The Argument against Gouging

In the wake of concerns about rapidly increasing gas prices and the resurgence of anti-gouging laws, I wanted to take a moment and think about whether there could be any economic justification for preventing price gouging. That is, is there any way of framing the problem so that economists would agree that anti-gouging laws are good for society as a whole.

To be clear, anti-gouging laws will help some people. Most economists, however, believe that when all is said and done such laws hurt more people than they help. I am skeptical. I am skeptical because I am always skeptical. I am particularly skeptical because the public reaction is so hardily in favor of such laws.

Collective ignorance is hard bullet for me to bite. That’s not to say that it doesn’t happen, just that it takes heavy doses of evidence to convince me that it’s true. I should say also that collective ignorance and mass ignorance are two different beasts. It is entirely possible for people acting in a society to arrive at the right conclusion even if each individual has no idea what’s going on. Call it social emergent intelligence.

The first culprit when trying to reconcile a difference in opinion between economists and the public is on distribution. Economics proper is largely silent on how wealth is distributed; the public cares a great deal.

So, what does price gouging do to the distribution of wealth. The most obvious answer is that it transfers it from costumers to sellers. This is true but for various reasons I find it unsatisfying. What interests me more is the transfer between customers.

When the price of something goes up people buy less of it. True enough. But, who are those people? Does everyone buy less of it? In particular, do the poor reduce their consumption more than the rich?

That depends in part on whether the good is a luxury or a necessity. When the price of luxuries go up, poor people stop buying them in droves but the rich only cut back a little. On the other hand, both the poor and the rich try to hold on to their necessities as long as the can.

Now let’s just say for the sake of pure argument that a person must have a few basics to survive including gasoline or some much more expensive alternative. The cost of the basic level is almost the entire budget of the poor but a small fraction of the budget of the rich.

Enter price gouging. The back drop is this: War destroys the US oil supply. There is a shortage of gasoline. Oil companies can respond one of two ways. The first is that they turn to the price system and keep increasing the price until demand falls. The second is some sort of non-price rationing like waiting in really long lines.

What happens if the oil companies choose the price system or gouging as the politicians call it. The price of gasoline keeps rising and rising and rising and doesn’t stop until demand falls to match supply. If the price rises to the point where the more expensive alternative is available then the wealthy will switch to it and all will be well.

However, what happens to the poor who could not afford that alternative to begin with? In this example they all die. They needed gasoline or the alternative to survive. They could only afford gasoline. Since the price of gasoline rises to the price of the new alternative they don’t survive.

What would happen if we used non-price rationing? In this example, the worst that could happen, even if you picked a rationing system at random, is that the poor still die. If the lives of any of the wealthy are threatened by the rationing system they will just turn to the more expensive alternative.

However, the lives of some of the poor could be saved. If the rationing system differs in anyway from the price system then more people will live. Said another way, price gouging is the worst possible thing that could happen.

For the nerds out there what is going on is that willingness-to-pay is not accurately measuring the utility gain because of budget constraints. The poor are forced into a corner solution. The poor would really like to trade consumption from states of nature without gouging to states of nature with gouging but cannot because of incomplete insurance markets. As a result relatively small utility gains for the rich are paid for with huge utility losses to the poor.

The death example is extreme but it is only for the purpose of clear illustration. No one disputes that death involves a large loss of utility. However, the poor could simply lose their jobs, not be able to take their kids to day care, or not be able to visit a dying relative. In any of these cases gouging could be worse than the alternative.

hat tip to mankiw