Download Natural and manmade disasters can be powerful leaning experiences

Stephen E. Margolis
September 15, 2006
Price Gouging
Price gouging is essentially an accusation, an accusation that some seller is charging a
price that is too high. In general, a claim that a price is too high is troubled, as it presumes
that there is some other price that is the right one. Where price gouging is charged, “too
high” is usually taken to mean that the price cannot be justified by the seller’s costs. The
seller will make a profit on the transaction, a profit that is deemed, by someone, to be
unreasonable, a windfall, or unnecessary.
The problem with the accusation is that firms in a market economy are not required to
price at cost, or at cost plus some set margin. In fact, one of the things that allows a
market economy to function is that businesses move resources into areas of the economy
where there are profits to be made. By doing so, these businesses increase the availability
of goods that are comparatively scarce. In time, those actions will force prices down and
erode profits.
In recent years, natural disasters and oil price fluctuations seem to be the circumstances
that prompt most of the accusations of price gouging. Each of these events can teach
lessons about how markets work in response to various kinds of external shocks to the
economy.
The approach of a hurricane can teach a lot. As a storm gains strength and tracks in our
direction, we become students of meteorology. Suddenly, the workings of weather
systems hold our attention, as fronts and steering systems and pressure differences are
matters consequence. With somewhat less drama, the aftermath of a hurricane can teach
us some economics. Now the social systems that ordinarily work mostly unnoticed to
provide the things we take for granted are called upon to deliver very different bundles of
goods and services and to do so quickly and under adverse circumstances.
Except in the most severe cases, almost as soon as hurricane conditions have ended, the
goods and services necessary for recovery begin to be delivered to the affected areas.
Some of these will be brought by state and local government agencies and some will be
provided by charitable organizations. Much will be provided by the public utilities. But a
very large share of the resources that will be required to restore normal life and repair
damaged property will be provided by private parties—business small and large that will
offer for sale a great volume of goods and services that ordinarily are provided on a scale
that is miniscule by comparison. Food, water, chain saws, blowers, tarps, garbage bags,
plywood sheets, roofing materials, rakes, batteries, propane, ice, gasoline, window glass,
framing lumber, roofers, tree cutting services, cleaning services, and on an on. All these
must arrive quickly to avert the immediate crisis and begin to bring life back to normal.
Most of this is provided—sold—to eager buyers by eager sellers.
Like the private economy that serves us in normal times, much of this crisis economy has
no central coordinating authority that makes it all work. Typically, even before the storm
has moved on, trucks are on their way to the affected area from scores of different
sources with hundreds of different goods. Stores that are stripped clean of emergency
goods before the storm hits, will be back open with restocked shelves not long after the
storm is over. An army of private actors puts this all in process. How this all happens
offers lessons in basic economics.
The recovery period offers attractive opportunities to these private actors. Some
companies will see an opportunity to burnish their reputations, to introduce themselves to
new customers or to cement their relationships with current customers. Many companies
will see an opportunity to sell larger than normal volumes of the goods they normally
sell. Others will see an opportunity to sell things that they do not—perhaps cannot—
ordinarily sell. It isn’t just profit opportunities that motivate these private actors—they
may also act out of concern for others, a sense of community obligation, or to enhance
their own positions in their communities. But the opportunity to profit plays a large role
even in emergency circumstances.
In economic terms, during a recovery period, some goods are subject to dramatically
increased demand (plywood, tree cutting services), some are subject to dramatically
reduced supply (clean water, fuel), and others may be subject to both. Either of these
conditions—increases in demand or decreases in supply—tend to increase prices. It is
into this mix that we typically hear allegations of price gouging.
Price gouging has no precise definition in economics. There is also no federal statute that
defines or prohibits price gouging. State legislatures, responding to public dissatisfaction
with high prices, have struggled to define price gouging. Twenty-nine states have price
gouging statutes, but these statutes vary widely in defining it. Most state statutes are
effective only when a state of emergency has been declared by the federal, state, or local
government. Many involve subjective terms such as “exorbitant,” “unconscionably
excessive,” or “unjustified” to define price gouging. As it is commonly used, price
gouging simply means that some seller has sold or offered to sell some good at a price
that someone else thinks is too high. Most often, price gouging is alleged when some
price has increased by a large amount in a small amount of time.
Allegations of price gouging are not confined to the aftermath of hurricanes, of course,
but such claims are often associated with some form of dislocation or disaster. War or the
threat of war has often brought increased prices for gasoline and with it a raft of price
gouging claims. Earthquakes, blizzards, heat waves and floods can also raise prices and
prompt charges of price gouging. Certainly claims about price gouging can appear where
increases in demand or decreases in supply are more gradual, but for the most part, such
claims are confined to circumstances in which price increases occur abruptly.
In ordinary circumstances, a price will adjust so that the available supplies of a good will
match the amount that consumers would like to purchase. Such price adjustments are
what coordinates production and consumption in a market economy. Price is a signal that
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tells producers whether the goods that they can produce will be worth more in the
economy than the cost of producing them. Price also is a signal to consumers, confronting
them with the costs that they impose on other members of society by consuming a
good—how valuable the good is elsewhere in the economy.
This perspective helps explain why it is difficult to provide a definition of price gouging
that captures the intended meaning—charging a price that is just too high. As we will see
in some of the examples below, almost any price, regardless of how high, performs the
important function of adjusting the quantities that producers produce and consumers
consume. Particularly during times of economic dislocation, the agility of unconstrained
markets in coordinating economic activity is an important advantage.
For the purpose of discussion, suppose we define price gouging as charging a price that is
just too high to provide any social function other than transferring wealth from the seller
to the buyer. That provisional definition will let us examine claimed instances of price
gouging.
Price adjustment in a crisis
When supplies of some good are dramatically reduced or demands are dramatically
increased, prices will increase, perhaps quite dramatically. Such a result is the ordinary
working of supply and demand, the most fundamental and best tested framework in
economics. That said, we might well ask, how does the price adjustment actually happen?
When it becomes evident to at least some people that the quantities of some good that are
available will not be adequate to satisfy the amounts that people would like to buy at the
current price, participants in the market begin to adjust the price. In some instances,
consumers will offer sellers higher prices in order to get the quantities they want. More
often, it will be suppliers that initiate the price adjustment by increasing their posted
prices. At some point it becomes clear to them that they will quickly sell out of their
inventories at the current price, and that even if they raise prices they can still sell
everything they have in stock or have available to them. They face an easy choice. They
can sell everything they have at a low price, or they can sell everything they have at a
higher price. A few sellers may initiate the price change and may even see their sales
slow for a short time, while those who are slow to raise prices sell out. Some sellers will
raise prices in a more passive way, simply by holding back inventories of goods, then
selling them when the price has gone up.
In economists’ terminology, the price increase brings about a new equilibrium, equating
supply and demand. The higher price performs the function of rationing the available
supplies. At the new price, consumers can obtain what they want at the available price,
although what they will want to purchase less than they would have purchased at the old
price.
All that said, many people, maybe even most people, are offended by price increases in
these circumstances. Aren’t sellers benefiting from other people’s misfortunes? Couldn’t
they afford to at least sell out their current inventories and their old prices? The answers
to the questions are yes and yes, but the questions and their answers are largely irrelevant.
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The important issue is whether the price increases have a good effect overall. And the
answer to that question is yes.
Price increases in these circumstances do two things, both of them very important. First,
they allocate the available supplies to the most crucial uses. Second, they draw more
supply into the affected area.
Again, hurricanes provide a useful example. In the aftermath of a hurricane, an urgent
problem is often removing fallen and leaning trees—most immediately from the tops of
houses, but also from roadways, driveways, parking lots and yards. In the immediate
wake of the hurricane, people who have the skills and equipment to remove trees are able
to charge prices that are considerably above their usual rates. At these high prices, only
the most urgent jobs get done. Trees on houses come off, trees on driveways can wait a
day or two, trees in parking lots and yards a bit longer. People planning regular
maintenance or landscape work will want to wait until prices go back to their normal
levels. Meanwhile, the high prices for these services draw tree removers from outside the
area, or draw people with tree-removal skills from other activities. Attracted by the
opportunity to earn high wages, crews may travel from West Virginia into Florida, for
example, and motorcycle mechanics may help out with tree removal for a few days.
Suppose, as is often urged, that tree cutters were prevented by law from charging prices
above the price levels before the storm hit? What harm would that do? For one, there
would be no reason for suppliers to seek out the most urgent recovery work, since the
rates the rate caps would have the effect of imposing a uniform price for all kinds of
work. Why seek out the most urgent jobs? Why do the risky and difficult work of
removing a tree from the roof of a house when safer and more routine landscape work
pays the same rates, the rates charged before the storm? Why not focus on putting your
own life in order rather than doing work for other people, particularly when the same
wages will be available next month? Why drive a truck six hundred miles to the disaster
area and stay in a motel when the same rates are available back home? Why work longer
days than usual when only the usual rates are offered?
Of course, these principles apply to more than tree removal. Recovery from a hurricane
requires the services of carpenters, roofers, glaziers, masons, electricians, and so on. And
it’s not just services that are needed after a recovery. Plywood, framing lumber,
plasterboard and roofing materials are in great demand. Again, higher prices will increase
the amounts of these products that are available in the recovery area and will allocate
available supplies to the projects that are needed right away: making surviving structures
weather tight to prevent further damage, making those structures habitable where
possible, and eventually, replacing structures that have been destroyed. New back decks
and remodeled family rooms should wait, and they will, as people put of such projects
until prices return to normal.
If prices of some goods are not allowed to rise in the face of dramatic decreases in supply
or increases in demand, then the amounts of these goods that people would like to buy
will exceed the available supply. The difference is a shortage and that shortage must be
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managed somehow. Sometimes, particularly when price is high, we say that price
“rations” the available supply. When price doesn’t rise, the available supply is still
rationed, but by other means. Businesses of various types will take care of their regular
customers first. Locals may get preferences over visitors or newcomers. Long waits in
lines may ration short supplies. In that case, the money price is only a part of the cost of
obtaining the rationed good. People also pay a price in time costs—the value of the time
they spend waiting in line or otherwise jockeying to obtain some good. This time cost
then becomes the means by which the good is rationed. Of course, a high time price for a
scarce good does nothing to encourage suppliers to increase the quantities available. The
time that people spend obtaining the good is just a transactions cost, it is a valuable
resource that is used up by the process of transacting. Time that could be spend on
putting thing right is instead spend standing around or trying to get people on the phone.
In times of crisis, high prices for certain essential goods do perform a vital social
function—increasing supplies and moderating demands so that available goods go to the
most essential uses. In comparison to various types of (non price) rationing, price
adjustment coordinates supplies and demands without using up a lot of people’s time that
could otherwise be put to better uses. For these reasons, increases, even large increases,
in the prevailing prices of goods sold openly in the market cannot be considered price
gouging, at least by the provisional definition offered above.
What then, about gasoline prices of five dollars, or more, along the evacuation routes
leading out of New Orleans just before hurricane Katrina? The prices, were roughly
double the prevailing prices just before the approach of the storm. Might this be an
example of price gouging that meets the definition offered above—serving no useful
function, merely an example of opportunistic behavior by the owner of the gasoline
station? Although the station owner may not have had anything better in mind, even
these high prices serve a valuable social function, possibly even a life saving one. Here
again, the high price served to allocate the limited quantities available to the most
important uses. At ordinary prices, even people with half a tank of gasoline, or more,
might be inclined to full up just to be sure that they’d have enough for the trip. People
with near-empty tanks who were stopping would have no incentive to do anything but fill
their cars up with gasoline. Since there wasn’t enough gasoline available for everyone to
leave New Orleans with full tanks, the limited supply would soon be exhausted. But at
five dollars a gallon, people who already had a half a tank of gas, or more, were
encouraged to drive a hundred miles or so up the road, spreading the demand for gasoline
over a wider area and leaving some behind for people who might otherwise run out of
gas. Similarly, people pulling in to gas stations were encouraged to limit their purchases,
again leaving some behind for other people who would come along later. Had they been
facing only the “normal” prices, the same prices that they would find further up the road,
they would have no incentive to curtail their purchases. The high price confronted people
with an important reality—gasoline would be very valuable to people who came along
after them—and prompted people to behave in a very cooperative way: Take what you
really need and leave the rest for other people.
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Ordinary price fluctuations
What about price increases in less extreme circumstances? What about gasoline prices,
for example, which seem to go up significantly with threats of war in the Middle East or
forecasts of bad weather. Can such price increases be justified? After all, those events
don’t actually increase the amount of gasoline that people are consuming or disrupt
deliveries of gasoline or crude oil. Isn’t that price gouging?
The price increases that result from potential or actual supply disruptions reflect the
anticipation that fuel supplies might be very limited at some time in the future. Where the
such disruptions become a realistic possibility, it would be desirable for consumers to
reduce consumption for a while, so that inventories can be built up as a precaution. If
price is free to adjust, that is precisely what will happen. Suppliers of gasoline and other
oil products know that if supplies are disrupted, scarce supplies would become very
valuable; we would face emergency circumstances like those the previous sections. Faced
with that possibility, some parties—mostly companies—would have an incentive to
accumulate inventories. As they do this, by reducing the amounts available to consumers,
prices will rise. This prompts consumers to reduce consumption, allowing buildup of
precautionary inventories. Here again, we see that price adjustments serve an important
purpose. In effect, such price increases shift resources from the present, where they are
relatively abundant, to a future in which they might be quite scarce.
Sometimes it is suggested that intermediaries such as wholesalers or retailers should not
be able to increase prices so long as they are selling products that they bought at an old
(lower) price. The logic is that the owners of these inventories would enjoy a windfall
gain, a profit that they did nothing to earn, if they are allowed to raise their prices. But if
companies that hold inventories cannot gain from price increases, yet must accept losses
from price decreases, the ordinary margins that they earn would have to increase to
compensate for the expected losses, so the average price to consumers would not be any
lower. But worse than that, wholesalers and retailers would have every incentive to keep
inventories as low as possible, which would have the undesirable effect of making us all
more vulnerable to fluctuations in demand or disruptions of supply.
What about a rule that said, in effect, you can’t raise prices of old inventory when
prevailing prices have gone up, but you don’t have to lower prices of old inventory when
prevailing prices fall? Such a rule would seem to be fair, but it would be no help to a
firm holding an inventory of gasoline when prices fall. Customers could simply go
elsewhere, leaving the firm with a lot of old expensive gas that they couldn’t sell at the
old prices. Consumer would buy from suppliers who had not been caught with big
inventories who were therefore already charging lower prices. All suppliers would have
to cut price, in spite of the rule, in order to compete. The rule therefore would provide no
escape from the problem and would leave wholesalers and retailers with an incentive to
keep maintain smaller inventories than they would in the absence of these pricing rules.
Also, policies aimed at preventing people from profiting from increases in inventory
values are inconsistent with the way that we treat the gains from other assets.
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Homeowners, for example, are not expected to sell their houses for what they paid, or for
a fixed amount above what they paid. Similarly, people who own stocks are permitted to
sell their stock for whatever the market price is when they are ready to sell.
A price increase is seldom welcomed by consumers, but price really is just the bearer of
some bad news. The actual bad news is that there is a reduced availability of the good,
relative to the amounts that people would like to consume.
Fraud, Duress, and Price Fixing
Does the argument above mean that there are no objectionable prices? Does it mean that
all price increases contribute to the overall efficiency of the economy? Not quite. Some
prices changes can meet the provisional definition of price gouging offered above,
transferring wealth to sellers without helping to coordinate resource allocation.
As noted above, most of the state statutes that specifically address price gouging are quite
vague and the statutes seem to prompt little prosecution. There are, however, legal
doctrines and statutes that do address specific actions or particular circumstances,
including emergencies. These doctrines are concerned with fraud, duress, and price
fixing.
Fraud involves some misrepresentation by one of the parties to a contract. Usually, we
think of fraud as sellers making misrepresentations, for example making false statements
regarding the quality of a product, its origins, or how it was acquired. Another kind of
fraud would be a misrepresentation about prevailing prices for a particular good our
service. A seller offering to sell a common vase for one hundred dollars that commonly
sells for twenty, but falsely claiming the assurance that “these commonly sell for more
than that, one just like this sold for $150 just last month,” is committing fraud.
Emergency circumstances may make people particularly vulnerable to fraud. Suppose a
tree removal company charged $8,000 to remove a tree from the roof of a house when the
going price of such a difficult job, even at elevated recovery prices, is $2500. Any
assurance given that such a price is “the going rate” or “what everybody is getting”
would probably constitute fraud. A seller charging such a price would be unlikely to
quote it openly as an offer to sell services, and on the contrary might make efforts to
conceal the details of the transaction. Such an “off market” price is unlikely to provide
useful information to market participants—encouraging suppliers to enter the market or
demanders to manage their demand. Such a transaction is likely to occur only when
market information is extremely poor, and particularly when buyers are in a position that
it is very costly to delay entering an agreement in order to determine actual market prices.
Anti-fraud statutes may be used to address certain instances of alleged price gouging.
Rules against misrepresentation reduce the incentive to mislead. Generally, we expect
that voluntary agreements leave both parties better of than they would be without the
transaction, but where one of the parties to an agreement deliberately misleads the other,
that presumption is unwarranted. Thus prohibitions against fraud are unlikely to interfere
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with many beneficial agreements. Still, anti-fraud statutes would apply only to limited
instances of alleged price gouging. Prices that are openly posted or announced and that
result in multiple voluntary transactions by informed parties unlikely to be addressed by
anti-fraud statutes and can generally be presumed to be beneficial.
The law of duress addresses circumstances in which people face serious personal injury
or significant loss of property. In such a circumstance, the law provides for some relief to
people who have agreed to extremely high prices. A person who is facing possible loss of
life is entitled to trespass, or to take needed goods, and pay only the damages that he
imposes on another party. The courts are unlikely to enforce an agreed-to price in a
circumstance in which the buyer was under duress.
One element of duress is that the endangered party faces pure monopoly, allowing the
seller-rescuer to extract almost anything from a buyer who otherwise faces loss of life, or
the full value of any property that would otherwise be lost. The doctrine therefore is
properly quite limited. Where several competing sellers offer the required goods or
services, and particularly where these are offered to multiple buyers who are similarly
situated, it is unlikely that sellers could negotiate prices that are abusive or
unconscionable.
Price fixing is a conspiracy among sellers to charge a particular price, typically a price
that is higher than the price that would emerge under competition. In short, it is an
agreement not to compete. Where a price fixing agreement is completely successful, the
conspirators charge the monopoly price. Such an agreement does interfere with efficient
allocation of resources.
Economists note that price fixing agreements tend to break down; that they contain the
seeds of their own destruction. The problem for such agreements is that while all of the
conspirators would like the agreement to survive, each one of them individually has an
incentive to cut their price slightly under the agreed-to price in order to capture customers
and the expense of other participants. Still, price fixing agreements do sometimes
survive, at least for a time.
Explicit price fixing agreements are illegal under U.S. antitrust law. (Section 1 of the
Sherman Act) Occasionally charges of price gouging incorporate an explicit charge of
price fixing. Far more often, the price fixing charge is implicit, as when people claim that
“Big Oil” decided to raise prices, or that the big oil companies “acted uncompetitively.”
Where there is reason to believe that price fixing is the source of a price elevation, there
are steps that federal and state authorities can take under the law. In fact, charges of price
gouging often do lead to such investigations. More often than not, when price gouging
charges do result in antitrust investigation, the price elevation is found to be the result of
ordinary market forces, not an illegal conspiracy.
For example, the Federal Trade Commission conducted an investigation of gasoline
prices in Spring 2006, in the aftermath of hurricanes Rita and Katrina. Their general
conclusion was that there was no evidence of a price fixing conspiracy at the refining,
transportation, wholesale or retail levels. For example, one section concludes, “[The
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FTC] Staff found no evidence of anticompetitive behavior in its review of national and
regional gasoline pricing after the hurricanes.”
The legal rules of fraud, duress, and price fixing are, as discussed above, quite narrowly
defined doctrines. So defined, these legal principles find some economic support: Fraud
supports transactions that may not result in gains from trade. Further, in a legal regime in
which fraud cannot be punished under law, potential traders must be wary and
consequently transactions become more costly. In a legal regime in which rescuers could
extract enormous prices, potential rescuers would have an incentive to withhold help until
circumstances indeed became dire. And price fixing results in inefficient monopoly
prices.
In contrast, vague laws against prices that just seem too high are troublesome from both
legal and economic perspectives. From a legal perspective, without clear definitions of
what is legal, it is difficult for sellers to know what the prices they can charge. Further,
without clear boundaries, prosecutors can use the law for political or other objectives.
From an economic point of view, price gouging statutes can, as discussed above, interfere
with price adjustments that are important for coordinating the economy. Coordination is
particularly important during a crisis.
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