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



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Sources:

Bradley, Robert L., Jr. and Thomas Tanton. “Motor Fuels and Natural Disasters: Don’t Regulate.” ALEC Policy Forum, Winter 2005 American Legislative Exchange Council. October 24, 2005 http://instituteforenergyresearch.org/TantonPriceGouging.final.pdf (04-3-07)


“In the Eye of the Storm: Gasoline Markets After the Hurricanes.” June, 2006 Federal Reserve Bank of Dallas, Houston Branch. Houston Business – A Perspective on the Houston Economy http://www.dallasfed.org/research/houston/2006/hb0602.html
Salinger, Michael A., Director, Bureau of Economics, Federal Trade Commission. “Moneyball and Price Gouging.” Address to Antitrust Committee of Boston Bar Association, Boston, MA. Feb 27, 2006. http://www.ftc.gov/speeches/salinger/060227MoneyballandPriceGouging.pdf




  • The gasoline suppliers’ response to Hurricane Katrina reinforces Hayek’s insight about markets’ superior ability to adjust to changes in scarcity. It was not necessary for anyone to know how much gas refining capacity was damaged, how much gasoline was still available, or how many people needed gas for their cars. The changing prices in the market communicated the relative scarcities and provided the information necessary for the market to allocate the amounts available in a way that best met needs in those particular circumstances.




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

  • After a disaster, people frequently clamor for particular goods and services that they do not routinely purchase, from mundane items like ice and plywood to major items like chain saws and generators.

  • In economic terms, these sudden increases in the demand for particular goods and services are demand shifts caused by changes in the prices of substitutes – ice for refrigeration and plywood for window glass, for example.

  • On the graph below, consumption shock is illustrated by the rightward shift of the demand curve, from Dbefore to Dafter:







  • The story this picture tells us is that people generally are willing to pay more. Intuitively, this makes sense. People who did not buy plywood before the storm now find it a good substitute for extremely scarce and very expensive window glass.

  • Additionally, if the natural disaster was unanticipated or gave very little warning, then the supply of things like ice, plywood, and generators immediately after the disaster is what the supply was before the disaster. As people substitute these products for refrigeration, glass, and other sources of electricity, competition for the substitute items increases.

  • Instead of one person wandering into the lumber yard to buy a sheet of plywood on Saturday morning, there may be hundreds; and one way they compete with each other is by being willing to pay more.



S before & after


$

P

Dbefore











Dafter


Q



  • As the graph illustrates, those people who are willing to pay the higher price will have their demand satisfied.

  • It is important to remember that people’s willingness to pay the higher price is determined by a variety of factors, only one of which is their income.

  • As in non-disaster markets, people make choices about what is most important, and they allocate their limited resources to satisfy those wants they consider most important.

  • Like a supply shock, a demand shock is addressed by price signals that not only communicate information but also provide incentives that change people’s behavior in markets. The higher prices that accompany consumption shock encourage consumers to purchase less – which is a good thing given the suddenly greater relative scarcity.

  • In the aftermath of disaster, pricing, unlike other methods of rationing, helps people evaluate their own needs realistically, helps to reduce waste, and helps to insure that more people’s wants are satisfied.

  • Consider ice to preserve food and medicine after a hurricane, for example. If ice is rationed by standing in line, then once the initial cost of a single ice cube is borne – the time it takes to get to the front of the line – there is no additional cost for more ice. Filling up numerous ice chests, “just in case,” is rational and should be expected. If, however, people must purchase ice by the bag – and the price of a bag of ice has risen to reflect the greater scarcity, people have an incentive to weigh the value of additional ice against the value of other things they want. The likely result is that each person will purchase less and more people will be able to purchase some ice.

  • Pricing also helps to address the knowledge problem that von Hayek identified. The argument, for example, that we could solve the problem of distributing ice by imposing a limit on the number of bags of ice each person is allowed to buy rests on the faulty premise that someone, somehow will be able to figure out the “right” amount. How will those in charge know how critical ice is to you – whether you are using it to keep life-saving medicine cool, chilling your soda, or bathing your sunburned feet after a day on the beach?

  • The U.S. Federal Trade Commission reports that rising prices in the aftermath of natural disaster reduce the incidence of hoarding, an understandable consumer response to the uncertainty created by the disaster but one that reduces the number of people who can purchase the desired product.

“. . . [W]hen there is a threat of a disaster, people will rush to the gas station to fill up. They might, if they think they have time, rush to Home Depot to buy a few containers to store gasoline in. Lines at gas stations will be long. Not only will these lines waste precious time, but the supplies will run out. Those who get to the gasoline station too late will find no gas available. Some of these people will be unable to evacuate. Others will try to get as far as they can and run out of gas on the road, possibly clogging escape routes, thus exacerbating the catastrophe.


This is not mere economic theorizing. Hoarding behavior is real. One might think that when a shortage looms, the governor of the state or perhaps the President should urge people not to stock up unnecessarily. . . . When politicians say, ‘There is no reason to stock up,’ citizens hear, ‘There is every reason to stock up.’
. . . [However, if the price of gasoline rises] . . . individuals have an incentive to buy just the gasoline they really need rather than to make sure to have a full tank in every car and a few gallons of inventory to boot. Of course, each individual choice to limit gasoline purchases is undetectable within the broader market. Magnify that choice over a substantial fraction of consumers in an area and the effect can make the difference between the maintenance of social order and chaos.” (Salinger, 3)


  • As with the supply shift, note that when a consumption shock occurs, it is not necessary for any one person to know how much ice and plywood are needed or how long until the electricity is restored in the disaster area. The changing prices communicate the changing scarcities and provide all the information necessary for people to make the best decisions for themselves and for the market.




  1. While prices function in markets to communicate information, competition prepares businesses to respond to disasters, and self-interest and the profit motive provide reliable incentives for them to do so.

  • Competition is a constant presence in the world of business, and the ongoing experience of successful competition prepares businesses to adapt to changing circumstances. Johanna Schneider, executive director at the Business Roundtable, comments: “What companies do is solve problems.” In that sense, disaster response is “business as usual,” in the pursuit of profit. (Private FEMA, 2)

  • The incentive to problem solve in the wake of disaster is heightened by the reality that the early responders stand to make the most profit. The potential rewards for quick response can even be large enough to provide strong incentives for some producers to invest in knowledge about potential disasters and to risk preparation for the next disaster, without knowing what it will be or where it will strike.

    • “The first business to a disaster area with provisions for victims stands to benefit handsomely from beating others to the disaster zone. Even private non-profit organizations have a strong incentive to identify disasters quickly. The faster they are on location to help those in need, the more likely are potential charitable contributors to give additional money to their organization.” (Sobel & Leeson , 10)




  • The competitive response can take a variety of forms, including those that, paradoxically, would seem to knowingly forego profit.




    • Within 2 weeks of Hurricane Katrina, corporate relief donations exceeded $200 million. Companies also suspended finance payments on cars and mortgages and donated supplies, equipment, and personnel.

    • Wal-Mart donations totaled over $20 million, “. . . $1 million in cash to the Salvation Army to help with activities such as providing 400,000 meals per day and portable showers, and another $1 million in cash to the American Red Cross to run their shelters, . . . $15 million . . . for other relief efforts . . . [and] truckloads of supplies such as water and ice to the emergency services in [the disaster zone]. (Konig)

    • The U.S. Chamber of Commerce set up a computer registry for relief supply needs. Donor companies logged into the registry to search for specific orders their expertise allowed them to fulfill.

    • IBM set up a computerized job bank for those who lost jobs because of the hurricane.

    • Firms in the pharmaceutical industry donated more than $9 million in cash and supplies of antibiotics, insulin, and toiletry kits. Eli Lilly & Co. sent a private jet with doctors, antibiotics, tetanus shots, and insulin to the Gulf Coast within a week of the hurricane.

    • The American Trucking Association provided updated road condition information to companies moving supplies into the area.


Sources:

Barbaro, Michael and Justin Gillis. “Wal-Mart at Forefront of Hurricane Relief.” The Washington Post, September 6, 2005. p. D01. http://www.washingtonpost.com/wp-dyn/content/article/2005/09/05/AR2005090501598.html (3-28-07)


Ed. “Private FEMA – In Katrina’s Wake, Wal-Mart and Home Depot Came to the Rescue.” The Wall Street Journal, Sept. 10, 2005, p. 1. www.opinionjournal.com/forms/printThis.html?id=110007238 (3-23-07)
Konig, Susan. “Private Companies Rush in to Help Hurricane Katrina Victims.” Health Care News, October 1, 2005. The Heartland Institute: http://www.heartland.org/Article.cfm?artId=17757 (3-30-07)



  • Without disparaging the benevolent intentions of corporate directors, it is worth noting that being charitable is a viable strategy in the pursuit of profit. In a world of instant communication and many competitors, successful businesses understand the long-term value of retaining customers and building a reputation for caring about the well-being of customers and community.

  • The incentives that motivate market response – profit and self-interest – operate in disasters just as they do in normal conditions to reduce the impact of scarcity.

  • Producers and sellers live in a world of changing demand, and their continued profit depends on anticipating and adapting. Those who do not respond quickly may lose out to competitors in the market.

  • Because of this constant need to respond, businesses have an incentive to gather and use information that is unlikely to be collected and processed by anyone else. Thus, they are attuned to the particular circumstances of time and place that are the key to effective disaster response. As the following examples illustrate, businesses routinely gather information and prepare themselves with the answers to questions that most of us do not think to ask until after the disaster strikes.




Sample Illustrations: Knowledge of the Circumstances of Time and Place
#1: Elephants?! Who Knew?

Suppose someone put you in charge. Make a list of things you would want to have on hand to respond to natural disasters. What? You did not have elephants and mahouts (elephant drivers) on the list? What were you thinking?


When the massive Asian tsunami of 2005 (Please see entry in the “Catalog of Disasters” addendum to the Introduction for a overview of the Asian tsunami.) killed more than 144,000 people and devastated huge regions of India, Thailand, and Indonesia, elephants on the set of Oliver Stone’s epic movie, “Alexander,” were shipped to the disaster area to perform rescue operations where modern technology was useless.
“We use the elephants because a truck can’t pass through the thick forest,” says trainer Laitonglian Meepan. “The elephant is like a four-wheel drive. They walk in the forest all their life.” (Zap2it.com)

“. . . [E]lephants work as a team. . . . The more careful elephants help to extricate corpses out of the wreckage, a delicate task since the bodies are badly decomposed. The elephants don’t touch the bodies; they gingerly lift whatever has collapsed on top so that a volunteer can remove the remains.


Aside from digging for corpses, the elephants have found another vocation: towing cars.
One of Medang’s jobs the other day was to remove a tree and several beams that had fallen on a blue Toyota. As soon as the car was freed, it was attached to a chain harness fitted around the shoulder and front legs of another male elephant, Rachman. Men hopped in the car to steer as the elephant began to pull.
It made a tremendous sound between the dull thud of the elephant’s foot steps and the scraping of the underbelly of the chassis through the wreckage. But before long, the Toyota was on a main street being inspected with satisfaction by its owner.
‘I couldn’t find a tow truck. And it would have been too expensive anyway,’ said the car’s owner Firdaus, 29. He paid the equivalent of about $14 for the service.” (Demick)
Sources:

Demick, Barbara. “Elephants Help Clear Tsunami Debris.” Deseret News, January 23, 2005. http://www.findarticles.com/p/articles/mi_qn4188/is_20050123/ai_n11497180 (3-28-07)


Zap2it.com. “‘Alexander’ Elephants Aid Tsunami Relief Efforts.” Zap2it.com, January 3, 2005. http://movies.zap2it.com/movies/news/pstory/0,3382,24175,00. (3-10-07)






#2: Strawberry Pop-Tarts? Wal-Mart Knew

While no single person or agency can possibly know the answers to questions like, “What’s needed? Who needs it? Who has what’s needed?,” markets can. The players in markets have an incentive – profit – to find the answers and provide the goods and services people want. The behavior of private firms in preparing for Hurricane Katrina illustrates the power of the profit motive:




  • Wal-Mart’s database of customer purchases told the company that things like strawberry Pop-Tarts, diapers, and toilet paper would be in especially high demand after a hurricane strike. As Katrina approached land, the company used this knowledge and their huge supply-chain to increase stock and move it south toward New Orleans.

  • The Wal-Mart distribution center in Brookhaven, Mississippi contracted with a local gas station for a special line to make sure that Wal-Mart employees could get to work, and Wal-Mart manager Brent Hinton pumped gas for seven hours to encourage and support Wal-Mart workers. Before Katrina made landfall, the employees had forty-five trucks of supplies loaded and ready to go.

  • Hurricane Katrina shut down 126 Wal-Marts. Within two days of the Hurricane strike, 66% of the damaged stores were operational again, and within six days, 80% were operational. In addition, mini-Wal-Marts, many of them in tents, opened throughout the area to sell – and to distribute free – supplies badly needed by hurricane victims.

  • Knowing the demands of victims of previous big hurricanes in Florida and seeing the destruction of New Orleans on television, Black & Decker paid workers for an extra shift to produce more generators over the Labor Day weekend.

  • Home Depot transferred generators, flashlights, batteries, and lumber to distribution centers surrounding the area where Hurricane Katrina was predicted to strike.

  • Phone companies assembled mobile towers, generators, and fuel, ready to move into the Gulf region after the hurricane passed.

  • FedEx used its computerized delivery-management system to chart alternative routes for planes and trucks taking supplies into storm-damaged areas.

  • Before the hurricane hit, State Farm Insurance set up hotlines for claims processing, rented blocks of rooms in hotels in surrounding communities, and began to move special teams of adjusters to the Gulf coast.

  • The market responded to the need for security that police and military could not provide after Katrina as fifty new private security companies were operating in the area within two weeks to provide protection for homes and businesses. The higher price people were willing to pay for security services sent the signal that the existing 185 companies could not meet the demand and acted as a magnet to draw in others with the skills and equipment to provide the service.

Sources:

Barbaro, Michael and Justin Gillis. “Wal-Mart at Forefront of Hurricane Relief.” The Washington Post, September 6, 2005. p. D01. http://www.washingtonpost.com/wp-dyn/content/article/2005/09/05/AR2005090501598.html (3-28-07)


Friedman, Thomas. The World Is Flat. New York: Farrar, Straus and Giroux, 2005. p. 136.
Sobel, Russell S. and Peter T. Leeson. “Flirting with Disaster – The Inherent Problems with FEMA (Executive Summary).” Policy Analysis, No. 573, July 19, 2006. Cato Institute. http://www.cato.org/pub_display.php?pub_id=6516 (3-3-07)





#3 How to Get Out? The Government Didn’t Know

Hurricane Katrina provided some clear examples of how the market provided disaster relief when the mighty power of the federal government could not.

“The giant private hospital company HCA held a “Hurricane Lessons Learned” planning meeting . . . following [2004’s] . . . devastating Florida hurricanes. Some key gaps they identified were: cell phones often fail, so alternative phone systems are needed. Roads become impassable, so emergency supplies have to be stored closer to hospitals. Back-up generators are needed. As a result of the meeting, HCA provided its hospitals with satellite phones, hurricane shutters and additional backup generators. It struck deals with local businesses like refrigeration, water, diesel and gasoline companies to provide supplies quickly in the event of an emergency. In hurricane-prone areas it also warehoused food, medical supplies and other gear closer to its hospitals. In the immediate aftermath of Katrina, senior management set up a ‘war room’ and quickly decided they would need to lease 20 helicopters to evacuate their Tulane hospital. HCA’s chairman and CEO didn’t hesitate in ordering them to do so. They used ham radios to create a makeshift air-traffic control system and immediately began ferrying critically ill patients out, without one mishap.
Literally across the street, the state-run Charity hospital was without emergency supplies and unable to get any governmental help in evacuating. Subsisting on fruit cocktail and a dwindling supply of water, Charity’s patients were only saved by being ferried by boat to Tulane and evacuated by HCA’s privately-leased helicopters.”
Sources

Theroux, Mary L.G. “Public and Private Responses to Katrina: What Can We Learn?” Oct 20, 2005. Speech presented at the Chief Executive Organization’s Women’s Seminar, Oct 7, 2005. Independent Institute, Oct. 20, 2005. http://www.independent.org/newsroom/article.asp?id=1589 (3-29-07)





#4 Everyone Knows What Normal Feels Like & Markets Make It Happen

. . . [T]he rapid ability of markets to address changing circumstances helps make communities resilient, a key feature of recovery . . . . From daily needs like food and childcare services to large purchases, like cars or houses, market signals effectively share information and enable us to fill a variety of needs . . . . Markets are a vital part of daily life, and in the aftermath of a storm, their re-emergence is critical to community development. . . .


The signals emerging from commercial society provide two key indications to people engaged in the rebuilding effort: they demonstrate what goods and services will be available to returning residents, and more importantly, they serve as a barometer of the long-run prospects of the community. . . .
One Mississippi resident spoke of the importance the reopening of national retail stores and fast food restaurants had for community morale:

‘It was Wal-Mart under a tent. We were all thrilled. Oh, we can go buy pop, or we can get . . . essentials. So we were really happy about that. That was a forward motion. And then Sonic opened. We had the busiest Sonic in . . . the whole United States. . . . Amazing. It was like fine dining. Ooh, this is wonderful, you know, ‘coz there was nothing else then. There was [sic] no stores. There was nothing that was even halfway resembling normal. I guess when businesses open up and they start being fully operational, it reminds us what normalcy used to be like . . . . Like Rite Aid [opened] and it was a one hundred percent Rite Aid . . . . I didn’t go in to buy anything. I just went to walk around and be normal.’”


Sources

Chamlee-Wright, Emily and Daniel M. Rothschild. “Disastrous Uncertainty: How Government Disaster Policy Undermines Community Rebound.” Mercatus Policy Series, Policy Comment No. 9., January, 2007. Mercatus Center, George Mason University., pp. 18-19 http://www.mercatus.org/Publications/pubID.3579/pub_detail.asp (3-10-07)



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