Coronavirus: Why Price Signals Are Important in a Time Of Crisis

The world is experiencing a crisis. The disease COVID-19, caused by the SARS-CoV-2 virus, a coronavirus species, has sent people into panic which has subsequently caused items to fly off store shelves. The corollary of this sudden increase in demand has been the rise in...

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The world is experiencing a crisis. The disease COVID-19, caused by the SARS-CoV-2 virus, a coronavirus species, has sent people into panic which has subsequently caused items to fly off store shelves. The corollary of this sudden increase in demand has been the rise in prices of goods such as hand sanitiser. The South African government has recently implement measures to penalise businesses that raise prices ‘excessively’. Many people don’t seem to have an adequate understanding of why prices rise and, more importantly, why it is crucial that they be allowed to.

Economics is all about trade-offs. It boils down to decisions made between alternative uses of scarce resources. What guides this decision-making process is the price mechanism. People may have heard economists refer to prices using the term ‘price signals.’ Prices are, indeed, signals that relay crucial information to all economic actors. When prices rapidly rise in a time of crisis such as this, it is indicative of changes in consumers’ subjective valuation of certain goods and services. Consumers are willing to pay more per unit of a product because the subjective utility that they derive from it has increased; one values hand sanitiser more when there is a pandemic than when there is not. Put differently, consumers have become more desperate to get a hold of something and are willing to forego more scarce resources to obtain it, rather than use those resources in alternative manners.

Yet, this begs the question: are suppliers justified in raising prices and in the process increasing their profit margins simply because their clientele has grown more desperate? The simple answer is: yes, and here is why.

When demand increases, the fundamental relationship between certain price levels and the correlative quantities demanded at those price levels change. For every quantity, the price that consumers are willing to pay increases. The equilibrium market price has thus shifted. If suppliers do not adjust their prices upward, shortages will inevitably occur at the lower price level because demand will outstrip supply.

Figure 1: Illustration of supply and demand with concomitant equilibrium level and areas of surplus and shortage

The subsequent increases in profit margins also serve a crucial purpose: they signal to producers where resources could be used more efficiently. Efficiency in this context means generating higher returns on inputs. Recall that economics is all about deciding between alternative uses of scarce resources. The increased profit margins in the market of hand sanitiser, for example, signal to producers that it would be more efficient to allocate scarce resources to the production and supply of hand sanitiser than to allocate it to other alternative production processes where lower returns would be generated. This increase in resource allocation to the production of the now-scarce product, hand sanitiser, serves the crucial purpose of alleviating the scarcity that has arisen.

It’s not only that current producers are incentivised to produce more. New producers are also incentivised to enter the market. The higher levels of competition in the market that develop over time leads to decreases in prices as producers compete for customers, sans any price fixing, and quite possibly increases in the quality of products as well, as producers have more profits available to reinvest in research and development.

Suppliers raising prices also serves another, mostly forgotten, purpose. It is important to remember that suppliers are also consumers. Whereas we demand goods and services from them, they demand other goods and services from their own suppliers. There is an almost invisible supply chain behind the products we take for granted. The prices of our suppliers’ inputs also increase for the same reasons elaborated upon earlier. If our suppliers do not increase their own prices, they’ll eventually incur losses and we’d be left with no hand sanitiser at all.

But what if government simply enforced price controls on all suppliers in the supply chain?

We would still be stuck with shortages, yet this time they would be more pronounced because they would last longer since the price mechanism would be sending out false signals. It wouldn’t be signalling to producers that there are better, more efficient ways in which they can utilize their resources. There would be no economic incentive to alleviate the shortages.

One might be moved to argue that economic actors should not only attempt to alleviate certain shortages in the market purely because there is some form of personal, economic gain. But this criticism is entirely removed from reality. In fact, it ignores the beautiful complexity of the market and, more specifically, the price mechanism. As Adam Smith eloquently put it many years ago:

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages.

Economic actors’ regard for their own self-interests is what makes the efficient allocation of resources through the price mechanism possible. All actors, irrespective of whether it is in a time of crisis or not, express their subjective valuations with regard to their own self-interest, and the price mechanism relays this information, signals it, to the market so that other actors can respond to these signals and allocate resources to where they are most needed.

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