While a market’s structure and evolution is primarily endogenously motivated and, consequently, in constant flux, it is also affected by exogenous forces. This is easy to realize when considering such trades as farming, fishing, and hunting, all of which depend on weather, climate, and so on as much – if not more – as endogenous factors. The market situation, including both supply and demand, of farm products, fish, and game are endogenous variables, which means they are effects arising from within the economic organism. In fact, the very reason we can think of them as products, which makes them potentially saleable through exchange, is due to consumers’ demand and because producers invest time, effort, and capital into supplying these goods with the intention of satisfying demand through exchange. These are all endogenous to the economy, and therefore cause changes “from within.” But production of farm goods, to limit our discussion to one the examples, is not purely dependent on endogenous effects like supply, demand, and production techniques; it is also dependent on non-economic factors like the suitability of the soil, precipitation, sunlight, temperature, the natural process of growth in planted seeds, and so on. Modern GMO techniques blur the boundaries of what used to be purely endogenous or exogenous, but there are still exogenous elements to them. Also, we have not yet figured out how to replace the sun as input to farming. So while entrepreneurs in farming expect a standard yield from their field, the real outcome of their efforts are subject to exogenous shocks as well as is limited by exogenous restraints such as the natural seasonality of farming: sowing in spring, growing in summer, harvesting in fall.
The farmer-entrepreneur has expectations of standard output quantity from the employed acreage, but actual production is affected by other things than economic factors such as the occurrence of adverse weather. For instance, the summer could turn out to be unusually hot and dry, or unusually cold and wet, and there may be severe storms or wildfires, all of which would have an effect (in this case, exclusively a negative effect) on the farm’s yield. While much less likely events, a meteor may hit the farm, a volcano may erupt and cover the fields in lava or ash, or a landslide or sink hole could completely undo the farm. These are all examples of exogenous forces that affect the yield of the farm (its output through production), and for this reason the farmer’s return to investment, and therefore contribute to the uncertainty of the undertaking: the farmer-entrepreneur cannot know whether the weather will be beneficial or not – or to what degree. They also originate specifically outside the economic system: neither the number of sun hours nor average temperature nor precipitation have economic causes. So while the economic organism overall is primarily an endogenously generated structure, it is also subject to exogenous forces that affect how and whether it works. The question, therefore, is whether and to what degree the economic system – the market – can handle, avoid or respond well to exogenous forces that can change the condition for production. As we know from previous chapters, the economy is already busy responding and adjusting to the numerous changes coming from within.
In general, risk management consists of lowering the cost of negative effects by employing one or a combination of two strategies: preventive action to reduce the likelihood that an event will occur, and responsive action to mitigate the effects of already occurred events. We will look at these two strategies as they apply also to the economy, and will revisit Adele’s apple-growing undertaking to illustrate. At the time we come back to see her, the orchard is recently established and has yet to bear fruit. In other words, she’s heavily invested and is still expecting the orchard to produce apples that she will eagerly sell to the market to cover her costs and make a profit.
Avoidance through Control
Before Adele decided to go into the apple-growing business, she studied it in detail so that she would know what to expect. Like any other specialized trade, there is a lot to apple-growing that those who are not in the business don’t know (or care) about. So there was a learning curve (that is, it took time and effort to acquire the knowledge and skill necessary), but Adele is a thoughtful person who lives by the motto of “better safe than sorry” so she didn’t mind investing the time and effort. Also, she would much rather spend a little now to limit the possible downside than risk losing it all. In other words, she is risk averse and thus prefers little risk to more risk.
When studying apple-growing, Adele realized that there are many things that can go wrong. As the production process is very long – it takes years from planting the trees until they produce apples – there are many things that can happen. With several seasons between planting the seeds and the first harvest, both very hot or very wet summers would delay the growth of the trees and therefore her return on investment. So she decided early on that it would be wise to invest in an irrigation system to make sure the trees would grow even if there was not sufficient precipitation. It cost her a lot extra to contract with Frank, who is an irrigation expert from the other side of the mountain, to connect pipes to the nearby lake for irrigation. But the cost was worth it, Adele figured, because the cost of delaying income from selling apples by a year or two would be disastrous. It therefore made sense to shoulder the extra cost up front, even though there is no saying whether there would be enough rain the next few years.
She is also aware of the risk that there might not be enough sun for the trees to bloom and bear fruit, but whereas this would postpone her chance of income in the same way as a lack of rain, the sun is much harder to replace. So that risk was one she would have to take despite all the other potential problems that she could have to face. In fact, to Adele the very reason there is no way of insuring the apple-growing business against too little sun made the irrigation system seem so much more worth it. Because the sun hours in the years to come is an uncertainty that she cannot control, the peace of mind from not having to worry about the supply of water to the trees is worth more to her. And she’s also made some calculations to make sure the irrigation makes business sense. Her conclusion was that adding the irrigation system means it will take her longer to cover her investment, but that she expects this cost of waiting to be lower than the cost of risking a slowing in the growth of the apple trees – even if the risk of a dry, hot summer is quite low.
So while she has chosen to control water supply to the trees, she has also chosen to bear the uncertainty of too little sun. Both too little precipitation and too little sun are exogenous events that would be very costly to Adele should they occur. Neither can be prevented in any real sense, since we cannot control nature. But the cost of slow tree growth due to a lack of rain can be avoided by investing in productive means that replace the natural process and therefore, in a sense, counteract natural effects. We can see, then, how the innovation of specific productive capital – the creation of economic resources – such as irrigation provides a means to make production independent of – and therefore controllable – the whims of nature. Indeed, the economic realm is continuously affected by and ultimately depends on the resources offered by nature, but its productive power is distinct from it. The production and maintenance of productive capital is a means to bring about a permanently higher degree of wants satisfaction.
Irrigation is not the only type of capital that Adele may choose to invest in to increase or speed up production. As we saw in previous chapters, she could invest in labor to clear the land, plant the seeds, and tend to the trees much more effectively – and therefore in a less time-consuming manner – than she would be able to herself. And she could invest in machinery to increase the productivity of the employed worker, thereby further increasing the output per paid labor hour. These are all endogenous or economic means to handle both endogenous and exogenous problems, and both using and not using them comes at a cost: to not employ others to help her means she will need to invest more of her own time and labor; to not buy machinery means she will need to employ more people; and so on. Economic decisions are always about tradeoffs between different good and different costs – and when they are expected to occur. Some things are impossible to control – such as the number of sun hours – whereas others seem too costly to be “worth it.”
In addition to the irrigation system, Adele invests in pest control. Some pests are too uncommon to be worth the trouble, but others pose real threat to her business. She chooses to set out scarecrows to keep birds from eating the fruit before it is sufficiently ripe to be picked. Scarecrows are not perfect, but will keep the number of birds down – and scare off the worst kinds – efficiently enough to cover the cost of the scarecrows and then some. Again, Adele estimates the cost of the means – buying and setting out several scarecrows – with the estimated benefit – avoiding in part the loss of apples to hungry birds. The issue of scarecrows was a no-brainer, since the scarecrows didn’t cost her much and will remain useful for a long time – and they will keep plenty of birds off the apples. The benefit of investing in them exceeded the cost by so much that there was no calculation necessary.
For other pests, however, it was not as obvious. Apple trees can be infested by moths and mites; they can become the homes of larvae like the Apple Tree Borer; and they can attract scab and other fungi or diseases. For many of these, there are countermeasures available that can help save the trees by preventing infestation. But whether it is a good investment must be decided without the facts known: whether Adele’s orchard will be infested is something she cannot know – she can only make educated guesses about the risk and the potential cost. In this case, she decides not to use any countermeasures. With the irrigation system and scarecrows, she imagines that she’ll have enough chance of getting a huge harvest that will produce a comfortable return on investment. Considering the whole undertaking, the risk of infestation is too small and the cost of prevention too high for it to make economic sense, she reasons.
Responding to “Shocks”
A couple of years into the apple-growing business and the orchard is beginning to look like an actual orchard. The trees are growing fast and Adele is happy with how the irrigation system kept the dirt moist when they experienced a couple of very hot and dry weeks last summer. Within a couple of years, she hopes to have a first limited harvest available for sale, and then in a couple of more years production peaks. So far, she’s avoided the costs of too little rain because of the irrigation system (which proved to be a good idea) and she hasn’t suffered much from loss of sun. Moreover, she’s had no real issue with pests an only a few birds have dared defy the scarecrows. She is very happy with how things have turned out, even considering that she chose to not employ anyone but is relying on her own – and a couple of nephews’ – efforts. It has been tough at times, but not too much to handle. So she is glad that she didn’t take on the extra cost of employing others; it would not have contributed to her bottom line.
As the spring nears, she hears reports from other apple-growers in the region that they have seen signs of scab on the trees. Scab is not an uncommon fungal infection, but it can potentially kill a whole orchard if it is not properly controlled. The news, therefore, is not good. Adele had actually noticed scab lesions on a couple of her trees in the previous fall, but took action to excise them from the trees. She chose to take other precautions as well, such as removing all leaf litter from under the trees often, but chose not to invest in the potentially harmful chemical controls that can be used to fight apple scab. So she realizes that she might be affected. But as she has seen nothing to indicate that her orchard has been infected, and has taken all the non-chemical precautions, she estimates that she is comparatively safe. The reports do not justify the cost and other unfavorable effects, in her mind.
The reports were not exaggerated. As spring moves into early summer, it becomes clear that many of the orchards suffer severe scab infections. The affected apple-growers lose the year’s harvest, since scabbed apples are very hard to sell – at least at a price that makes sense. Adele and a few others are lucky to not be infected, whereas other apple-growers had chosen to apply chemical controls. The latter apples sell at a lower price because of the potential harmful effects, but these growers – in contrast to Adele – considered the lower revenue to be a worthwhile cost in comparison to the risk of losing a year’s harvest or the whole orchard. As a result of the scab, the supply of apples to the market diminishes.
Whether or not others are aware of the scab, it soon becomes obvious that there are not as many apples available as expected. Consumers looking to buy apples find grocery stores with empty apple bins, and the stores in turn cannot find apples to fill their bins. As consumers’ demand exceeds the available supply, the price is bid up. The effect is here the same as if consumer demand had suddenly increased and entrepreneurs therefore made a mistake in expecting to produce to satisfy a lower demand. In fact, the story is exactly the same whether or not consumer demand changed: entrepreneurial mistakes have caused a mismatch between supply and demand, which brings about a price change.
Some entrepreneurs will realize that things have changed unexpectedly sooner than other entrepreneurs. For instance, some grocery store entrepreneurs would increase their price of apples before the shortage was obvious because they judged or imagined the situation correctly. These stores would at first be avoided by consumers, since their price of apples is way too high – apples are available at lower prices elsewhere. But as soon as the grocery stores with lower prices run out of apples, anyone who wants apples would need to go to a high-price store. That is, after all, the only place that still offers apples for sale. Of course, those consumers who don’t think the higher asking price for apples is “worth it” will not go there. But there may be enough actual customers for these entrepreneurs to sell their stock.
Likewise, some wholesaler entrepreneurs would imagine that prices are traded at a too low price and therefore raise their prices. Grocery stores would at first avoid them, since apples are available from other wholesalers at a lower price. But as soon as the shortage becomes apparent, they will consider the higher price – if they think consumers are likely to pay enough for the remaining apples. And the same applies to the unaffected apple-growers – like Adele – who are likely to realize the shortage sooner than those further down the chain. They will require a higher price to sell their apples because they imagine the lower supply is not met by a lower demand and therefore will mean the market will bear the higher price.
What this means is that a shortage does not necessary have to be realized before the adjustment process begins. In fact, consumers may not see empty bins but only a higher price tag – because entrepreneurs throughout the supply chain have adjusted their buying and selling in anticipation of how consumers will react to the lower supply. And the consumers may in fact be completely ignorant of the sudden large-scale scab infection of orchards. They don’t need to know the details, but need only react to the prices that entrepreneurs ask for apples: if it is too high, too few of them will buy; if it is too low, too many of them will want to buy. As a result, the entrepreneurs will either realize their mistaken anticipated price and make the proper adjustments up or down, or will end up bearing the full cost of their mistake. The entrepreneur’s task, after all, is to attempt to correctly anticipate consumers’ true valuation of the good they offer for sale – and bear the uncertainty thereof.
So we see that exogenous shocks to the “economic organism” are handled just as endogenous such: by decentralized, bottom-up adjustments to prices and offerings. In our example, apples were infected by apple scab which reduced the supply. As the general tendency in any market is to find the proper balance between supply and demand through price, an exogenous shock to supply is not different from an endogenous shock from changing consumer preferences. It is also not different from an endogenous shock to supply through disruptive innovation, which can completely change what is produced and how it is being produced. But can the market’s decentralized and “automatic” adjustments be sufficient in a time of real crisis? What if there is not a scab affecting apples, but an earthquake or hurricane devastating a whole city?
A disaster, whether it is devastation due to natural forces such as earthquakes, volcanic eruptions, tsunamis, and hurricanes or man-made destruction from wars or rent control, can, economically speaking, be understood as an abrupt and radical increase in scarcity. While the apple scab was also an increase in scarcity (the scab diminished the supply of apples), it affected a single good and one that was likely inessential for the population. Disasters, in contrast, have a huge impact on the supply of essential goods such as food, shelter, and power; they greatly reduce the supply – or even wipe it out – and therefore put people in a very delicate situation, fully exposed to the elements. In other words, they create abject scarcity of essential goods within a very short time frame.
For it to be a disaster, the change needs to be unanticipated. As we discussed above, market production is continuously adjusted toward the anticipated future by entrepreneurs attempting to outdo each other by finding a better use for resources available or invented. If supply of essential goods is dramatically reduced but the change is anticipated, then prices and production structures have already been adjusted to account for this change, and the disastrous effects are therefore mitigated if not even avoided. A disaster is therefore different from other radical change because it is rarely if at all anticipated – and it affects most or all goods across the board.
So how would the “market” respond to for instance an earthquake that breaks bridges in two, wrecks and flattens houses, and causes mayhem? The answer is no different from above: by finding prices where supply meets demand and by reallocating resources toward their better uses. Following a disaster, there are fewer resources available than before but there are still resources. Of course, the initial and direct response to a disaster is likely to be in the form of community and voluntary efforts rather than organized for-profit entrepreneurship: neighborhood communities, churches, families and other associations, new and old, get together to pool their resources in order to help those in greatest need. For example, temporary hospitals would be set up and run by volunteers, people would get together in teams for organized search and rescue, and temporary shelters would be made for those without. These community and volunteer efforts should not be discounted or underestimated, but they too will benefit from the market response.
At some point, and following a disaster this would be rather soon, the affected region will fall short of and therefore need supplies from elsewhere – as well as produce their own to the degree possible. Both of these, which aim to increase supply, are primarily economic activities, and can thus be explained using the template from above. Two responses are needed: increased inflow of necessary and needed goods, and reallocation of remaining resources toward the now more highly valued needs (shelter, food, water, etc.).
The increased inflow of goods from elsewhere is accomplished in two ways, both of which are important. First, there is the voluntary and community-based relief efforts through aid: for instance, private people or organizations renting trucks to transport and offer their personal property to those in need; there are also organizations dedicated to relief work and aid like the Médecins Sans Frontières (Doctors Without Borders), the Red Cross, and so forth. These organizations are dependent on the charity of those who were not affected, and therefore indirectly on the productive power of economies not devastated. Of more direct interest to us here, however, is the incentive-based mechanism for directing goods toward disaster areas. As above, this involves adjustments to the prices of goods. As the need increases for certain goods, so does the willingness to pay for those goods and as this leads to a higher price it produces an incentive to increase production of those goods to satisfy the demand.
Antibiotics may serve as an example of this. The need for antibiotics is higher following disaster than before, whereas the demand in other, unaffected areas likely does not undergo as drastic change. The price may therefore go up in the affected area, which will attract antibiotics from other regions. As the price goes up, of course, we know that more of the more highly priced goods will be reallocated toward the higher price (the more intense want/need). But how can the price go up in a disaster area? After all, people who have lost everything hardly have money to pay for antibiotics. This may be true, but it is not necessary to have cash in hand to pay the higher price. But the higher price is the most effective way in which existing antibiotics are directed toward their better uses – and the way to effectively drive up supply by increasing production. What matters is that the higher price is offered in some way, not that cash is provided. So the price can be offered and paid by those donating money for relief efforts, by those needing effort offering future payment (that is, they assume debt), or by suppliers in unaffected areas hoping to increase their customer base by developing goodwill through gifting antibiotics to disaster areas. The effect is the same: the relative price of the good in the disaster area increases, and therefore more of it will be allocated toward satisfying wants and needs there rather than in other places.
But we should not forget that the redirection of antibiotics toward the greater need, whether this is through donations or charitable activities or market action, also means there is relatively less of this good available overall. In other words, the price goes up as the demand has increased overall and this incentivizes producers to increase and accelerate production and therefore increase the available supply. So even though there may be higher “bids” for antibiotics in the disaster-stricken area, the relative asking price will also increase in surrounding areas and this will bring about increased production as well as inflow from more distant areas. In other words, the price mechanism works to both redirect existing resources toward their greater need from area to are, and increase supply of goods that become relatively less abundant (more scarce).
Price also plays a role in reallocating resources already in use in the affected area. For instance, a single-family dwelling could be used as a hospital. In many cases, owners may recognize the need and therefore offer their space to help those in greater need. Where this is not the case, a higher price – whether offered in cash, goods, service, or future payment – entices those in control of the resources to allow them to be used toward the greater good.
This is also about discovery, since resources can have multiple uses. Thus, a resource used in a certain way, and generally recognized as usable primarily in that specific way, may have other uses that directly contribute to satisfying the more urgent needs. These uses are discoverable because the greater needs are identifiable through the adjustment to prices. Whereas prices may not be determined immediately (or in a vacuum), and therefore may not be of much use immediately following the earthquake-caused disaster, prohibiting prices to be determined can itself bring about a disaster. Prices, as we have noted above, do not need to be cash prices but can be expressed in other goods, in access or other grants of opportunities, or anything else that individuals consider valuable. Indeed, a disaster area may adopt a completely different means of exchange – a different kind of money, as it were – that makes more sense in that situation.
Whereas disasters make it less obvious how the economic organism would properly and without direction adjust to the new conditions, the mechanisms remain the same. The difference between a disaster area and the examples of “shocks” above is the former’s greater magnitude, which calls for faster change, and because infrastructure for communications and power as well as existing institutions, such as money, may have been affected or even destroyed. Such changes indeed hinder the economic organism from effectively responding, but this does not change the fact that better ways are hard to come by – if at all possible. Whereas the immediate relief may be charitable and in the form of aid, this effort depends on market mechanisms for its ability to function and – more to the point – continue to provide relief. The market mechanisms are far from efficient, but provide the framework within which individuals’ incentives and actions are aligned and the totality pull in the same direction.
The aftermath of Hurricane Katrina, to date the costliest natural disaster and one of the deadliest hurricanes in United States history, can be used to illustrate the effects on and response by the economy to natural disaster. Hurricane Katrina hit the Gulf of Mexico in August 2005 caused vast destruction and flooding along the Gulf coast from Central Florida to Texas. The most severe flooding, with water lingering for weeks, happened in New Orleans, LA, as a result of extensive levee failure in the city’s hurricane surge protection. A large part of the city was evacuated as the destruction made much of the Gulf coast dangerous or uninhabitable, without functioning infrastructure and services. For instance, at the peak of the storm the big-box retailer Wal-Mart closed 2 of its distribution centers and 126 of its stores, of which “more than half ended up losing power, some were flooded, and 89 . . . reported damage.” But within 10 days 121 of those stores were open again, as a result of corporate resources redirected toward preparing for the impact of the storm and more resources allocated toward restoring damaged stores.
Several of the big-box retail chains as well as large fast-food restaurant chains like McDonald’s have permanent crisis centers with dedicated resources to prepare for destruction and disasters, and tasked with quickly re-establishing “business as usual” upon impact. As the storm neared, these businesses directed more of their resources to these centers in order to plan and prepare for impact and thereby minimize the interruption and cost due to destruction. In fact, private enterprise responded quickly to Hurricane Katrina and were overall much more effective than government in providing necessities such as food and water as well as shelter, and restoring supply chains to the affected areas. As reported by economist Steven Horwitz, businesses “responded with speed and effectiveness, often in spite of government relief workers’ attempts to stymie it, and in the process saved numerous lives and prevented looting and chaos that otherwise would have occurred.” Their response, both the preparation for and the execution of restoration efforts, illustrate the redirection of resources from unaffected parts of the market toward those parts in greater need.
These efforts were not made simply to quickly restore profitability, even though this was likely an important reason for repairing stores and re-establish supply chains. Many of the private businesses took active part in community efforts to restore normalcy, both through assuming large costs for restoration work, donations to charity, and helping employees and their families to find new or temporary homes. They also provided food and necessities such as water free of charge to those in need. Wal-Mart is credited with providing the local population with water and food, hospitals with medicines and supplies, and provided space in their stores to serve as headquarters for help organizations working with relief efforts.
This private relief effort was not uniquely done by big national corporations, of course, though they were by their sheer size, and thus the amount of resources they control, able to redirect more resources to the affected areas. The local communities focused their time, resources, and energy toward restoring their neighborhoods and reclaiming their normal lives. Numerous private citizens both in the affected areas and elsewhere coordinated efforts to help those in need by themselves contributing manpower and supplies as well as helping through established charitable organizations in place. The majority of this work, of course, was carried out by those most severely affected, that is the inhabitants of the flooded and otherwise affected areas, who had their dwellings destroyed, their families split up, and who lost their jobs and incomes. Whereas it took only days for the hurricane to pass, the work to restore the lives and destruction to property –estimated to in excess of $100 billion – took many years. Upon being evacuated and displaced, hundreds of thousands returned to the New Orleans area to rebuild what had been destroyed.
We can see, therefore, how Hurricane Katrina, while a terrible event that killed well over 1,000 people and displaced hundreds of thousands, illustrates what was argued above about redirected resource flows and changing preferences in the face of disaster – both in the directly affected areas and elsewhere. Much of the relief efforts – especially the first wave of supplies and restoration – were effectuated by the economic organism in the form of community efforts and private capital owners (both businesses and persons). The existing infrastructure, supply chains, and productive capital structure were highly effective at responding to the Hurricane Katrina disaster, and constituted an important part of charitable work within and toward local and regional communities. The governmental authorities “responsible” for such efforts were not.
Disaster and Optionality
What separates disaster from the destruction we discussed in the previous chapter is the scale and scope of its effect. The destruction of a window pane is very limited, yet can have significant impact on the market through the “ripple effects” that change what is being produced and how – even though it is limited in scale and scope. If a broken window can have such an effect on people’s choices down the line, as we saw in the case of what choices are made and who makes those choices (the shoe maker versus the glazier, and so on), imagine the potential effects of a large number of windows being broken on a particular day. This could easily change consumption and investment patterns in such a way that the outcome of market production – what the market ends up producing – is different from what it otherwise would have been. Add to this picture that not only windows are broken, but that all kinds of resources are destroyed, worn out, or outdated continuously. It becomes obvious that an economy must deal with and be able to respond to these changes, some of which are predictable while others are not. And this is indeed what we see through supply chains and trade: things break all the time, and this must be part of the calculation made by entrepreneurs. This is part of the reason they will require a profit margin in order to undertake an uncertain endeavor: to cover for expenses due to unforeseen events. It is also a reason why the economy as an organism produces superior results to any planned structure. Planning only works based on known events or known probabilities of events, but with the future being highly uncertain in more ways than we can probably imagine, a planned system will be too rigid to be able to respond to the myriad minor changes and the number of major changes that affect production. The flexibility of decentralized production and the decentralized decision-making that the market offers is unbeatable, as we saw in chapter 4, because it is highly flexible, include redundancy, and therefore can respond to changes using the information available locally or the imagination by single entrepreneurs.
Consider the situation where destruction is not limited in scope or scale, as was the case in chapter 5, but where destruction affects production in a great number of ways at the same time. And that this destruction is also widespread, and therefore affects many types of production at the same time. This is the nature of disaster, as was discussed above. It destroys otherwise believed to be permanent (or at least long-lasting, endurable) resources and pulls out the rug from under the feet of entrepreneurs’ production undertakings. As in the case of destruction, this has an effect on what people need and want, and it oftentimes creates a very urgent need to satisfy the most basic wants: shelter, food, medicine, safety. In other words, consumers no longer demand the great number of different types of goods that they recently were willing to spend money on buying, but instead focus their attention solely or primarily on re-establishing what we can refer to as “normal life.” Needless to say, they are less interested in their optionality – the various different types of goods and services offered – than they are in satisfying the very urgent needs the disaster has caused.
The fact that a disaster sets back society by large-scale and large-scope destruction, which effectively strips people from the means by which they satisfied their basic needs, changes people’s preference rankings. They will likely still find value in choices as well as in gadgets and goods and services that provide convenience, but these wants pale in comparison to the basic needs that no longer are satisfied. As the basic needs are not satisfied, they are felt with a great sense of urgency. Consequently, we can say that, to them, what matters is to fulfill or satisfy those needs – not other, and less highly ranked wants. This is the same thing as saying that they feel a strong uneasiness with regard to the basic needs that were lost due to the disaster, whereas the uneasiness they feel with regard to non-basic needs such as convenience is comparatively much lower. It therefore makes sense to redirect resources to satisfy the basic needs first. Depending on the scale and scope of the destruction, all resources may need to be reallocated toward providing shelter, food, security, and so forth.
A disaster, which is in fact destruction of great magnitude, destroys a large part of the capital structure within the economy and therefore inhibits its ability to satisfy wants to the degree previously possible. This is a burden on consumers, but a burden that is at least in part lessened by the changing preferences. As the urgency of satisfying basic needs following a disaster spikes, consumers are no longer as troubled with the wants that used to be their focus – they are now, relatively speaking, much less urgent and therefore of much lesser relative value. So it is not the case that the inhabitants of a city hit by a hurricane, for instance, will strive toward the same goals as prior to the hurricane. And they will not even consider it much of a burden until they have regained their previous standard of living. At the very top of their preference ranking is to satisfy those basic needs that they no longer can satisfy. A disaster therefore impacts the capital structure of the economy while at the same time, due to the loss, effectuating a change in consumers’ preference rankings. People in general, by being stripped of their means to satisfy basic needs, focus their attention to re-satisfy those and therefore, as a result, change how they rank their preferences. The loss of capital, in a sense, is met by a reassessment of the importance of wants to a similar degree: with the loss of capital, consumers adjust their preferences to meet the availability of capital.
This does not, of course, mean that consumers are not made worse off by the disaster – the destruction of capital is indeed a loss of much of their combined ability to satisfy wants. This, in effect, is the reason people change their preference rankings. There is no point in pursuing or being bothered with the wants that are now very far from being satisfied. In other words, whereas a person might find the business hours of a nearby 7-Eleven disturbingly limiting, or the lack of a specific color of shirt, these sources of uneasiness are soon forgotten when there is, for instance, no electric power or one’s dwelling is destroyed. The loss is undoubtedly there, and it is of course felt and due to the destruction, but many of the wants that were satisfied but are now lost are of little importance relative the utmost urgency of the much more basic needs, possibly necessary for survival, that are no longer satisfied.
Whereas the disaster is an exogenous event with disastrous effect on the workings of the economy, through the destruction of capital, the endogenous response consists of both reallocating resources and the reassessment of preferences. Both of these endogenous responses serve consumers by readjusting their and the producers’ expectations. They re-match, in a sense, consumer expectations and, consequently, their attention to wants, to fit the remaining capital structure and the resources made available from elsewhere, and thus the economy’s ability to satisfy the held wants. As the capital structure is rebuilt, which does not necessarily mean it is rebuilt in the image of what used to be since the relative importance of preferences may have changed, consumers’ demand will shift as wants are satisfied. We saw this above in how more wants can be satisfied as a society’s capital structure is expanded and, consequently, value created. This holds true whether or not the economy suffers a disaster. While there is great suffering following a disaster, from an economic point of view it constitutes a temporary setback through the loss of capital – and a shake-up of wants satisfaction. As the destruction inhibits the ability of the market to provide alternatives for consumers, and thus constitutes a loss of optionality, the focus of producers and community necessarily shifts toward restoring the economy’s ability to satisfy consumers’ basic needs rather than their optionality. To have several alternatives of similar value to choose between is a luxury that can only be afforded when a certain level of prosperity, and thus standard of living, has been achieved.
Hayek FAv. 1941. The Pure Theory of Capital. Routledge and Kegan Paul: London.
Hayek FAv. 1945. The Use of Knowledge in Society. American Economic Review 35(4): 519-530.
Horwitz SG. 2009. Wal-Mart to the Rescue: Private Enterprise’s Response to Hurricane Katrina. Independent Review 13(4): 511-528.
Horwitz SG. 2010. Doing the Right Things: The Private Sector Response to Hurricane Katrina as a Case Study in the Bourgeois Virtues. In Accepting the Invisible Hand: Market-Based Approaches to Social Economic Problems. White MD (ed.), Palgrave Macmillan.
Rydenfelt S. 1981. The Rise, Fall and Revival of Swedish Rent Control. In Rent Contro: Myths and Realities. Block W, Olsen E (eds.), The Fraser Institute: Vancouver.
Storr NM, Chamlee-Wright E, Storr VH. 2015. How We Came Back: Voices from Post-Katrina New Orleans. Mercatus Center at George Mason University.
Zimmerman A, Bauerlein V. 2005. At Wal-Mart, Emergency Plan Has Big Payoff. In Wall Street Journal.
 See (Hayek, 1941)
 See (Hayek, 1945)
 Swedish economist Assar Lindbeck has stated that “In many cases rent control appears to be the most efficient technique presently known to destroy a city—except for bombing.” Quoted in (Rydenfelt, 1981: 213, 230)
 (Zimmerman & Bauerlein, 2005)
 See (Horwitz, 2009)
 (Horwitz, 2009: 512)
 See (Horwitz, 2010)
 See (Storr, Chamlee-Wright, & Storr, 2015)