Of Prices and Price Gouging - International Center for Law & Economics
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Of Prices and Price Gouging

Price gouging regulations (PGRs) have been a popular topic of late in the blogosphere, particularly in the wake of increased post-Katrina (and Rita) gasoline prices. Becker and Posner make the now familiar economic case against PGRs here and here. The basic economic argument against PGRs is well tread ground which I will not repeat here. Suffice it to say, however, that the economic logic has not been sufficient to win the day with state legislatures for one reason or another. According to Federal Trade Commission Chairman Majoras’ Statement to Congress, at least 28 states currently have statutes that provide remedies for short term price spikes in the aftermath of a disaster. For example, Eliot Spitzer recently penned a new bill updating NY’s PGR to trigger upon a 25% markup rather than a “gross disparity” between cost and price. Some of the failure is for obvious reasons. As Chairman Majoras writes:

consumers are understandably upset when they face dramatic price increases within very short periods of time, especially during a disaster. But PGRs that have the effect of controlling prices likely will do consumers more harm than good.

But what is responsible for the disconnect between proponents of PGRs, who view such statutes as helping consumers, and the economists like Becker, Posner, and others (I include myself as an “other”), who view PGRs as harmful to consumers? Two arguments often raised in defense of PGRs (I realize there are others) on consumer welfare grounds are: (1) that they are “like antitrust laws,” and (2) that supply does not respond sufficiently to price signals during a disaster. Both are insufficient to justify PGRs for reasons I explain below the fold.

1. The antitrust objection. Dave Hoffman (while guesting at Prawfs, now at Concurring Opinions) articulates this argument here. While I respond at greater length in the comment there, I will repeat the basic point. State and federal antitrust laws already prevent the exercise of monopoly power, whether unilateral or via cartel, to exploit consumers in the aftermath of a hurricane. If monopoly power is the problem, there is no need for additional regulation, especially regulation that requires courts to do things like measure whether the price is “unconscionable,” or exhibits a “gross disparity” relative to some “normal” price. Of course, monopoly power is NOT really the problem. These price increases are the result of real scarcity and not artificial scarcity. For example, at one point, over 95% of the Gulf Coast crude oil production was inoperable.

2. Price signals are not sufficient to increase supply during an emergency. The conventional resistance to simply letting the price move to its new equilibrium is that these higher prices will not reduce the shortage. Dave Hoffman makes this claim in a second post on PGRs (as have many others): “Even high prices will not serve to reduce demand for, say, water and gasoline, over the short term if folks think their lives are going to depend on having such commodities nearby.”

This argument understates the role that prices play in our economy. Henry Manne’s post on the theory of price formation got me thinking about this the other day. What do prices do? At a minimum, prices send signals to suppliers to send more product into the market and to consumers to use less of the product. For instance, Chairman Majoras’ Statement notes evidence that gasoline imports in the US during “hurricane season” were approximately 34% higher than imports over the same period the year before. Now, folks might reasonably quarrel about the magnitude of these effects under different conditions, which will depend upon the relevant elasticities. But I would hope that we would all agree that to the extent that the price mechanism reduces the shortage, it is a good thing. Of course, PGR proponents would also have to believe that a PGR is better than the market at creating such incentives since PGRs will result in rationing by other mechanisms.

But on a more fundamental level, I believe that at least some of the resistance to abandoning PGRs in favor of markets is the result of an incomplete view of prices and incentives. Assume that we know what price increases are necessary. What should we make of a non-collusive price increase “beyond” that level? What is the role of such pricing in our economy? Does such pricing activity have any value? Yes. To borrow from Henry’s post:

There are traders out there copying what they think others are doing, technical-factor traders, optimists, pessimists, pure gamblers, portfolio adjusters, abstainers, and even tax schemers. It is hard to place them all in the category of arbitrageurs, and yet, as we infer from the prediction market literature, it is quite plausible that each is actually contributing towards the ultimate correct price, including the ones who are quite wrong in their individual trades or even, as Robin Hanson reminds us, the ones who are manipulating the price.

Henry’s post emphasizes the lesson that even traders who misjudge the scarcity created by the hurricane have a role to play in markets. Absent evidence of anticompetitive conduct already protected against by the antitrust laws, these misjudgments are the type of trial and error behavior that are a primary source of competitive activity accruing to the benefits of consumers. Armen Alchian, in his famous essay on Uncertainty, Evolution, and Economic Theory, wrote that:

success is discovered by the economic system through a blanketing shotgun process, not by the individual through a converging search.” In other words, there is much economic value in the process of innovative market activity, even that which is mistaken.”

While I would be the first to agree with those who would string up gas station dealers or refiners for collusive activity such as price-fixing in the wake of Katrina, it is my view that the role of price formation in generating benefits for consumers (i.e. reducing a shortage) has been described too narrowly in the PGR discussion. The formation of prices that evolves from the competitive process generates many benefits for consumers — benefits that PGRs are simply not able to reproduce.