No Such Thing as a Free Lunch: Principles of Economics (part 17)

It turns out that advancing equal opportunity and economic empowerment is both morally right and good economics, because discrimination, poverty and ignorance restrict growth, while investments in education, infrastructure and scientific and technological research increase it, creating more good jobs and new wealth for all of us.

William J. Clinton

Demand and Supply Applications and Elasticity 

(Part B)

by

Charles Lamson

Constraints on the Market and Alternative Rationing Mechanisms

On occasion, both government and private firms decide to use some mechanism other than the market system to ration an item for which there is excess demand at the current price. Policies designed to stop price rationing are commonly justified in a number of ways.

The rationale most often used is fairness. It is not "fair" to let landlords charge high rents, not fair for oil companies to run up the price of gasoline, not fair for insurance companies to charge enormous premiums, and so on. After all, the argument goes, we have no choice but to pay---housing and insurance are necessary, and one needs gasoline to get to work. While it is not precisely true that price rationing allocates goods and services solely on the basis of income and wealth, income and wealth do constrain our wants. Why should all the gasoline or all the tickets to the World Series go just to the rich?

Various schemes to keep price from rising to equilibrium are based on several perceptions of injustice, among them (1) that price gouging is bad, (2) that income is unfairly distributed, and (3) that some items are necessities, and everyone should be able to buy them at a "reasonable" price. Regardless of the rationale, the following examples will make two things clear:

1. Attempts to bypass price rationing in the market and to use alternative rationing devices are much more difficult and costly than they would seem at first glance.

2.  Very often, such attempts distribute costs and benefits among households in unintended ways.

Oil, Gasoline, and OPEC In 1973 and 1974, the Organization of Petroleum Exporting Countries (OPEC) imposed an embargo on shipments of crude oil to the United States. What followed was a drastic reduction in the quantity of gasoline available at local gas pumps.

Had the market system been allowed to operate, refined gasoline prices would have increased dramatically until quantity supplied was equal to quantity demanded. However, the government decided that rationing gasoline to only those who are willing and able to pay the most was unfair, and Congress imposed a price ceiling, or maximum price, of $0.57 per gallon of leaded regular gasoline. That price was intended to keep gasoline "affordable," but it also perpetuated the shortage. At the restricted price, quantity demanded remained greater than quantity supplied, and the available gasoline had to be divided up somehow among all potential demanders.

You can see the effects of the price ceiling by looking carefully at Figure 3. If the price had been set by the interaction of supply and demand, it would have increased to approximately $1.50 per gallon. Instead, Congress made it illegal to sell gasoline for more than $0.57 per gallon. At that price, quantity demanded exceeded quantity supplied and a shortage existed. Because the price system was not allowed to function, an alternative rationing system had to be found to distribute the available supply of gasoline.

Several devices were tried. The most common of all nonprice rationing systems is cueing, a term that simply means waiting in line. During 1974, very long lines began to appear at gas stations, starting as early as 5 a.m. Under this system, gasoline went to those who are willing to pay the most, but the sacrifice was measured in hours and aggravation instead of dollars.

A second nonprice rationing device used during the gasoline crisis was that of favored customers. Many gas station owners decided not to sell gasoline to the general public at all but to reserve their scarce supplies for friends and favorite customers. Not surprisingly, many customers try to become "favored" by offering side payments to gas station owners. Owners also charged high prices for service. By doing so, they increased the real price of gasoline but hid it in service overcharges to get around the ceiling.

Yet another method of dividing up available supply is the use of ration coupons. It was suggested in both 1974 and 1979 that families be given ration tickets, or coupons, that would entitle them to purchase a certain number of gallons of gasoline each month. That way, everyone would get the same amount, regardless of income. Such a system had been employed in the United States during the 1940s, when wartime price ceilings on meat, sugar, butter, tires, nylon stockings, and many other items were imposed.

When ration coupons are used with no prohibition against trading them, however, the result is almost always identical to a system of price rationing. Those who are willing and able to pay the most simply buy up the coupons and use them to purchase gasoline, chocolate, fresh eggs, or anything else that is sold at a restricted price. This means that the price of the restricted good will effectively rise to the market-clearing price (the price at which the quantity demanded of a product or service equals quantity supplied and no surplus or shortage exists in the market). For instance, suppose that you decide not to sell your ration coupon. You are then forgoing what you would have received by selling the coupon. Thus the "real" price of the good you purchase will be higher (if only an opportunity cost) than the restricted price. Even when trading coupons is declared illegal, it is virtually impossible to stop black markets from developing. In a black market, illegal trading takes place at market-determined prices. 

NCAA March Madness College Basketball National Championship On Sunday, March 16th, 2003, the National Collegiate Athletic Association (NCAA) announced the 65 teams that would compete in the NCAA Division I Men's Basketball Championship..."NCAA March Madness" had begun. The 65 teams were whittled down over the next three weeks to a final four. The semifinals were held on Saturday, April 5th, and the championship game took place at the Louisiana Superdome in New Orleans on Monday, April 7th, between Syracuse and Kansas.

The NCAA controlled the distribution of 54,000 Final Four tickets. The face value of each ticket was between a minimum of $100 for upper level, distant few seats and a maximum of $160 for lower level seats. Clearly, the potential demand for these tickets was enormous, and the NCAA made a decision to price them below equilibrium. How do we know that they were priced below equilibrium? Many ticket agencies have tickets for sale, and a check of prices being paid over the Web in mid-March of 2003 showed that upper-level tickets were being sold for over $1,750, while lower level tickets between the baskets in the first 20 rows were going for an astonishing $10,000!

Let us say that the average price at which the original tickets were sold was $140 and that the equilibrium price that would equal the quantity supplied and the quantity demanded was $3,000. Figure 4 shows the story graphically. Supply is fixed at $54,000. The quantity demanded at the original sales price is not known, but it is probably a very large number.

One obvious question is, if the market were not used to ration or distribute the originally available tickets on the basis of ability and willingness to pay, how were they distributed? Several methods were used. First, 4,500 tickets are saved for each of the final four institutions. Presumably, these went to school officials, players and their families, big donors, and season ticket holders. Each school, no doubt, had a different priority list. Next, 15,000 tickets were sold to the general public through a drawing all the way back in July 2002. Anyone could send in a check for the face amount of the tickets, the lucky winners were drawn at random, and the money was returned to those who were not drawn.

The remaining 21,000 tickets went to a variety of groups. The largest allotment went to corporate sponsors and the media. In a way, these groups "pay" for their tickets. CBS, for example, paid millions of dollars for the rights to televise the tournament. That payment was distributed among the teams by a formula. Corporate sponsors paid CBS and the NCAA millions for the rights to advertise. In return, each group received a set number of tickets to distribute as it saw fit.

What happened next was that a market arose. As long as people who are willing to pay very high prices (those who are represented by the upper left portion of the demand curve in Figure 4) can communicate with those who somehow were able to get tickets at face value, there will be trades! The Internet provides a convenient way for potential buyers to communicate with potential sellers. A simple search turns up dozens of organized ticket sellers.

Let us suppose that I was selected in the drawing in July and bought a pair of $100 tickets. How much must I really pay to go to the game? The answer is "what I can sell those tickets for." If I can sell the tickets for $4,000 a pair, I must turn down the $4,000 market price in order to go to the game. There is an opportunity cost. I must reveal that it is worth at least $4,000 because I forgo $4,000 if a friend and I can go to the games.

What then can we conclude about alternatives to the price rationing system?

*MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 73-77* 

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