The Shortage Fallacy

Someone recently sent me a disturbing article from May in the Washingtonian about nutrient shortages at hospitals in Washington, DC. According to the article, there are illness of malnutrition there not seen in many developing countries, especially for very early NICU children. I recommend reading the article in its entirety (when do I not?), despite its disturbing nature. The article, besides bringing to questions of social priorities (and hence policies and hence politics), sheds light on shortages.

Shortages don't really exist. It sounds absurd, especially for anyone who reads the article, or remembers (or at least has seen pictures of) the long gas lines in the Carter years, or hears anything from Silicon Valley about the difficulty of finding good engineering talent (and hence the need to import more under H1B visas). Merriam-Webster defines a shortage as a "lack" or a "deficit", which isn't very helpful. Investopedia does a better job, with "A situation where demand for a product or service exceeds the available supply." This makes a little more sense. We want and are willing to buy 100 apples, but there are only 50 available on the market.

The key to understanding shortages (and why they don't really exist), is that it is a lack of sufficient product to meet the demand. In our example, if we only wanted 50 apples, we would not consider it a shortage. It is the mismatch between the demand (100) and supply (50) that causes the shortage. In a normal economy, there is a built-in mechanism for managing these mismatches. It is called, the "price." If apples are selling for $0.25 each, and we want 100, but there are only 50 available, the apple sellers will increase their price until only 50 are demanded. The increase in price reduces our desire for apples until the demand matches right up with the number available.

What happens, though, if our apple seller is not able to raise prices? There are a number of reasons for this, but most boil down to one of:

• Social: people absolutely refuse to buy any apples over $0.25, believing it to be inappropriate
• Monopsony: there is only one buyer, and s/he refuses to buy any apples over $0.25 due to his/her purchasing power
• Governmental: this really is just a variety of the social and monopsony, as the government, reflecting the social desires of the people, regulate the price to not more than $0.25

When this happens, there will be shortages. People still want 100 apples, since the price is just $0.25, but the apple growers either cannot make more (bad year) or it just isn't worth it for them. In other words, shortages aren't real, they are artificial artifacts (is that redundant?) of an inability to raise prices.

Coming back to the infants in the hospital, the shortage of nutrients is a combination of all of the above. Socially, people have come to believe that basic lifesaving medicines, especially for children and especially for newborn infants, is something that should not cost "too much." Leaving aside any value judgements (and hence the politics), when customers will not agree to pay more than a certain amount, the price is capped and hence so is the output. From a monopsony perspective, there are few serious buyers of these nutrients. There are many hospitals, but they have banded together into purchasing groups, limiting the scope for the manufacturers. Finally, the government both increases the cost of manufacture due to stringent (and possibly necessary) regulations, while often restricting prices.

Since all three factors are at play, a shortage is inevitable.

How should an executive manage in a possibly capped environment, especially when providing essential products and services?

• Social: Sophisticated (not crude) public education is crucial. If your product can extend a person's productive life by 10 years, they should appreciate the value you have brought them, which, in turn, should increase their willingness to pay (or have society pay for it). Pharmaceuticals have been notoriously bad at this.
• Monopsony: Avoid markets where there is just one buyer . If you are already in that market, find ways to split multiple arms of the buyer and entice other buyers into the market, even at high cost.
• Government: Hire an expert in dealing with government regulation, but these are secondary. If you have multiple customers, and the public is well-educated, government will be easier to manage.