Thursday, November 1, 2012

How Price Gouging Laws Cause Even More Devastation During Natural Disasters

It's unfortunate to see when natural disasters such as Hurricane Sandy hit, especially when it hits countries that don't have the infrastructure to adequately respond. When these disasters take place, goods and services get more expensive due to scarcity. When a producer raises prices to the point where they are considered unfair or unreasonable, the practice is pejoratively known as price gouging. Since this practice is viewed as a form of exploitation of consumers during a crisis, many states have implemented laws [known as price gouging laws or anti-price gouging laws] that prevent price gouging from taking place. Before jumping on the bandwagon of calling sellers predatory, it would behoove us to first figure out the role of prices, what exactly price gouging laws do, the ethical issues with this practice, and given this information, determine whether price gouging laws are good, negligible, or just a terrible idea.

You think this would be a simple question, but here it goes: What are prices? A price is a market mechanism that relays information, mainly that of supply and demand. In the case of a hurricane striking, one experiences a supply shock, which is a sudden contraction of supply (i.e., there are less goods available than beforehand). As the graph below indicates, that means a sudden increase in prices:

Depending on the nature of a given good, that can also mean an increase of demand (below):

The natural disaster has caused a definite contraction in supply because inventories, vehicles, and infrastructures have been greatly debilitated, if not completely wiped out. In addition,  the demand for at least some of these goods is also going to increase because the consumer has an urgent demand that needs to be fulfilled. The price increase is thus inevitable. Due to the shortage described above, it is a safe bet to say that the quantity of a good before the natural disaster will be less than afterwards (∆Q < 0). The new prices in the short-run reflect scarcity, consumers place higher value on a given good, and based on these incentives and new information, the consumers and producers act accordingly. From a consumer standpoint, because the prices are much higher than one is accustomed to, a knee-jerk emotional reaction of unfairness ensues because they think that prices are the problem when prices are in fact a reflection of the problem.

Let's take a look at what the government attempts to do to mitigate the unfairness. Most states have price gouging laws and they vary from state to state, but the general idea is that the government says that a producer cannot charge over a certain price.  Since one can assume that the price the government sets will be below the market price, it creates a price ceiling:

As can be observed in the price ceiling graph above, Qs < Qd, which is another way to say that price ceilings create a shortage. The textbook example for the effects of the price ceiling is when the United States government imposed a price ceiling on gasoline back in the 1970s, which ended up in people waiting in long lines for gasoline and an inefficient use of resources. How is a shortage created in the first place? If a seller is forced to sell a good a price lower than what the market dictates, the seller would either sell less (depending on size of inventory) or even pull out of the market completely. Since certain sellers respond to these incentives as such, there is less quantity of a good available, thereby exacerbating the situation.

If the government imposes and dictates that the price of a good is just as much pre-disaster as it is post-disaster, the consumer will purchase and use this commodity with no more care than they did prior to the disaster. This eliminates the consumer's incentive to conserve, which is something that needs to be done during a crisis. Without that incentive, goods are consumed all quickly and thus become even more scarce. The idea is that goods in the affected area now are of higher value than they were pre-disaster. Without these laws, consumers are forced to think twice about whether they truly need a good in their time of need. If the consumer truly doesn't think the good is worth the cost, they can either try to find another provider or do without the good. No one is forcing the consumer to buy the good, and the practice of price "gouging" should not be a crime because it's the producer's prerogative to decide what to do with his business. However, if the consumer ends up paying the good, it's because the consumer attaches greater value to purchasing the good than what the customer gives up for that good.

Even if one cannot afford the good, the poorer individuals benefit from the economic system that permits price gouging, and here's how. Another issue is that price gouging laws take out an incentive for another group: producers outside the affected area. If I am a retailer who is observing the crisis, I will notice the potential for windfall profit in the area. What does that mean? The price will signal to me (or the [global] market for the good) that a particular good is especially needed. As a retailer, I have a profit-based incentive to send my goods there in an expedited fashion to make more profit. This mechanism helps incentivize producers to distribute much-needed goods to individuals much faster than if price gouging laws are in effect. More producers enter the market and compete for the business of the consumer by lowering prices. The mechanism of market competition helps lower prices back down to pre-disaster levels more quickly than government intervention. The producers make additional profits and the consumer receives important goods faster while returning the markets to normalcy quicker: a win-win situation. In spite of these price gouging laws, it's how Wal-Mart and other large retailers helped during Hurricane Katrina. It looks like it's even happening now. To mute that signal (i.e., the higher price) only delays a timely recuperation from the disaster.

Matt Zwolinski brings up many good points in the video below, but one of the points of particular interest was asking the question of what is the alternative distribution mechanism under price gouging laws. The answer is that it is based on a first-come, first-serve basis. If you couldn't get in line early enough or didn't have any political or business connections, you're screwed. And if you're poor, you can't even afford the prices of the black market because they're even higher than the "unregulated market," so again, screwed.

Postscript: If the Left-leaning Matthew Yglesias agrees that price gouging laws are a bad idea, not to mention most economists, it's yet another indicator that price gouging laws are a bad idea. The economics of price ceilings point out how price gouging laws cause shortages and delay economic recovery from a natural disaster. Both the consumer and the producer are harmed in the process. And that doesn't even get into things such as what constitutes a "'fair' price", consideration of respect of private property, or what gives the government the right to arbitrarily setting prices when efficiency or rationale are hardly at the forefront of just about any government intervention. It's just another example of when good intentions lead to unintended consequences. When will our politicians learn?

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