Wednesday, May 16, 2007

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

11 comments:

Gabriel Mihalache said...

With a fix supply (or with a nationalized stock), any price will clear the market.

One problem with price controls is the shortages that they induce, which is a big deal at any time frame over a few days. Also, it makes the law of one price break down, therefore keeping "outside" supply from pushing down on the price.

We also known that in an Edgeworth's Box model, for example, if one of the agents has 0 of one of the goods, then the 2nd Welfare Theorem fails and there's no price system that would result in efficient allocation. -- this might connect a bit with what you're saying.

But let me return to the fixed supply issue, with an example...

If there are 10 people in a crashing plane, and the plane only has 5 parachutes in the possession of one individual, the outcome is clear. With perfect information, he'll sell the parachutes to the 4 most wealthy individuals/most willing _and able_ to pay for them.

In the short run, when there are inventories which can be treated as fixed supplies, it's very tempting to resort to non-pricing distribution mechanisms. (Distribute the parachutes to women and children, for moral reasons.)

What prices do is create incentives for both increase supply and increased saving/rationing/careful usage.

The question of when the economic system breaks down, or is preferable to be broken down, is an interesting one. How does a capitalist economy respond to a huge catastrophe? At which point does it all include in looting, violence and so on?

Anonymous said...

Prices also affect how much of the product people buy in anticipation of the emergency. When expecting a storm that might knock out my electricity, I might be inclined to pick up a couple extra packs of batteries for my flashlights. If I find that they cost $10 a package instead of the customary $5, I could very easily decide to skip the second insurance pack, thus leaving it for my neighbor.

happyjuggler0 said...

The back drop is this: War destroys the US oil supply. There is a shortage of gasoline.

Ok, now imagine that the price is legally mandated to be kept at the previous equilibrium price. Call it $3 per gallon, pre-tax.

Now imagine also that the rest of the world also sells at $3 per gallon, pre-tax.

Under price controls (aka anti price gouging regulation), where is the incentive for producers to ship extra gasoline to the US instead of their usual customers worldwide?

Under a free market set price however, gasoline floods into the US as global producers rush to make more money.

Shortage ends much sooner under free market prices than under the "pro-consumer" method of anti price gouging. Fewer people die under the anti-comsumer method of free markets. This calls into serious doubt the notion that legislation against price gouging is pro-consumer.

Of course the rest of the world winds up paying higher prices as supply distribution arbitrages. But there would be much more scope for cutting down on unnecessary car trips (e.g. "let's watch a pay per view movie tonight kis instead of going to the theater"), which while painful for some (the kids really wanted to go to the movie theater), the pain is less than death, at least for the most part.

The higher prices would also likely produce more supply at the margin, such as international refineries who choose to delay scheduled (non-critical, in the short run anyway) maintainance so as to capture higher prices today than they would likely have gotten a couple of months in the future.

happyjuggler0 said...

anonymous from May 17 also has a point to which I would add that if you knew prices for batteries would rise when storms approached, you'd be more likely to stock up sufficiently during sunny times for a rainy day, so to speak. The idea being that during non-stormy times that prices are "normal", or lower than during stormy times if merchants are allowed to "price gouge" their customers.

Karl Smith said...

Yes, there are reasons why gouging is good. The most obvious being that it discourages supply.

The interesting question is, are there any cases under which gouging is bad. Are we as economists dogmatically supporting gouging without examining whether or not there is some argument for it.

My gut feeling on these sorts of things is that most of these arguments are really about parameter values, almost never personal values or even logic.

Anonymous said...

Yes, there are reasons why gouging is good. The most obvious being that it discourages supply.



you mean "ENcourages supply", because high prices induce more production - this is known as the law of supply.

Taylor said...

Karl,

You forgot to ask yourself what right anyone has to tell an oil producer how much they can or can not charge for the oil they produce.

The answer is no right, because to argue the opposite is to imply that oil producers are the slaves of oil consumers and that by their very choice of occupation (by their very existence, actually), they somehow owe it to oil consumers to only charge a particular "fair price." And then it gets even more confusing when you try to explain what a "fair price" is, which is always arbitrary and therefore wrong.

There isn't an argument against gouging. If there is, there is an argument against all other aspects of the free market and therefore there is an argument for communism... which there isn't. Logic is only logical when it is consistent... by claiming to have a logical argument against one aspect of voluntary interaction you should be able to carry that principle forward against all voluntary interaction.

Garth said...

Karl,
I happen to agree with your thoughts on this one (note that this does not mean I agree with anti "gouging" legislation necessarily.

I think your point is much broader than even you are stating it though - you really are asking why (or at least 'if') the field of economics insists on looking through only one lens of an issue. It's always about efficiency (or at least the potential for lump-sum efficiency) and assumptions (like ignoring the effect of supplying less of a good necessary for life with few alternatives - like gas).

It seems the problem is that economists mostly never ask about equit or fairness. Largely in our models, the effects of consumption of gasonline is analyzed similarly to conumption of a candy bar.

Your question really is, shouldn't these other things matter to an economist at least to some degree, and I would argue "yes," they should.

But "no," they largely currently don't.

Anonymous said...

karl man its a slow summer i keep clickin but nothing new whats going on

Corporate Serf said...

When the rich and the better off among the poor switch to the (currently) more expensive alternative; wouldn't the competition drive down the price of the alternative? Not saying your scenario can't happen, but it depends on exactly how much the price of the alternative change in response to the demand. (Is this elasticity? I don't have formal economic training; more a mathie type)

Interesting dynamics can occur in this scenario. For example, I suspect if this coefficient is bigger than some critical value what would happen is the fall in price would draw in more and more of the poor, which will result in more and more price decreases until all the spreads are squeezed out in that product. (A kind of phase transition)

Celesta said...

Fantastic!