Paul

Ibrahim

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September 15, 2008

Thank God for Price Gouging

This column deals with the theory behind “price gouging.” Tomorrow’s column will apply the theory to recent and ongoing situations in hurricane-affected areas.

In wake of the recent hurricanes that have hit the south, the recurrent issue of “price gouging” has inevitably arisen as officials in the affected areas go on a hunt for any vendor who dares to raise prices. Little do they know, however, that they are doing the people they serve a major disservice.

Let’s take the gas stations as an example. No one knows where their prices should be at any one point except for the gas stations themselves. What they generally should do, and what they actually do (as long as there is no government interference), is sell at a price maximizing profits.

But then an emergency happens, like Hurricane Katrina. Hundreds of thousands of people are cut off from the world for a week. Transportation into Louisiana is down, and supply lines for local businesses are non-existent. The gas stations in Louisiana don’t have a way to re-supply, and they have to work with only what they have in stock (as do grocery stores, etc.).

Because there is a shortage of gas in the area, a gas station owner will logically raise the price of his gas from, say, $3 a gallon, because he will not be getting re-supplied anytime soon, and demand hasn’t dropped to compensate for this lack of gas. So by raising the price, he is making people bid for the gas in a way. Let’s say that judging from the demand he is getting, from the prices of his competition, and from other economic factors, he decides that at $8 a gallon he will make the most profit. In other words, at under $8 he will sell everything before he gets re-supplied, and at over $8 he won’t be able to sell enough to make as much profit as he would at $8.

Now when he (and his competition) does this, people become indignant. “Look at this guy! He was selling gas for $3 a gallon yesterday and now he’s more than doubled it! He’s ripping us off!” Then the media starts reporting that gas station owners are engaged in “price gouging,” and the politicians make speeches about how we shouldn’t let the evil gas station owners profit off of hard-working people. They pass a law that says if you sell gas at more than (a highly arbitrary) $3 a gallon, you are going to be prosecuted.

At $3, people will buy at least as much gas as they were buying before (in fact, they will probably buy much more, because they know that the gas stations will run out). There are long lines at the pump, and the lucky ones who happened to get there first buy as much gas as they can. The rest are left without any gas whatsoever.

It could very well be that those who did get the gas were teenagers who don’t really need to drive their cars, and who will burn the gas by just driving around town. And it could very well be that those who did not get the gas needed it the most, because their business depends entirely on it, or they have to drive to Grandma’s, who is alone in the aftermath of the storm.

So it is true that lowering gas prices to $3 sounds good, in the sense that people might not be angry about being “ripped off.” But in reality, they are. While a lucky few get the gas, the rest have no hope of driving regardless of how urgently they need to do so.

So how do we resolve this? How do we know who truly needs the gas and who does not? No person or government agency knows, nor will they ever know. Instead, the best way to discriminate in favor of those who need the most gas and against those who do not is, in fact, to increase the price. A bunch of teenagers driving around their high school would not be willing to pay $8 for the gas, but someone who needs the gas for an emergency, such as getting to sick grandma, will pay $8.

And so you know, if you really need gas for an emergency or an important trip, there will always be gas for you there, even if it is expensive. At $3 a gallon, however, the gas is long gone, and wasted. Indeed, expensive gas is better than no gas.

Of course this does not only apply to gas. Take bottled water in a Katrina-like situation. The price goes up from $1 to $7 a bottle, people get angry, and the politicians force the price to remain at $1. Again, it is going to be hogged. Whoever gets to the grocery store first, even if they had just received their delivery of water dispenser containers that will last them three months, will still buy all the cheap water and put it to whatever use – brushing their teeth, washing their dogs, watering their plants. But those who do not have water at home and urgently need to drink, and who arrive late, remain thirsty because there is no water left. The government never knows who needs the water most. The best way to determine need is through the price system.

Allowing prices to discriminate in favor of the truly needy is such an effective mechanism that no government should ever interfere with it. One fine economist even labels the process “economic triage.”

Indeed, following a bomb explosion at a restaurant, the medics are clearly expected to care for those who lost two limbs prior to those who scratched their elbows. But having the government prevent price-driven discrimination between those who need products the most and those who do not need them much is like having the government force medics to give everyone equal attention at a health disaster scene.

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