings. There still remains the problem of communicating to him such further information as he needs to fit his decisions into the whole pattern of changes of the larger economic system.


How much knowledge does he need to do so successfully? Which of the events which happen beyond the horizon of his immediate knowledge are of relevance to his immediate decision, and how much of them need he know?
There is hardly anything that happens anywhere in the world that might not have an effect on the decision he ought to make. But he need not know of these events as such, nor of all their effects. It does not matter for him why at the particular moment more screws of one size than of another are wanted, why paper bags are more readily available than canvas bags, or why skilled labor, or particular machine tools, have for the moment become more difficult to acquire. All that is significant for him is how much more or less difficult to procure they have become compared with other things with which he is also concerned, or how much more or less urgently wanted are the alternative things he produces or uses.” (Hayek, 525)


  • Second, he explained that price is the signal that transfers pertinent and necessary information throughout the economy.

“Fundamentally, in a system where the knowledge of the relevant facts is dispersed among many people, prices . . . act to coordinate the separate actions of many different people. . . . It is worth contemplating for a moment a very simple and commonplace instance of the action of the price system to see what precisely it accomplishes. Assume that somewhere in the world a new opportunity for the use of some raw materials, say tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter . . . which of these two causes has made tin more scarce. All that the users of tin need to know is [what the higher price tells them—] that some of the tin they used to consume is now more profitably employed elsewhere, and that in consequence they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the whole economic system and influence not only all the uses of tin, but also those of its substitutes and the substitutes of these substitutes, the supply of all the things made of tin, and their substitutes, and so on; and all this without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes. The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all.” (Hayek, 526)




  • We might well argue that natural disasters give new urgency to the need for “rapid adaptation to change,” but they certainly do not alter the fundamental task of coordinating localized, widely dispersed information that Hayek identified.

  • The allocation task may be more urgent or of greater magnitude during disasters, but it remains fundamentally the same task we routinely trust markets to perform to our great advantage.

“The continuous flow of goods and services is maintained by constant deliberate adjustments, by new dispositions made every day in the light of circumstances not known the day before, by B stepping in at once when A fails to deliver. Even the large and highly mechanized plant keeps going largely because of an environment upon which it can draw for all sorts of unexpected [emphasis added] needs; tiles for its roof, stationery for its forms, and all the thousand and one kinds of equipment in which it cannot be self-contained . . . .” (Hayek, 524)




  1. Prices communicate the information and provide the incentives to mitigate the impact of supply shocks caused by natural disasters.

  • “Supply shock” occurs when disasters interrupt or destroy the goods and services – housing, electricity, water, and gasoline, for example – that people rely on in everyday life.

  • In economic terms, a supply shock is a shift in supply, which is illustrated graphically by a moving the supply curve to the left, from Sbefore to Safter:


Sbefore

Safter







  • The story this picture tells us is that less is available, regardless of the price – or at every price. Intuitively, this makes sense. If a hurricane devastates a city and surrounding regions, there is less housing available in every price range.

  • Because people in the community still have a demand for housing, the change in supply causes an increase in the price of housing.


Safter


$
P

Sbefore










Dbefore & after





Q


  • Importantly, rationing the now more-limited housing by price communicates two important pieces of information that help society cope with the increased scarcity imposed by the disaster.

  • First, the higher price acts as an incentive for consumers to conserve. For example, an extended family with two or three damaged houses may decide to crowd together in one rental house or apartment after the storm to keep expenses down.

  • Second, higher prices call into the market housing that was not available at lower prices. People may decide to rent spare rooms, empty apartments above garages, or travel trailers normally parked in storage, for example.



Case Study:

The Gasoline Market Coped with Supply Shock after Hurricanes Katrina and Rita

(Please see the entry in the “Catalog of Disasters” addendum to the Introduction for an overview of the economic impact of Hurricanes Katrina and Rita.)
Background:

The crude oil refining industry in the U.S. was running at almost peak capacity before Hurricanes Katrina and Rita struck the Gulf Coast in 2005. Additionally, Hurricane Katrina struck just before the Labor Day weekend, traditionally a period of peak demand in the U.S. gasoline market. As the devastation from Katrina became apparent, media reports sparked fears of a “gasoline crisis,” fears that surfaced again with news coverage of the clogged highways, abandoned cars, and closed gas stations that greeted motorists fleeing Houston as Hurricane Rita approached.


Certainly, the hurricane damage was significant. A 2006 report by the Federal Reserve Bank of Dallas summarizes the combined impact of Hurricanes Katrina (August 29, 2005) and Rita (September 24, 2005) on the Gulf Coast crude oil refining industry and on the U.S. gasoline market.

“Figure 1 shows the total crude refining capacity (in barrels per day) closed down on the Gulf Coast in the days following Hurricane Katrina’s Aug. 29 landfall and through the remainder of 2005.[1] At the peak of the closures, as Hurricane Rita moved through the Gulf of Mexico on Sept. 24, capacity of nearly 5 million barrels per day—about 70 percent of Gulf Coast capacity—was briefly shut down. At the same time, crude capacity of another 500,000-750,000 barrels per day was operating under reduced runs as a precaution, due to damage or because of a lack of feedstock. Entering 2006, two New Orleans refineries and the large BP refinery in Houston were still closed for repairs, representing a combined capacity of 804,000 barrels per day still out of service.



“The resulting fall in gasoline production was felt widely in U.S. and global markets. Gasoline prices peaked at $3.12 per gallon nationwide the week after Katrina made landfall. Over the next 10 weeks, U.S. gasoline prices averaged 51 cents per gallon more than during the prior 10 weeks.” (http://www.dallasfed.org/research/houston/2006/hb0602.html)

Quite simply, the feared gas crunch did not happen. There was no widespread, debilitating shortage of gasoline, and despite isolated reports of $4 and $6/gal., the U.S. generally experienced little disruption – and certainly nothing that could be called a gasoline “crisis.” Within two months gasoline prices were back on a downward track that would take them to historic lows. At year’s end, three refineries (two in New Orleans and one in Houston) that normally produced over 800,000 barrels per day were still closed, and gasoline prices continued downward.

Analysis: What happened to avert a shortage after a massive supply shock took out up to a quarter of daily supply in a country famously dependent on oil and gasoline?
The market sent out signals, in the form of prices, and the behavior of producers and consumers changed in response to the prices.
The Dallas Fed looked at data from three time periods: ten weeks before Katrina, ten weeks of “emergency” (from the date of Katrina and including the date of Rita) and ten weeks after Katrina. The comparison of production with foreign imports and exports in the Gulf Coast region and in the rest of the U.S. is summarized in the table below:

Effect of the Hurricanes on U.S. Gasoline Supplies

(thousands of barrels per day in each period)






Gulf Coast

Rest of U.S.




During

Emergency

Before & After

During Emergency

Before & After

Production

Total Gasoline

3,121.9

3,564.0

5,008.6

4,832.0

Imports

Total Gasoline

223.7

71.2

978.1

950.3

Exports

Total Gasoline

93.0

144.6

10.6

11.7

Changes in Inventories

Total Gasoline

-23.8

12.1

67.4

-78.8




  • The data show that as production declined on the Gulf Coast production increased elsewhere in the U.S., which the Fed explains as a response to higher prices.

“On the Gulf Coast, average gasoline output during the emergency was reduced by 442,000 barrels per day, or 12.4% below the 10-week averages before and after the storms. In the rest of the U.S., gasoline production rose by an average of 177,000 barrels per day, or 3.7% . . . in response to price incentives . . . .” [emphasis added]

  • The Fed also concluded that price signals also attracted imports of gasoline from overseas, and attracted it to the Gulf Coast, not New York City, where most gasoline imports enter the U.S.

“In the 10 weeks before and after the storms, over 90 percent of U.S. gasoline imports . . . entered states outside the Gulf Coast, especially through New York Harbor. These imports rose only 2.9 percent in the rest of the U.S. . . . [but more] dramatic changes were observed on the Gulf Coast, where gasoline imports nearly tripled during the emergency.”

  • Exports from the Gulf Coast decreased:

“Although gasoline exports represent a relatively small portion of total Gulf Coast production, they make up over 90 percent of U.S. gasoline exports.

. . . During the emergency period, exports from the Gulf Coast fell by 51,600 barrels per day (35.7 percent), adding to Gulf Coast gasoline supplies.” [emphasis added]



  • And, finally, companies took gasoline out of inventory to supply their stations. Before and after the storm, Gulf Coast refineries tended to add about 12,000 bpd to their inventories. During the storm emergency period, they were taking out about 28,300 bpd and sending them to gas stations. (The rest of the country reacted to the storms by building up their inventories, which, the Fed notes, has become a characteristic reaction to uncertainty by the U.S. oil market.)

  • Summary: The Fed study showed that the biggest factors offsetting the drop in Gulf Coast gasoline production were an increase in imports and a decrease in exports.

Analysis: Why did the shifts in imports, exports, and inventories take place?

  • The Fed study further investigated the question of what drew additional imports to the U.S. during the emergency, and concluded there were two determining factors:

1) price change, and

2) waivers of environmental requirements.



  • The Fed looked at the gasoline price differential between the Gulf Coast of the U.S. and Rotterdam, a major international oil trading center. During the ten weeks of the emergency, the price on the Gulf Coast, which is normally $.88/barrel higher than Rotterdam, soared to $8.03 higher. The statistical analysis indicates that this price differential was responsible for about 1/3 of the additional imports.

  • The remainder of the import increase was found to be the result of the Environmental Protection Agency temporarily suspending regulations that greatly raise costs of production for foreign producers of gasoline. In effect, the EPA stepped out of the way of the market for ten weeks. EPA regulations raise production costs, creating incentives for foreign producers* to by-pass the U.S. in favor of markets without or with less-costly environmental restrictions. During the ten weeks in which the EPA restrictions were suspended and foreign producers did not have to bear the costs of meeting the regulations, it was profitable enough for them to sell in the American market.

  • (*The majority of additional imports came from Europe, Canada, and South America. For a spreadsheet showing amounts by country, see U.S. Department of Energy, Energy Information Administration, “U.S. Net Imports by Country,” http://tonto.eia.doe.gov/dnav/pet/pet_move_impcus_a2_nus_epm0f_im0_mbbl_m.htm )

With the regulations suspended, changing market prices ensured that, even in emergency, goods, services, and resources were allocated to their most valuable uses. Signals – in the form of price and profit potential – went out to gasoline producers and they responded by diverting their products to the Gulf Coast. When the emergency period passed, the falling prices – and the re-imposition of costly EPA regulations – caused producers to return to their pre-disaster allocation patterns.

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