Friday, December 18, 2009

"Price Gouging"

Apparently most of the states have laws on the books against the practice of "price gouging", which occurs when sellers raise prices, usually on critical goods like water, plywood, generators, gasoline, batteries, and ice, after a storm or some other disaster has caused serious lifestyle disruptions to a large segment of the local population. The wording of the laws seems to vary from place to place, but generally the rules state that a seller cannot raise normal prices beyond some amount---in some cases the amount specified is zero, in some cases it is 10%, in some it is "reasonable"---in response to a crisis. The idea is obviously to prevent unscrupulous and opportunistic merchants from taking advantage of desperate disaster victims.

While intentions may be good, this is yet another case of an economic scenario in which the right heart leads to the wrong results. Laws against price-gouging almost guarantee that there will be a shortage of critical goods if and when a disaster does strike a community. There are three reasons for this:

1. No incentive for merchants to carry excess inventory. Let's say that a local Home Depot sees that the demand for portable generators is normally at level 5, but in the wake of a major hurricane that demand goes to level 10 immediately. If Home Depot carries an inventory of generators that is appropriate for normal conditions, the generators will sell out quickly before or just after a storm and then there will be no generators available at any realistic price. In order to have enough to meet a level 10 demand, the store will have to order many more generators than it ever sells under normal conditions, which means dedicating inventory space and possibly working capital to products that may (with a high probability) just sit there on the shelves. Perhaps the hurricane never materializes and Home Depot just carries excess generator inventory indefinitely.

To carry the excess inventory of generators, Home Depot needs to be compensated for the risk that the economic justification for carrying this inventory---a sudden, upwards demand shock for generators created by mass power outages---never comes. The store manager needs to feel that the excess generators will fetch a premium in the event of a storm in order to cover the (possibly greater) probability that the store will just end up ordering more than it can sell. The concern is one of irreducible uncertainty.

The result of anti-price gouging legislation is that Home Depot won't maintain an excess inventory of generators, and thus the store will sell out of these products quickly when they are needed most, probably in the short period before a major storm arrives when it has become clear that the area in question is going to get hit. At the point that Home Depot and other stores sell out, the cost of a generator truly skyrockets---you have to start looking at more and more extreme measures being necessary to obtain one.

There is a cruel irony at work: dropping the anti-price gouging legislation would lead to many stores carrying the excess inventory in the hopes of making these special profits, but if many stores do this it would lead to prices coming down on the increase in supply. The paradox is that allowing merchants to charge as much as they can gives them the incentive to carry the inventories, which in turn brings generator prices down because of the creation of competitive pressures on the sell-side. The best way to guarantee the availability of cheap generators during a disaster is to allow competing sellers to try to price gouge.

2. Emergent entrepreneurs have no incentive to become involved. Continuing with our generator example, a private citizen in a neighboring-but-relatively-unaffected city or county could rent a large truck, purchase a bunch of generators and some supplies, bring his chainsaw (to cut his way through fallen trees) and rifle, and attempt to make his way into the disaster area in order to set up shop and sell generators. However, he would not be able to charge a premium over what he purchased the generators for (unless he was willing to break the law), and thus would be unable to cover his costs, let alone to achieve the kind of profit that would be necessary to motivate someone to drop everything and attempt a short-term, high-risk, capital-intensive project like this.

This is not to say that heroic Good Samaritan types will be dissuaded, because such people exist and will operate at heavy financial losses and personal risk to try to bring aid to the needy. However, these people are recognized as heroic for a good reason: they are rare. Once again, the best way to get generators into the area is to encourage a range of motivating emotions, most notably greed, in order to deploy resources and human creativity towards a social good.

3. There is no mechanism for differentiating between casual and serious needs. Charles may want a generator because he needs to keep his life support equipment going; Bob may want a generator because he wants to be able to continue to watch porn. Unless the people at Home Depot can read minds and determine what uses Bob and Charles have in mind, that last generator may go to Bob if he happens to get there a few minutes before poor Charles.

If the generator sells at a premium, however, Bob would be expected to decide against a purchase long before Charles would. We can certainly all construct hypothetical situations in which Bob would be prepared to pay more for a porn capability than Charles would be willing to pay for his physical health (Bob is a desperate porn-addict; Bob has vast wealth; Charles doesn't actually care about his physical well-being), but the market price discovery mechanism is not about trying to guarantee the optimal result in every single instance, no matter how unusual, eccentric, or insane.

We can also look at this from a labor perspective: if in the wake of the same storm you try to hire a contractor to build a gazebo in your backyard, you may find that virtually none are available. The few who are may give you a price quote for the job that is far in excess of what you would have normally expected to pay, so you put the project on hold. The reason for the lack of availability and high prices is because the contractors are busy doing major projects, like putting families' homes back together. If a contractor takes on your job, he may miss another, larger and more lucrative one, so he wants to be paid for his risk. Given the dire needs of some members of the community, your gazebo should in fact be put on hold, but the only way for this to happen is through the indirect transmission of the market price discovery system.

If contractor wages were artificially held down by government price controls, however, this mechanism would not be able to work. The attempt would no doubt be to prevent the wealthy from monopolizing resources at the expense of the poor, but the actual effect would be to give all projects the same priority and to cause distortions and poorly coordinated distributions of resources. If the free market system were permitted to work, a large piece of the problem could be solved efficiently and then government agencies, NGOs, charity organizations, churches, and the like could come in and try to identify those who had clear needs, but who lacked ability to pay.

Wage and price controls have historically managed to induce scarcities very effectively, and variations on our Home Depot/generator theme can be applied to many other industries, including health care. It is one of the great conceits of central planning enthusiasts that they believe they have access to more information than does the "distributed intelligence" of a free market, and that they can arbitrarily set the optimal clearing price without knowing the evolving dynamics of true supply and demand.

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