Friday, 17 September 2010

Further defence of price gouging

I wrote:
...When the stores opened that morning they had only a fixed supply of bottled water available. How should they have allocated that very scarce supply among all the potential customers?

The method they chose, by and large, was first-come, first-served. But is that the method most likely to ensure that the woman needing clean water for mixing baby formula would get some while folks like me, who only needed it for doing dishes, didn't? That seems pretty unlikely.

Instead, it went to the people who were best able to queue. The folks with the most pressing demands might have worked harder to get to the front of those queues, but it's pretty unlikely that those who wound up getting water were the ones who needed it most. Instead, it would have been the folks living close to grocery stores who didn't have pressing property damage to deal with.

Now, imagine that prices had been allowed to do their work. A litre of water might have risen from about a dollar to perhaps even $10, noting that there's no reason a shop can't take IOUs when the eftpos is down.

With the price hike, folks with less pressing needs would have left water on the shelves for those whose needs were more pressing. The guy who needed the water only to do the dishes would have left it on the shelves for somebody who needed it more - not out of the goodness of his heart, but out of concern for his wallet.


The most pressing needs get first attention when prices allocate scarce supply; that doesn't work as well under first-come, first-served.

Price increases also draw in supply from further afield. We've heard a lot over the last couple of years about skilled tradespeople moving to Australia in pursuit of higher wages. Right now, their services would really be appreciated here in Christchurch.

But if the prevailing wages prior to the quake were enough to send them off to the West Island, a price freeze here is unlikely to draw them back. If they look back across the Tasman and instead see hourly rates double what they'd been earning prior to moving to Australia, they might consider spending a few months back home helping out.

John Jackson and Canterbury Employers' Chamber of Commerce chief executive Peter Townsend argued that some grand supremo might be needed to ration out scarce tradesmen, ensuring that resources go to the most critical areas first.

But how can any such supremo decide how much I value having my wall fixed as compared to how much my neighbour values having her chimney fixed, let alone weighing up priorities across different damaged factories and retail outlets?

Economist Friedrich Hayek proved back in 1945 that it's impossible for any supremo to be able to do that accounting; prices, by contrast, do it automatically by forcing each of us to weigh up how much we value having a job done now as opposed to waiting for prices to drop.

And no supremo can order Kiwi tradesmen working in Australia to come home. ...
Responses to a couple of critiques:

Some other rationing system may be fairer.
Perhaps, but I can't think of any that could be rolled out in the hours following an earthquake. Recall that it took over a day for City Council to get tanker trucks with water to affected areas. Think that implementing a rationing system would be quicker? I'd put even odds on the system not being operational before standard water supply came back online. Further, any rationing system would have to deal with the Hayek knowledge problem: the Supremo would have to peer into each supplicant's soul to determine how much he really needed the scarce good.

It hurts poor people.
No. No no no no NO. Having gouging rather than first-come-first-served hurts only the people who would have been first in the queue under first-come-first-served (henceforth, FCFS). Everybody else, by definition, cannot have been made worse off. Why? Because under FCFS, they get nothing (by definition - there's nothing on the shelf when they get there); under gouging, they can CHOOSE to get nothing, or to buy something at a high price. If poor people were most likely in the front of the queue, then it might hurt those poor people. But it would help the poor people behind them in line. Are the poor people at the front of the line that much more morally worthy than the poor people at the back of the line?

Further, why would we expect that it would be poor people first in line under FCFS? Rich people are more likely to use cars rather than buses, right? Did any of you see any buses running after the quake? Me neither. Rich people are less likely to be single parents than poor people. Who's more likely to be able to queue up quickly in an emergency: somebody who's in sole charge of a kid (or several kids) who are terrified because of an earthquake, or somebody who can leave the kids with the other parent?

The only counterexamples I can think of are that poor people might be more likely to live within walking distance of shoppes if they've no cars, and that rich people might have been more likely to have to rush off to attend to their business premises.

Weighing all this up, it seems to me that poor people are less likely to be at the front of the queue. If that's the case, then gouging transfers utility from relatively richer folks at the front of the queue to poorer folks at the back.

The best argument against price gouging is that stores doing so will lose customers. But that's an argument about how individual firms should optimize - not an argument for legislation to accentuate already too strong incentives to avoid price hikes.

Max Stearns, currently visiting at the department, provided a nice anecdote about price gouging during Hurricane Katrina. After the hurricane hit New Orleans, a couple guys from a few states north of Louisiana loaded up a truck with some generators and hurried down, intending on selling the generators at a good profit. They were arrested for profiteering. Does that make it more likely that generators make it to where they're needed?

I'd argue further that economists have an important job here. Voters, very frequently, have very very wrong beliefs about the effects of policies. Policies that sound like they help the poor very frequently don't. Just because voters like protectionism doesn't make protectionism good policy; it's the economist's job to point out the very real costs of acting in accordance with protectionist preferences.

And just because customers may have misguided beliefs about the effects of price gouging doesn't make a store's holding prices constant (with consequent empty shelves) the best of all possible worlds; rather, economists ought to be pointing out that the beneficiaries of sticky prices in the face of crisis aren't the poor but whomever lucks into being first in the queue. If customer antipathy to price gouging stems from a misguided application of a laudable love for the poor, then jumping up and down a bit about the actual effects of such policies is important.

Bottom line: price gouging in a crisis hurts only those who would otherwise have been at the head of the queue, and there's no good reason to think that poorer people would disproportionately have been represented at the front of those queues. I'd rather expect the opposite.


  1. Excellent Op Ed Eric.
    The response to your article can be seen in this morning's NZ Herald which is titled "Warning over Christchurch earthquake chimney scam"

    By calling those who raise their prices "scammers" they are misrepresenting the economic transaction that scammers engage in (i.e. theft) with the method (the price mechanism) that these traders are employing to best allocate scarce resources.


  2. Excuse my ignorance Eric, but in regard to your rebuttal of the 'It will hurt poor people' argument, aren't the poorest people going to be simply unable to respond to the price increase, regardless of need? You suggest that under price gouging, poor people 'can CHOOSE to get nothing, or to buy something at a high price', but in reality do they really have that choice if they have no cash flow? Isn't it really only the better-off that have this choice? With a limited amount of stock, the seller of the water is likely to be able to sell all of his stock to the people able to afford his high price, meaning the people with no cash flow, and arguably greater need (more children etc) just miss out? I have a feeling that the rich would still overestimate their requirements for water in such traumatic circumstances, even faced with a higher price signal, leaving little for the also-rans. Once the number of people able to pay the higher prices for water has been exhausted, I guess the sellers would drop their price accordingly, but isn't it potentially too late (healthwise) for some people by then? I take your point about the 'first-in-the queue' system not necessarily benefitting the poor either, but surely price gouging is not the perfect answer?

  3. @Plum:
    1. Poor people who couldn't afford the low price of water to start with will be indifferent between gouging and first come, first served: they get nothing either way.
    2. Poor people who can afford $1 water but can't afford $10 water would split into two groups - the smaller group who is made worse off by gouging because they would have been at the front of the queue, and those farther back who are indifferent: they get nothing either way.
    3. Poor people who can afford $10 water, though they'd of course prefer to get it for $1. Those who would have been at the front of the queue are made worse off by gouging, but all of those at the back are made better off.

    Rich folks could buy out all the stock in either state of the world if they were seized with some kind of hoarding urge. But I can't imagine that price gouging would make rich folks more likely to hoard - demand curves slope downward. And, stores can always combine gouging with "Two to a customer" rules.

    First best, but impossible, would be to just give every poor household $100 in small bills in an envelope that only opens in case of a natural disaster, and run price gouging.

    Bottom line, I just find it implausible that there are many folks in the "Could afford $1, can't afford $10, and would have been at front of queue" compared to folks at the back.

  4. Good arguments. Two further thoughts:

    1. Diminishing marginal returns are really important. A key effect of higher prices is that most of the same people will still buy water, but they'll each buy less of it. So the people at the front of the queue, who might buy 10 bottles for washing the dishes, their hair, teeth, cooking and drinking; will instead buy 3 bottles and forget about the dishes and hair. More people will have water for the basics, at the cost of some dirty hair.

    2. An effective way for stores to price-gouge without being criticised (or indeed prosecuted) is to stock multiple brands of water. A regular brand sold at $1 and a premium brand at $4, in elegant (and probably smaller) glass bottles. Under normal circumstances few customers buy the premium bottle. But when there's an earthquake and the regular ones sell out, the premium brand is the only one left - and the remaining customers will buy that instead, for their cooking and baby bottles, with the hair still unwashed.

    This policy is easier to implement for the other classic gouging case, snowshovels in a blizzard, which don't expire. But, to some extent, it can certainly work for water too.