Heroes or Villains? The Economics of Price Gouging (Well, It’s Complicated #4)

The technical definition of price gouging is the practice of producers and/or retailers raising prices well above normal equilibrium levels during periods of short supply, generally during exogenous shocks that both decrease supply and increase demand.  In plain English, that means that when something happens to limit available supplies of high-demand items, such as an environmental disaster, some sellers increase their prices for those products to levels so far above normal that they’re seen as exorbitant.  For example, we often see the price of water and other basic staple supplies skyrocket in the days following major hurricanes and other disasters that disrupt supply chains.  The general public tends to condemn such behavior as taking unfair advantage of customers in their time of need, and many states have laws against it in the name of consumer protection.

But of course, the advocates of free market economics see it as nothing more than natural market forces, and often after such events they come out to proclaim store owners who engage in price gouging as heroes of the free market.  Recently, after Hurricane Harvey devastated the Houston region and Hurricane Irma did the same for the Caribbean and swaths of Florida, multiple articles appeared praising price gouging shopkeepers as heroic, or at the very least helpful rather than harmful.  The argument in both cases had basically four parts.  First, increased prices moderate demand by reducing hoarding tendencies and making customers only buy what they genuinely need, freeing up resources for other customers in need.  Second, higher prices encourage suppliers to bring in more of the goods in question to take advantage of the demand opportunity.  Third, there is no “right” price, only that dictated by the market—if the market dictates prices ten times what they were yesterday, that’s not immoral, it’s just economics.  To quote one such article, “facts should trump feelings,” so the feeling of unfairness is an illegitimate argument against economically rational behavior.  And fourth, private property rights mean individuals should be allowed to set whatever prices they want, because no one has a right to their property except through voluntary free exchange.  And since it’s just good business sense to sell your property for as much as possible, no one should tell you otherwise.  But I personally believe this, like many other pure free market views, presents an oversimplified picture of a much more complicated reality.  So let’s look at each in turn, and see what modern economic theory tells us is really going on.


 

Point the First: Price Increases Moderate Demand, Increasing Efficient Allocation of Resources

Well, yes and no.  Basic supply and demand theory tells us this is what SHOULD happen: prices increase, so people buy less (e.g., only what they really need), thus preventing hoarding.  The problem is that this moderation of demand is bounded by the fact that the goods in question generally are staple goods, necessary to survival in emergency conditions.  Thus, there’s a limit to elasticity.  Elasticity is how much demand changes as prices increase or decrease, and the more “inelastic” something is, the less sensitive demand levels are to price changes: few people drink more water when the price is low, nor are they physically able to drink much less even when the price is extremely high.  People need a minimum amount of water intake to survive.  Similarly, they need food.  They need heat.  Depending on the emergency situation in question, they may need other basic staple supplies like wood to reinforce their shelters and protect themselves from the elements, etc.

The reason societies find price gouging so egregious is because it’s seen as taking advantage of inelastic demand in a time when customers have no other option but to pay whatever the seller asks.  Yes, it might moderate hoarding behavior, but that purpose could be achieved by limiting purchase quantities per customer, without hurting those who can’t afford the elevated prices on goods they literally need to stave off death.  Plus there’s the flip side of the coin: it may also increase hoarding, as customers are afraid prices will continue to rise or supply will run out entirely, so it’s better to pay exorbitant prices now than risk going without later.  Limiting hoarding, even if effective, is a relatively minor positive when the potential externality is extreme hardship and potential death for those who literally cannot afford the high cost of these basic necessities.


 

Point the Second: Higher Profit Margins Encourage Suppliers to Increase Supply to Meet Demand

In an ideal hypothetical economic landscape, this would absolutely be true.  Unfortunately, we don’t live in the hypothetical world of free market models.  Our real world has what is sometimes called transfer friction, or in layman’s terms, logistics concerns: increasing supply means either producing more or bringing in supplies from outside sources.  In the emergency situations that often lead to price gouging, like natural disasters, often neither of these are physically possible for days or even weeks following the initial event.  Producers within the disaster zone are unlikely to be able to increase production capacity when all the infrastructure, including their own supply chains, has just been destroyed.  Nor can outside suppliers transport goods into the zone effectively when the logistics infrastructure has been devastated.  The logistics infrastructure that DOES exist is often commandeered for general disaster relief efforts, so there’s not much capability to flood the market with goods for a profit motive, even if outside suppliers desperately want to do so.

Take, for example, Hurricane Harvey: the public water system was contaminated with floodwaters, making it unsuitable for human consumption in many areas.  Thus drinking water had to come in the form of bottles or purifiers.  But no one IN the disaster zone could readily produce a significant supply of potable water, and no one OUTSIDE the zone could readily transport such a supply into the zone for sale, as the roads and railroads and ports were under water or heavily damaged.  The market could not easily respond to the increased demand level by increasing supply (and thus bringing prices back down) at least until the infrastructure could be repaired.  Thus increased prices do NOT effectively incentivize increased supply during an emergency when the supply chains cannot support it.


 

Point the Third: There Is No Right Price, Just the Market Price.  Facts, Not Feelings.

Maybe.  In terms of morals, sure.  But human markets aren’t made up of perfectly rational and emotionless decision makers.  They’re made of humans.  And both neuroeconomics and behavioral economics provide very strong evidence that feelings matter as much as reason in economic decision making.

Prospect theory, for which Daniel Kahneman won the Nobel Prize in Economics in 2002, tells us that we as humans don’t judge value in terms of absolutes, but in terms of gains and losses from the previous baseline.  Comparisons are relative—we might say that our subconscious minds think in terms of percentages rather than absolute values.  When my bank account is empty, a $100 windfall is a huge gain; when I’m a millionaire I barely even notice it.  Similarly, if a product is $1000 one day and $1100 the next, it’s a small jump, but when it instead goes from $10 to $110, we say the price “skyrocketed,” even though both increases are exactly the same amount of money in absolute terms.  What this means is that modern economic theory tells us there in fact IS a “right” price in economic decision-making, at least when the decision-maker is Homo sapiens rather than Homo economicus: the prior baseline from which the decision-maker is judging relative gains and losses.  If the price goes down, we are happy.  If it goes up, we are unhappy.  And if it skyrockets, we are angry.

This becomes important, because emotions have a major impact on our decision-making.  Which ties into the final point.


 

Point the Fourth: It’s Good Business to Maximize Profit, and Property Rights Mean No One Should Tell Us No

First, let’s be clear here.  I am staunchly in favor of property rights and the freedom to do what you want with your property so long as it isn’t actively infringing on the rights to others.  That said, human beings are social animals.  We’ve evolved in a social context, and many of our evolved behaviors are directly optimized for social, rather than individual, survival.  Two of the most interesting (and relevant) of these evolved social behaviors are what behavioral economists call “inequity aversion” and “altruistic punishment.”

Inequity aversion is the well-demonstrated tendency for people to dislike being treated unfairly and seeing others being treated unfairly.  The Golden Rule isn’t just something your elementary school teacher taught you to ease classroom interactions with the other kids—it’s a fundamental feature of human nature.  Yes, we’re by and large self-centered, but almost all of us have an innate sense of fair play, and we disapprove of behaviors that violate such unspoken norms.

Altruistic punishment is the (also well-demonstrated) willingness of human beings to go out of their way, often to the point of actively hurting their own self-interest, to punish those they see as behaving unfairly.  So not only do we dislike unfair behavior, but we want to punish it when we see it, even if it costs us to do so.  (This is a fascinating social trend, and some researchers believe our unique version of altruistic punishing behavior is one of the keys to human success versus other social animals.)

Why does this matter?  Well, while individuals should have the right to sell their property for any price they want, a basic understanding of modern economics tells us why price gouging is a terrible business decision in the long run.  From behavioral economics, we know people dislike being treated unfairly and seeing others treated unfairly.  We also know that they are willing to go out of their way to punish those they see as treating themselves or others unfairly.  And from Prospect Theory, we know that such judgements of unfairness are influenced not by absolute value of the price increase, but rather its relative value compared to the prior baseline.

Game theory helps us mathematically model optimal decision making in interactive situations, like when a seller is deciding whether to raise the price of an inelastic good to take advantage of temporary increased demand.  But there’s a different answer when the game is played once (such as a transaction between individuals who will likely never see each other again) and when it’s repeated (such as transactions between a shopkeeper and his or her regular customers).  With an individual interaction game, there is no long term loss from treating someone unfairly, because they have to take it or leave it—and for inelastic goods, they’re probably going to take it.  But with a repeated game, treating people unfairly may lead to a temporary spike in profit margins, but is likely to be repaid with long-term punishment, such as formerly regular customers shopping elsewhere because they no longer want to deal with someone who they feel took advantage of them in their time of need.  There is a strong business incentive for local stores to avoid being seen as acting unfairly, because long term profits are heavily impacted by short term perceptions.

Maximizing profits when your customers are desperate may well lead to having no customers when they have competing options.  Altruistic punishment means they’ll likely be willing to go to the competition, even if it’s a bit out of their way, rather than reward you with their custom.  And they may even be able to get their friends and neighbors to do the same—we’re social animals.  Do what you want with your property, but be aware that actions that are seen as unfair may very well have longer term repercussions.


 

Price gouging is not merely increasing prices in response to demand.  It is a huge price increase relative to previous baseline prices, at a time of high inelastic demand, when supply physically cannot increase to match said demand.  Thus, it’s sellers taking advantage of a situation in which buyers must buy their product at the price they set, because there are no other options like going without or shopping elsewhere.  Human social nature means we see this as unfair and are willing to punish such behavior even at cost to ourselves, which makes it a risky business decision, trading short term certain profit for long term potential losses.  It may or may not limit hoarding, but it most certainly hurts those who can’t afford the new prices for goods they desperately need.  Price gougers may not be evil villains, but they certainly aren’t noble heroes.  They’re just people trying to make a quick buck.

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