Thursday, May 20, 2010

Price Gouging

Andrew Zumwalt, M.S.

Price gouging sounds like a horrible thing. The “gouge” part really carries the negative connotation. When someone hears “gouge”, usually it’s in reference to “gouging out someone’s eye” which sounds pretty gruesome. It is surprising, then, to hear Professor Mike Munger, Chair of the Political Science Department at Duke University, talk about the positive effects of price gouging. The point Dr. Munger was trying to emphasize was the valuable information that prices convey. The best way to illustrate this is with same story he told.

 On September 5, 1996, Hurricane Fran slammed into Raleigh, North Carolina. Category 3, 120 MPH winds and 10 inches of rain caused trees to fall and damage to buildings. Roads were blocked and electricity was out for several days. With the absence of electricity, refrigerators stopped working and food started to spoil. Important medications like insulin and baby formula that must be kept cold began to warm and spoil in the September heat. Stores that had ice quickly sold out or the ice melted. The price of ice quickly rose to infinity, since ice could not be bought at ANY price.

Into this ice void, several young men from a nearby town that had been untouched by the hurricane rented a refrigerated truck, bought 500 bags of ice, and headed out to bring ice to Raleigh. They realized that the demand for ice would be greatest in the center of the city, so they cut through the obstacles with chainsaws and moved blockages off the road. When they got to the center, they opened their truck and sold ice for $12 a bag.

Twelve dollars a bag!?!! Ice normally sold for $1.70, and people were outraged about the high price of ice. Those outraged still bought ice, because the alternative (no ice) was worse and more costly in terms of spoilage, but they were still unhappy. Eventually, the police were called and the young men were arrested for price gouging and the truck with ice was impounded (and turned off in the impound lot, causing a big puddle). The price gouging law in North Carolina makes it illegal to sell items at a price “unreasonably excessive under the circumstances.” According to the story, people in line clapped when the police arrested the price gougers.  The clapping is confusing because the price of ice for those still waiting in line rose from $12 back to infinity (no ice at any price).  

The high price of ice actually provides some valuable information. First, the high price signals to consumers that ice is hard to come by or scarce. Consumers should only buy ice if they really need it. Who decides if the consumer really needs ice? The consumer! The consumer makes that decision by examining the benefits and costs of using that ice. For example, if ice was $12 a bag, you may not choose to keep the diet soda cold -- the benefit of a cold diet soda is not worth the cost. However, if one had to keep insulin or baby formula cold, they might consider the ice ‘cheap’ because having to replace those items might be very expensive, especially in the wake of a hurricane.

Second, the high price of ice sends a message to suppliers: Get ice here quick! The premium for ice encourages suppliers to redirect ice from places of plenty or produce more ice. The high price more than compensates for hurdles or obstacles that the supplier might encounter. However, as more suppliers or producers provide ice, the price of ice will fall as competition intensifies.

Both of these benefits disappear with anti-gouging laws. The important message about the scarcity of ice disappears when the price remains unchanged. Consumers may buy three bags of ice to keep their diet soda cold, and, if the supplies are limited, those bags may be gone when the consumer with the insulin or baby formula arrives. Empty store shelves of bread and milk before a big snowstorm is an image you may have seen.

The message to suppliers is also lost. If a premium cannot be charged to deliver goods through obstacles or at a greater cost, then suppliers may not have enough incentive to produce or deliver the goods. This lack of incentive causes a perverse lengthening of the shortage until obstacles or challenges are removed. In this way, anti-gouging laws are similar to price controls. The best example for the effects of price controls is the rationing of gasoline during the 1973 oil crisis. By limiting the rise in price, suppliers may have little incentive to deliver. They may have other incentives (corporate goodwill?), but there will be a definite subdued response.

In summary, anti-gouging laws may cause more immediate and lasting harm by not allowing prices to send their powerful signals to both consumers and producers in the wake of a disaster. Suppliers may have little incentive to supply goods at the before disaster price, and consumers will not have a strong incentive to curtail their consumption.

Other sources for information about price gouging:

The article that inspired this tip: They Clapped: Can Price-Gouging Laws Prohibit Scarcity?

The podcast that inspired this tip: Munger on Price Gouging from EconTalk

The Price of Everything: A Parable of Possibility and Prosperity by Professor Russell Roberts; chapters 1 and 2 are available for free

Missouri Attorney General’s website on price gouging

An economist responds to his mother about price gouging from Marginal Revolution, an economics blog

Recently, a water main broke in Boston causing a scarcity of clean water. Several economics writers took the time to remark on the price gouging actions:

See the Invisible Hand is a companion blog to the textbook Modern Principles of Economics authored by Tyler Cowen and Alex Tabarrok

What’s wrong with price gouging? Is an editorial written in The Boston Globe about price gouging.

Freakonomics Blog post about the event

Andrew Zumwalt, M.S.
Director of the MoTax Education Initiative
162 Stanley Hall
University of Missouri
Columbia MO 65211


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