Tuesday, June 23, 2009

Windfall Profits and That Which Is Not Seen (Art Carden)

Art Carden uses Bastiat's classic parable of "That Which is Seen, and That Which is Not Seen" to show the fallacy of so-called "windfall profits":

I was the teaching assistant for a course on the theory of property rights during the fall semester of 2002. We spent quite a bit of time discussing rent control, various rent-control cases, and the legal principles that informed judicial decisions surrounding rent-control cases.

One of these principles was an aversion to "windfall" profits. Windfall profits occur when an entrepreneur enjoys profits in excess of what he expected, usually as the result of a drastic change in market conditions.

People often point to the run-up in gas prices — some gas stations were charging over $3 a gallon — after the September 11 attacks as an example of firms enjoying windfall profits. The price per gallon is higher than the cost per gallon. This, it is argued, is unfair, especially when an entrepreneur/business owner enjoys profits that he doesn't have to "work" for.

We often discussed this in terms of what was called the rate-setting equation, in which the court set prices according to the formula

rate = operating cost + reasonable return

This ignores two things. First, the definition of "reasonable" is arbitrary. Second, expected prices determine the costs an entrepreneur is willing to incur.

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