Is Price Gouging a Problem?

By: Lakshya Bharadwaj

Is price-gouging wrong? For many, this practice does not exactly seem to be ethical. So, there is a moral angle here which suggests that raising prices of goods such as toilet paper and bottled water when a hurricane cuts off supply—and forces the market into a shortage—is not the most humane practice.

The economic angle, which is more important for policymaking, views price-gouging as a regular supply-side response to a shock. The economics around this practice suggests that price-gouging is not only reasonable, but it also serves many crucial economic purposes.

Why Price-Ceilings Are Illogical

In free and competitive markets, prices are signals. If you have ever laid eyes upon the supply and demand graph found in Econ 101 textbooks, you understand what I speak of. Consumers demand goods based on price. Suppliers produce them after being encouraged or discouraged by the same. When governments step in and cap prices during emergencies, this signaling property of market prices under this free-market mechanism is heavily distorted. Consequently, people lose the incentive to ration resources when they need to be rationed the most.

When governments jump in to “remedy” shortages during crises by enacting anti-price gouging laws, they create unintended consequences such as hoarding. If I am a consumer who learns that a pack of 12 toilet paper rolls has been capped at eight dollars in a situation where an unhindered equilibrium price could easily be 20 dollars for each such pack, I have every reason to rush to stores and buy many more rolls than I could use in a month, assuming my digestive system remains agreeable. What would happen if all consumers in my area made similar runs to stores? I hope this question drives the point closer to home.

You guessed correctly. Now local shelves are being emptied even faster of toilet paper rolls, and the shortage that could have been managed and mitigated has been aggravated! If toilet paper rolls are indeed 20 dollars a pack in a “disaster” market without a government-imposed cap, people will ration their stocks more judiciously and buy only what they need. Stores will be able to serve more people, thus alleviating the problems caused by the shortage.

People will spend 20 dollars on a roll only if they need it, rather than panic-buying an unscientific quantity at capped prices. In trying to help disaster-struck populations, the government leaves them worse-off by implementing anti-price gouging rules.

Policymakers also need to understand that nothing is stopping a handful of people who get to the stores first from buying out the entire stock and selling them to the unfortunate majority at prices much higher than what these consumers would have paid in an unfettered local market. Since these individual “profiteers” can easily find a way to price-gouge despite formal price caps, it is much better to let stores distribute essential items at a competitive equilibrium through formal channels, even if it is at a higher equilibrium price.

Supply Side Arguments

A description of consumer responses to the capping of prices ensured by anti-price gouging laws does not complete the picture. We must consider the supply side of production and supply during crises such as hurricanes to fully understand why price gouging is a natural, legitimate, and beneficial economic adjustment. When prices rise, producers are motivated to produce more. This increase in production, if you recall, can be observed by moving up along the supply curve.

What happens when the price of an essential item is capped in a region that needs that item much more than others? If a production manager learns of this situation, she has no economic incentive to increase the supply of that much-needed good to that particular region. Without a legal intervention that imposes a price ceiling, higher prices would naturally motivate suppliers to supply more, thus easing shortages in desperate regions.

Prior Research and Empirical Evidence

The scope and length of this article limit my ability to guide readers through a quantitative process of measuring the harm caused by legislation against price gouging. However, I would like to defer to research published by academics with a much deeper knowledge of economics and policy than I can claim to have.

Montgomery, Baron, and Weisskopf noted in a paper published in 2007 in the Journal of Competition Law & Economics that, in cases that were thought to be the producy of deliberate attempt to engage in price gouging, it was actually the case that  “price increases were due to the normal operation of supply and demand and not market manipulation.”  The authors were evaluating the aftermath of hurricanes Katrina and Rita in drawing conclusions regarding anti-price gouging laws.

An analysis of the two-month period of price increases following Rita and Katrina revealed to Montgomery, et al the economic benefits that were realized from a lack of anti-price gouging laws at the time in 2005. The economic damages in presence of these laws, the authors estimated, would have been between $1.5 billion and $1.9 billion.

Of course, the morality of increasing prices during floods, hurricanes, or other emergencies can still be questioned, but when governments target price gouging, morality is not the backbone of their legislations. Since economic wellbeing is the intended target of these anti-price gouging laws, the best way for these laws to accomplish their goals is to stop existing. We can keep debating whether said price manipulations are the right thing to do, but at least we can have these debates without the discomfort of cutting our paper towel rolls in half (or into thirds in some cases) to fulfill our toilet paper needs.

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