Daily Archives: September 17, 2017

Price Gouging is Bad

With Texas recovering from Hurricane Harvey, and Florida and the Carribean from Hurricane Irma, the internet is blossoming with takes on how actually price gouging is good. It’s not.

The Econ 101 argument offered in favor of price gouging is that higher prices provide a market signal to entrepreneurs to figure out a way to increase the supply of the desired good. This is indeed the very basic version of how supply and demand works. However, it’s a terrible way to allocate resources during the short term impacts of a natural disaster.

The point of the profit motive is supposed to be to reward people for doing things that benefit society, not to hand them windfall profits for just happening to be in the right place at the right time. This is why few people complain about Apple’s huge profits, since smartphones and laptops are generally considered to be good products. Creating the iPhone was hard and took a lot of time and money, and people generally accept that Apple has earned its profits. Apple also faces fairly robust competition in smartphones from other innovative companies like Samsung.

On the other hand, Martin Shkreli is widely and rightly considered to be a villain, who bought the rights to produce and distribute a drug created by someone else’s hard work and innovation, and then used a market distortion, a government-granted monopoly, to jack up the price. People see that Shkreli is just trying to enrich himself by squeezing sick people in need of medical treatment, and is not really interested in doing anything socially beneficial. In addition, the structural barriers to market entry created by the government-granted monopoly make it nearly impossible for anyone with entrepreneurial spirit to deliver to Shkreli the market smackdown his fiendishness so richly deserves.

The short-term supply shocks and demand panics induced by natural disasters are not quite the same as government-granted monopolies, but they create similar outcomes. For example, the airline industry did not do anything innovative to greatly increase the demand for air travel upon the approach of Hurricane Irma. There is not a large amount of slack in the airline industry that can be brought to market by enormous price increases, a fact revealed by the very ability of the airline industry to increase prices by an order of magnitude in advance of the storm.

Because their occurrence, in both time and space, is unpredictable and their impact is very short-lived, the incentives created by natural disasters align very poorly with good profit motives. No one expects that Delta raising prices to over $3,000 will lead to a burst of innovation or capacity growth in the airline industry, just as no on expects that Jet Blue’s $99 flights to flee Irma will have a long run impact on airline industry capacity or profitability.

Investment in expanding capacity of any industry requires time, money, and other resources. The unpredictable nature and short duration of natural disasters results in there being little long-term incentive to invest in capacity to overcome their short-term impacts. Nobody is going to build an oil refinery and gasoline distribution infrastructure that is only useful and profitable for the two weeks after the time a hurricane happens to hit a major American city.

In addition, many shortages caused by natural disasters are not structural shortages caused by lack of capacity in the supply chain, but panic-induced shortages similar to bank runs caused by fear of future shortages and a resulting desire to hoard. I happened to be in Fort Worth during Hurricane Harvey, and every gas station had a line out into the street, with many running out of gas, despite there being no real supply disruption in the area.

A large increase in the price of gas in such a situation is not the proper response. Again, no one is going to build extra refineries & distribution infrastructure for these random occurrences. A large increase in prices plus hoarding behavior will just lead to unearned profits for “first to the well” hoarders and inability of low-income people to afford resources they may really need.

The proper policy response to short-term disruptions caused by natural disasters is rationing, to ensure everyone has fair access to enough resources while normal supply chains are repaired.

The finance industry understands this, of course, when it itself is subject to short-term panics such as bank runs or similar events in markets for financial instruments. These situations are handled by limiting or suspending withdrawals, i.e. rationing, until the institution can find a way to overcome the panic.

A similar response to natural disasters is appropriate. Rationing, not price gouging, is the right way to distribute resources during short-term shocks.