For the past couple of weeks I have written about how capitalism is broken, and how to fix its crumbling pillars, including changing our understanding of self-interest, promoting competition by regulating monopolies, and ensuring the proper role of government. In today’s post I want to talk about the importance of the price mechanism, and how we can ensure that prices send the proper signals to both consumers and producers.
In a capitalist economy, prices are set by supply and demand. When more people want to buy a product, the price will rise, providing incentives to producers to increase supply. This includes bringing new producers into the market. If prices rise too much, consumers will either find a substitute or choose not to buy a product, either because they can’t afford it, or don’t think it is worth the price. At some point, prices should stabilize at an equilibrium level, where the quantity demanded equals the quantity supplied.
As I said before, this works pretty well for most consumer goods, where finding a substitute is easy (android phone instead of an iPhone) or going without is an option (eating at home instead of eating out). But what happens when there is no substitute and going without is not an option? If you need to fill your gas tank, there’s no real substitute for gasoline (unless you live in one of the vanishingly few cities that have functioning public transportation). And if you need medical care, going without can have catastrophic consequences. Prices for essential goods with few – or no – viable substitutes are called inelastic. That means demand doesn’t fall much when prices rise, and demand doesn’t rise much when prices fall. You can only drive one car at a time.
In a free market, capitalist economy, the price mechanism is essential for sending signals to producers and consumers. It is the way the “invisible hand of the market” communicates its intentions to market participants. But if prices are controlled artificially, rather than in response to supply and demand, then those signals aren’t sent, and the economy can’t efficiently allocate scare resources (which is the whole point of an economic system). Price manipulation occurs all the time, sometimes to benefit consumers, and sometimes to benefit producers. But either way, they distort the economy.
What happens when prices are artificially low?
Let’s take a look at what happens when prices are kept artificially low.
For the past few decades, interest rates – the price of money – have been kept artificially low by the Federal Reserve. When the cost of borrowed money is cheap, people tend to borrow a lot of it. At the same time, low interest rates tend to push asset values up (see my June 20 post for an explanation of how that happens). In the case of the housing market, low interest rates made for lower mortgage payments, which made it possible for buyers to afford more expensive homes. A shortage of homes available for sale exacerbated the problem, and as a result since 2001 housing prices rose at nearly double the rate of inflation. And now that interest rates have gone back up to the average of the past 50 years, the average family can no longer afford the average home.
If you’re data averse, you can skip this next part, but if you like numbers,[i] consider the following:
From 2001 through 2022, the total stock of houses in the U.S. rose 21.7%, or 0.9% per year. This was roughly the same as the rate of growth in the number of U.S. households. While many analysts believe there is a housing shortage in the U.S., for at least the last twenty years new home construction has kept pace with the growth in the number of households.
In 2001, the average rate in the U.S. for a 30-year fixed mortgage was 7.08%, and at that level the median family had to pay about 27% of their income to afford to buy a house at the median sale price.
From 2001 through 2022, mortgage interest rates fell to a low of 2.68% (in December 2020). During the same period, the median sale price of a home rose 164%, an annual rate of 4.5% (compared with a 2.4% increase in inflation). Outstanding mortgage debt grew even faster as borrowers financed a larger percentage of their new homes. At a 2.68% mortgage rate, the median family was paying just 19.3% of their income to afford the median home.
Today, 30-year mortgage rates have risen to 7.75% and home prices continued to increase. What used to be an affordable median home price at a 2.7% mortgage rate would now take 42% of a family’s income.
Pop Quiz: Which of the above numbers is an aberration? Is it the 2.68% mortgage rate – a rate that was 5% below the 50-year average – that that made ever-more-expensive houses affordable? Or is it today’s 7.75% mortgage rate, a rate that reflects the current growth and inflation environment, as interest rates are supposed to do?
Too-cheap money for too long drove housing prices far too high, rendering them unaffordable to most buyers. But housing prices are sticky. Once people believe their home is worth a certain amount, it is very hard for them to sell for less. So now, thanks to decades of economic malpractice on the part of the Fed, we are in a situation where young families cannot afford to buy a home. Is it any wonder people aren’t thrilled with the economy?
What happens when prices are artificially high?
Prices that are kept artificially high also distort the economy, but in a different way. Artificially high prices limit economic growth, either by reducing demand or by limiting investment in new supply. Artificially high prices also suck money out of the economy and into the pockets of billionaires. (I really tried to avoid using the “B” word in this post, but it’s impossible to discuss the problems with the economy without mentioning them.)
Let’s look at a key commodity where the price is artificially manipulated: oil. Oil derivatives, such as gasoline and petrochemicals, respond to market forces, and are driven by increases and decreases in the price of oil. But while oil prices respond to supply and demand factors, the overall supply of oil is highly influenced by the oil cartel, OPEC, which represents some of the biggest oil producing countries in the world.[ii] OPEC members produce about 40% of the world’s crude oil and OPEC’s oil exports account for about 60% of the petroleum traded internationally.[iii] Another 23% of global oil production comes from the so-called OPEC+ members, which includes Russia.[iv] Together, these countries produce nearly two-thirds of the world’s oil, and they act in concert to influence prices by setting production levels. With few exceptions, these countries all have relatively small populations, and they rely heavily on oil income. It is in their interests to keep oil prices high enough to cover their budget needs, but not so high that they kill demand – or spur investments in alternatives.
Since 2001, oil prices[v] have ranged from a low of $16.55/barrel in April 2020 to a high of $133.88/barrel in June 2008. Today a barrel of oil is about $85/barrel, lower than recent highs, but higher than it would be if global oil production rose in response to higher demand. Instead, Saudi Arabia, the world’s second-largest oil producer after the U.S., announced in late 2023 that it would reduce production through 2024 in order to keep prices high. This was done in part to help out Russia, which relies heavily on oil revenue to prosecute its war against Ukraine. As a result, gasoline prices are 49% higher than they were in 2002, almost double the rate of inflation during the same period. High gasoline prices have contributed to inflation in the U.S., hampering consumption and rendering growth lower than it otherwise would be.
What happens when too low prices in one thing collide with too high prices in another?
Overall, prices for healthcare are artificially high, but there is one area of healthcare where prices are too low: the cost of Medicare. As someone who just joined Medicare after years on the individual market, what I have to pay for healthcare is unbelievably low. My monthly premiums and deductibles are a fraction of what I used to pay, and copays are almost non-existent. I recently went to the eye doctor and received a full eye exam for $35 (it would have been free, but I opted for an additional procedure) and then used my annual $300 eye wear credit to get two pairs of glasses. With very few exceptions, I can have all the healthcare I want with almost no out-of-pocket costs. Needless to say, I and the other 65 million people on Medicare will demand a lot more healthcare than people with high premiums, deductibles and copays.
Now, let’s say I’m diagnosed with diabetes and need medication to treat it. One of the options is Ozempic, a drug produced by Novo Nordisk. Novo Nordisk’s patent on Ozempic was approved in 2017 and expires in 2031. The monthly cost for Ozempic ranges from $1,000 to $1,200 per month, which I could never afford on the $50,290 median household income of U.S. adults over 65.[vi] There are other options that are far less expensive, but Ozempic has the added benefit of promoting weight loss. If I had to pay for it myself, I would have to settle for an alternative. But I have Medicare! And my plan covers the entire cost of the drug. And you know who benefits from that – besides me? Why Novo Nordisk, of course. They get to keep the price high knowing there are enough people on Medicare or with private insurance plans that cover the drug. Yes, they spent money to develop the drug and run clinical trials. And yes, they deserve to reap the rewards of their investment. But how much do they deserve? And at whose expense?
According to the Center for Economic and Policy Research,[vii] the United States spends over $600 billion on prescription and non-prescription drugs that would likely sell for $100 billion if they did not have monopoly patent protections. That money is going into the pockets of executives and shareholders of the pharmaceutical companies – and it’s coming from all of us. They can only run this game because someone like me can get it for free – paid for by Medicare (meaning, all the rest of you). Of course, if you don’t have Medicare or other good insurance, tough luck!
By coincidence, I came across a very interesting and relevant article this week written by Leana Wen, a physician and columnist for the Washington Post. The article was entitled “Obesity drugs might not be worth their high prices,” and it presented a cost/benefit analysis of reducing obesity and its related health problems against the cost of the new class of weight-loss drugs. Her conclusion was – based on the current cost of these drugs – that society as a whole will not be better off financially simply by bringing down obesity related illnesses. In other words, the cost of treating obesity with drugs like Ozempic is higher than the potential cost benefit of reducing obesity-related illnesses. What struck me was that nowhere in the article did Dr. Wen question the price of Ozempic, which is totally unrelated to its cost of production and the profits it generates for Novo Nordisk. So, millions of people are denied access to what appears to be a miracle drug – even though they are paying for it with their taxes, and even though it costs far less in other countries – because Novo Nordisk was granted a patent, and our leaders are unwilling to stand up to the lobbyists.
Prices just want to be free
For a free-market economy to work properly, prices must respond to supply and demand. When prices are kept artificially low, excess demand will swamp supply and result in imbalances that may take years to resolve. Likewise, when prices are kept artificially high, money is sucked out of the economy and into the pockets of monopolies. And when “free market” meets “free lunch,” all hell breaks loose.
[i] All the following data is sourced from either Statista or the St. Louis Fed.
[ii] OPEC members include Algeria, Iran, Kuwait, Nigeria, Saudi Arabia, Venezuela, Iraq, Angola, United Arab Emirates, Indonesia, Ecuador, Qatar and Congo.
[iii] https://www.eia.gov/finance/markets/crudeoil/supply-opec.php#:~:text=OPEC%20member%20countries%20produce%20about,the%20total%20petroleum%20traded%20internationally.
[iv] https://www.eia.gov/todayinenergy/detail.php?id=56420
[v] Prices for West Texas Intermediate Crude. Source St. Louis Fed.
[vi] https://finance.yahoo.com/news/heres-typical-income-among-retirement-123000260.html
[vii] https://www.cepr.net/ozempic-and-wegovy-dont-cost-what-the-new-york-times-thinks-they-do/