Of Prices and Price Gouging

Josh Wright —  18 January 2006

Price gouging regulations (PGRs) have been a popular topic of late in the blogosphere, particularly in the wake of increased post-Katrina (and Rita) gasoline prices. Becker and Posner make the now familiar economic case against PGRs here and here. The basic economic argument against PGRs is well tread ground which I will not repeat here. Suffice it to say, however, that the economic logic has not been sufficient to win the day with state legislatures for one reason or another. According to Federal Trade Commission Chairman Majoras’ Statement to Congress, at least 28 states currently have statutes that provide remedies for short term price spikes in the aftermath of a disaster. For example, Eliot Spitzer recently penned a new bill updating NY’s PGR to trigger upon a 25% markup rather than a “gross disparity” between cost and price. Some of the failure is for obvious reasons. As Chairman Majoras writes:

consumers are understandably upset when they face dramatic price increases within very short periods of time, especially during a disaster. But PGRs that have the effect of controlling prices likely will do consumers more harm than good.

But what is responsible for the disconnect between proponents of PGRs, who view such statutes as helping consumers, and the economists like Becker, Posner, and others (I include myself as an “other”), who view PGRs as harmful to consumers? Two arguments often raised in defense of PGRs (I realize there are others) on consumer welfare grounds are: (1) that they are “like antitrust laws,” and (2) that supply does not respond sufficiently to price signals during a disaster. Both are insufficient to justify PGRs for reasons I explain below the fold.

1. The antitrust objection. Dave Hoffman (while guesting at Prawfs, now at Concurring Opinions) articulates this argument here. While I respond at greater length in the comment there, I will repeat the basic point. State and federal antitrust laws already prevent the exercise of monopoly power, whether unilateral or via cartel, to exploit consumers in the aftermath of a hurricane. If monopoly power is the problem, there is no need for additional regulation, especially regulation that requires courts to do things like measure whether the price is “unconscionable,” or exhibits a “gross disparity” relative to some “normal” price. Of course, monopoly power is NOT really the problem. These price increases are the result of real scarcity and not artificial scarcity. For example, at one point, over 95% of the Gulf Coast crude oil production was inoperable.

2. Price signals are not sufficient to increase supply during an emergency. The conventional resistance to simply letting the price move to its new equilibrium is that these higher prices will not reduce the shortage. Dave Hoffman makes this claim in a second post on PGRs (as have many others): “Even high prices will not serve to reduce demand for, say, water and gasoline, over the short term if folks think their lives are going to depend on having such commodities nearby.”

This argument understates the role that prices play in our economy. Henry Manne’s post on the theory of price formation got me thinking about this the other day. What do prices do? At a minimum, prices send signals to suppliers to send more product into the market and to consumers to use less of the product. For instance, Chairman Majoras’ Statement notes evidence that gasoline imports in the US during “hurricane season” were approximately 34% higher than imports over the same period the year before. Now, folks might reasonably quarrel about the magnitude of these effects under different conditions, which will depend upon the relevant elasticities. But I would hope that we would all agree that to the extent that the price mechanism reduces the shortage, it is a good thing. Of course, PGR proponents would also have to believe that a PGR is better than the market at creating such incentives since PGRs will result in rationing by other mechanisms.

But on a more fundamental level, I believe that at least some of the resistance to abandoning PGRs in favor of markets is the result of an incomplete view of prices and incentives. Assume that we know what price increases are necessary. What should we make of a non-collusive price increase “beyond” that level? What is the role of such pricing in our economy? Does such pricing activity have any value? Yes. To borrow from Henry’s post:

There are traders out there copying what they think others are doing, technical-factor traders, optimists, pessimists, pure gamblers, portfolio adjusters, abstainers, and even tax schemers. It is hard to place them all in the category of arbitrageurs, and yet, as we infer from the prediction market literature, it is quite plausible that each is actually contributing towards the ultimate correct price, including the ones who are quite wrong in their individual trades or even, as Robin Hanson reminds us, the ones who are manipulating the price.

Henry’s post emphasizes the lesson that even traders who misjudge the scarcity created by the hurricane have a role to play in markets. Absent evidence of anticompetitive conduct already protected against by the antitrust laws, these misjudgments are the type of trial and error behavior that are a primary source of competitive activity accruing to the benefits of consumers. Armen Alchian, in his famous essay on Uncertainty, Evolution, and Economic Theory, wrote that:

success is discovered by the economic system through a blanketing shotgun process, not by the individual through a converging search.” In other words, there is much economic value in the process of innovative market activity, even that which is mistaken.”

While I would be the first to agree with those who would string up gas station dealers or refiners for collusive activity such as price-fixing in the wake of Katrina, it is my view that the role of price formation in generating benefits for consumers (i.e. reducing a shortage) has been described too narrowly in the PGR discussion. The formation of prices that evolves from the competitive process generates many benefits for consumers — benefits that PGRs are simply not able to reproduce.

13 responses to Of Prices and Price Gouging

  1. 
    Michael Guttentag 21 January 2006 at 7:58 pm

    Josh. I look forward to hearing what you have to say about the role of disclosure in this area.

  2. 

    Michael, I understand and appreciate your disagreement. I guess my short answer would go something like this:

    I think you are right that one should consider the possibility that while PGRs and regulations of other prices (like slotting deals) deviate from regulations of similarly situated transactions in a meaningful and legitimate way from an economic perspective. My view is that I have considered this possibility and rejected it with respect to PGRs, i.e. am unable to find economically meaningful explanations of the differences between PGRs and the regulatory stance towards price movement in general.

    On the other hand, I find the differential treatment of slotting and similar transactions much more interesting from an economic standpoint. The history of antitrust law is Exhibit A in support of the proposition that many novel practices are treated harshly until better understood on economic grounds. This ignorance may helpfully explain some of the differential treatment, but I do think that the issue of disclosure requirements across different slotting settings is a promising for future research (and an issue I am currently working on).

  3. 
    Michael Guttentag 21 January 2006 at 7:23 pm

    Josh. Fair enough. My only disagreement is that I think you should consider PGRs and the regulation of slotting agreements as falling on the same continuum. Couldn’t PGR just be a more extreme example of the mechanisms by which economically similar transactions are treated differently? Of course, I expect that you and I may disagree down the road as to what causes this resistance and whether it is normatively legitimate.

  4. 

    The fundamental flaw in any disaster analysis is the assumption that a market exists. Markets are intended to find equalibrium in the long run. In the short run, they are worthless except in that they adjust capital expenditures for the long run. Additional supply cannot be created on demand instantaneously. What you get in the short run is a demand shift on a vertical supply curve.

    Now if businesses knew that they would be able to receive a 25% or 50% premium under constrained market conditions, they would adapt their models accordingly. It isn’t like oil companies lose money when a 25% premium is available for their good. A prudent supplier would carry additional supply so that they could take advantage of this premium if a disaster were to occur. This would allow that supplier to enjoy additional profit when disaster occured. This would also entail an initial capital expenditure for providing storage of the additional supply. In summary, the cost during normal times would be higher, but supply would be available during emergencies.

  5. 

    Michael — I mean this as a compliment, and I hope you take it as such, but I do not think that you are the marginal consumer of such policy arguments.

    It is true that a result of my work explaining slotting fees shows that the effects are quite similar to other forms of pricing, i.e. wholesale price discounts, though they are treated differently by the antitrust laws. This is a result, however, and not an explanation of why the antitrust laws are hostile to these sorts of payments for distribution. Explaining the economic forces that create slotting fees (or other economic acts) is an important first step to figuring out what we should do about them, and how they might be similar to other practices.

    I take your point to be that explaining why the law might treat PGR type regulations, or payments for distribution, or [insert the controversial economic practice of your choice here], should also be part of this research agenda. Agreed. For instance, I am currently working on explaining why different regulatory regimes are present across different contexts of payments for distribution (slotting, payola, insurance steering, mutual fund revenue sharing fees, etc.), and whether these regimes make economic sense. Posner’s blog post also considers some exceptions to the economic case against PGRs.

    However, I think it is worth noting a key difference between these practices and what is at issue at PGRs — prices. PGRs threaten something more fundamental than antitrust scrutiny of payments for distribution. The latter misunderstands the economic motivation for one form of payment when many other substitutes are available. Because payments for distribution are so prevalent in our economy, this is an important error, and one that I have spent a good deal of time addressing in my own research. However, the former exhibits a fundamental misunderstanding not of the economics of a particular practice, but of price theory as a whole.

    In short, you seem to be saying that MORE economics considering more subtle differences between contexts would be the key to more effective policy arguments. I am far more skeptical that more economics would do anything. I think good old fashioned price theory is sufficient to figure out that PGRs are rarely, if ever, good policy.

  6. 
    Michael Guttentag 20 January 2006 at 2:43 pm

    Geoff – I was primarily referring to the deregulation of large industries starting in the 1960’s, including air lines, trucking, and securities exchanges. But it is certainly possible to look at the glass as half empty as well as half full. But for those darn progressives, we never would have started regulating all of these industries in the first place.

    Which gets to my question to Josh. Josh shows in his post here, and in some of his work on slotting fees, that transactions that are economically similar, for example, charging market prices or paying for distribution space, are treated differently by legislators in different contexts. Fair enough, but I’m not convinced that the problem arises because economists have not been able to detail specifically how markets work. I think it would advance this research to continue to work through why similar transactions are treated differently depending on context or setting. Maybe this leads to a consideration of behavioral factors or maybe it leads to a consideration of transaction costs, or, I would suspect, an interesting combination of the two.

    To my mine, a model that addresses the factors that lead to different outcomes in economically comparable situations would provide a more effective policy argument than an argument that primarily shows the underlying economic similarities between the different settings.

  7. 

    I think Mike’s claim that “Economists have won the day” is overstated. Economists aren’t shit in Washington (pardon my French) except when they provide some rhetorical cover. This is particularly and painfully true when it comes to Congress. So while economists may have an ear or two at the FTC, who listens to them on the Hill? As is so often — and so problematically — the case, PGRs are an example of a response to the irresistible force in politics to do something. That they are categorically condemned by people who know enough to condemn them (how’s that for tautology?) is really neither here nor there when the people want action. (Or am I being too cynical?)

  8. 

    Thanks for the comments.

    Michael: The prevalence is tough to explain. One obvious reason is the “adding injury to insult” feeling of high prices hitting after such a disaster creates some political power in the direction of PGRs and the like. Perhaps another reason is that economists, as Henry points out in his post over at Ideoblog, have not clearly enough articulated the theory of price formation. These are guesses. Obviously, my view is that the economic arguments should have already won the day.

    Dave: I am a bit confused by the question. The interesting economic characteristic of the “one hotel in town” story is the “one” and not the “hotel” v. the gas station, i.e. the story of a hypothetical monopolist gas station is more interesting because of the antitrust implications. In my mind, there is not much difference between the two situations in either event as long as the supplier has not created the scarcity. In a hurricane, this is typically not the case.

    You are also right that I did not deal completely with the difference between PGRs and antitrust laws, perhaps in another post. I have not done detailed research into who has been prosecuted, but it is my understanding that the PGRs do not require evidence of collusion, simply markups that satsify whatever standard is adopted by the regulation (“gross disparity,” 15%, 25%, etc.). Perhaps you know more about this?

    I do agree that PGRs might be considered a substitute for antitrust laws. Indeed, my point is that they very poor substitutes.

  9. 

    Josh,
    Good post. Question: is the analysis of PGRs the same regardless of the good in question? That is, do you think the “one hotel in town” story presents the same problem as the gas station problem? It also isn’t clear to me that you’ve dealt completely with the difference between a PGR, which provides for an after-the-fact penalty, and a price-cap (which really would provide a direct “remedies for short term price spikes”). Given enforcement costs, isn’t it possible that PGRs are being used as substitutes for antitrust enforcement (i.e., the only folks who get prosecuted months later are those folks where there is good, but not conclusive, evidence of collusion)?

  10. 
    Michael Guttentag 18 January 2006 at 11:57 pm

    Josh. It seems clear to most (any?) economist that these price gouging laws do not make sense. So how do you explain their prevalence, particularly when economists have won the day in arguing for a variety of other policy adjustments?

  11. 

    An excellent point. Many in the academy are fond of pointing out that market behavior often seems to come with undesirable negative externalities of the sort that merit regulatory intervention. But it is certainly worth pointing out that the market itself provides an unseen positive externality, too, and that we should factor this benefit in before we intervene in markets and restrict the free movement of prices.

Trackbacks and Pingbacks:

  1. TRUTH ON THE MARKET » Teson and Klick on Global Justice and Trade - October 26, 2007

    […] where this sort of failure would be common in the public discourse, i.e. the widespread support for price-gouging legislation sounds like a paradigmatic example of discourse failure.  But what incentives to serious, […]

  2. TRUTH ON THE MARKET » Economic Illiteracy of the Week? - May 18, 2006

    […] I am fond of Larry Ribstein’s concept of “criminalizing agency costs” (see, e.g., here), but what about imposing criminal sanctions for rationally responding to changes in supply conditions? While I am not creative enough to coin a new phrase, it seems obviously economically wrong-headed (much like the criminalization of agency costs) to use criminal sanctions to punish firm’s for increasing prices in response to a reduction in supply. Should firms collude in the wake of a natural disaster, the antitrust laws are plenty sufficient to punish this sort of behavior (see my previous comments here). There is simply no need for a federal price gouging law. […]