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Thursday, September 22, 2005

O'Reilly's Price Setting Genius

From O'Reilly's Talking Points last night:
"One thing struck me. After all the experts we've talked with, after all the research we've done, we still can't find out who exactly sets the price of a gallon of gasoline, which human being in America does that."
My reaction? I can't believe it. Perhaps it suggests we should draw the conclusion that there is widespread economic illiteracy?

My question for you is: How would you explain to someone listening to or reading O'Reilly's analysis that he's got things all wrong? I suggest that you should consider 2 ways to approach this. You could think about this in terms of the standard model of a market with demand and supply curves. Or, you could think in terms of Hayek's idea of a spontaneous order. I'm also curious about whether you think one of the 2 approaches is better than the other?

I did it this way.
Markets are not tangible things like pencils. Markets are models developed by economists to demonstrate how consumer and producer choices respond to one another to determine how much of a good is supplied and at what price. The supply curve is a representation of producers’ decisions to produce some quantity of a good in such a way as to maximize profits. The demand curve is a representation of consumers’ willingness to pay for that good. The shape and slope of this curve is determined by consumer behavior. It is this behavior that determines the price of gasoline, which is represented on our supply/demand model at the point the two curves intersect. So, we should not be looking for the one person responsible for setting gasoline prices to figure out the reason for the price of gas. Instead we should be telling every gasoline purchasing American to take some responsibility for their actions. If they want the price to fall, try changing behavior such that less gasoline is consumed.

From the spontaneous order perspective I think Hayek would say prices are a reflection of consumer and producer knowledge of particular time and place. Producers will attempt to engage in profit maximizing behavior and consumers will respond to those efforts by consuming particular quantities of gasoline. If consumers are consuming too little, or too much gasoline for producers to be maximizing profit, then producers will change their behavior. Again, it is the decisions of consumers that send signals to producers to indicate whether or not profits are being maximized. If consumers want cheaper gasoline, consume less of it.
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Spontaneous order:
"The market works in magical ways," I would tell them. The market is a group of people that voluntarily exchanging goods and services. In the method of spontaneous order, the given market supply and demand would be generated by the immediate willingness for people to pay that given price. If there is a natural disaster, there will be an immediate price increase. This is due to the fact that thousands or millions of people desire the gas. The market, the troves of people escaping the disaster, are willing and able to pay that price for gas. The price will have risen, due to the increase in demand imposed on the gas suppliers by the market demand. Spontaneous order allows the market to generate a sensible order, provided that that there is no price gouging. The market will determine the price.
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