From Alex Tabarrok at www.marginalrevolution.com:
Response to my Mother
My wonderful mother is upset, like pretty much everyone else, at the price of gas. “Well, the hurricane has knocked out a lot of production on the gulf coast,” I say. “Yes but there’s plenty of gas in the pipes that was produced before the hurricane – the suppliers are gouging.” she responds. Arrghhh….must resist, must resist, must be ….nice. “mmm,” I say. You and my Econ 101 students (103 actually), however, are not so lucky.
Many people think that price is determined by historical cost. Price is never, ever, determined by historical cost. Price is determined by supply and demand. If supply or demand change then the price changes regardless of historical cost. Last year’s fashions? The price falls regardless of cost. Chopped up dead sharks? If demand is high, the price is high regardless of historical cost. If the demand for gas were to suddenly fall, the price of gas would fall too, regardless of cost. In the present situation the supply of gas has been reduced and the price has gone up. Historical cost is always irrelevant.
Is the high price due to supplier gouging? Not at all. If you want to blame anyone for the high price blame your fellow buyers not the suppliers. A high price means that some other buyer is outbidding you to obtain the limited supply. It’s buyers who push up prices in a competitive market and it’s suppliers who push prices down!
It’s true that some suppliers are making big profits but people have the cause and effect backward. It’s not the high profits which are causing the high price. It’s the high price which is causing the high profits. If you were to tax the high profits, for example, you wouldn’t reduce the price. Indeed, quite the opposite because the high profits motivate suppliers to increase the quantity of gasoline as quickly as possible.
The last point brings us full circle because as the situation stabilizes suppliers increase the quantity supplied until price is pushed down towards long-run costs (which are also historical costs). Thus, in the usual situation it appears that price is determined by historical cost. It’s only in the brief time period when a shock shifts (short-run) supply away from historical cost that we can see the truth. Price is determined by supply and demand.
Addendum: Is it just me or did Ken Arrow ever feel the need to correct his Mom on economic matters? Did Adam Smith? “Look Mom, I know you’re upset about the price of mutton but let me tell you about this new theory I’ve been working on…”