October 23, 2005 to October 31, 2005
Should Price Gouging in the Aftermath of Catastrophes Be Punished?
Should Price Gouging in the Aftermath of Catastrophes Be Punished?--Posner
Hurricane Katrina has produced a mass of interesting revelations. One is that more than half the states have laws forbidding "price gouging," often defined with unpardonable vagueness as charging "unconscionably" high prices. These laws are rarely enforced. But the sharp runup in gasoline prices as a result of Katrina (and also Hurricane Rita, which followed almost immediately), impeding imports of crude oil and causing a number of refineries in the path of the hurricanes to shut down temporarily, prompted a flurry of enforcement threats and even a few fines. It also prompted denunciation by politicians of greedy refiners and gasoline dealers, and proposals for federal legislation prohibiting "unconscionably excessive" gasoline price increases.
What prompts such reactions besides sheer ignorance of basic economics (a failure of our educational system) and demagogic appeals by politicians to that ignorance is the fact that an unanticipated curtailment of supply is likely to produce abnormal profits. The curtailment reduces output, which results in an increase in price as consumers bid against each other for the reduced output. In addition, the reduction in output is likely to reduce the sellers' unit costs; the reason is that sellers normally sell in a region in which their costs are increasing--if they were decreasing, the sellers would have an incentive to expand output further. With both price rising and cost falling, profits are likely to zoom upward. (Some gas stations are reported to have seen their profits increase by 400 percent shortly after Hurricane Katrina struck.) In times of catastrophe, with consumers hurting, the spectacle of sellers benefiting from consumers' distress, while (it seems) deepening that distress by charging them high prices, is a source of profound resentment, and in a democratic society profound resentments trigger government intervention.
Such intervention is nevertheless a profound mistake, and not only from some narrow "economic" perspective that disregards human suffering and distributive justice. If "price gouging" laws or even merely public opinion deters refiners and dealers from charging the high prices necessary to equilibrate demand and (reduced) supply, there will be shortages. Consumers will still be paying a higher price than before the shortage, but they will be paying the higher "price" in the cost of time spent waiting on line at gasoline stations, or (if they drive less because of the shortage) in the form of restricted mobility. And those who need the gasoline the most, not being able to express their need by outbidding other consumers for the limited supply, will suffer the most from the shortages. The only beneficiaries will be people with low costs of time and nonurgent demand.
But here is an interesting wrinkle. Admiralty law and common law (both are systems of judge-made law, but they are classified separately by lawyers because they used to be administered by separate courts) alike forbid certain practices that might be described as "price gouging." Suppose a ship is sinking, and another ship comes along in time to save the cargo and passengers of the first. The second ship demands, as its price for saving the cargo and passengers of the first ship, that the owner of the ship give it the ship and two-thirds of the rescued cargo, and the captain of the first ship, on behalf of the owner, being desperate agrees. The contract would not be legally enforceable; under the admiralty doctrine of "salvage," the second ship would be entitled to a "fair" price for rescuing the first, but to no more.
In a parallel case, also maritime but governed by common law rather than admiralty law (the Alaska Packers case, well known to law students), seamen on board a ship that was fishing for salmon in Alaska waters went on strike, demanding higher wages. The captain of the ship agreed because, the fishing season in these waters being very short, he could not have hired a replacement crew in time to make his quota. Again, however, the court refused to enforce the contract, in essence because it had been obtained under duress.
These cases, it turns out, are subtly but critically different from the "price gouging" alleged in the wake of Katrina and Rita. The refiners and dealers who raised prices after the hurricanes disrupted gasoline refining had not created the situation that resulted in a reduction in supply. If they had, say by agreeing to increase price above the existing level, they would have been punishable for violating the antitrust laws. (There were some accusations of price fixing, but as far as I know they have not been substantiated.) Similarly, in the salvage case, the rescue ship is not being asked to ration a limited supply by raising price; there is no one else competing for the rescue service--there is just the one ship in distress. And in Alaska Packers, there was no labor shortage, which would have justified seamen in demanding higher wages; the seamen created the shortage by refusing to work. From an economic standpoint, their workers' cartel was symmetrical with my hypothetical refiners' or dealers' cartel. Both are examples of opportunistic behavior--behavior designed to take advantage of an unforeseen opportunity to charge a monopoly price by threatening to withhold output. The hurricane-induced scarcity of gasoline that pushed up prices was not an artificial scarcity, but a natural one. The price increases generated by a natural scarcity (or indeed any scarcity not created by the person or firm imposing the increase), while they may generate "windfall profits," are unavoidable in a way that price increases due to a shortage created by a cartel are not.
A further exception to taking a hard line against responding to a natural scarcity by imposing price controls, some would argue, is the rare situation in which the consequence would be an intolerable gap between wealth and welfare. Suppose there is a highly limited supply of human growth hormone, so that if price is allowed to ration demand, all the hormone will be purchased by rich people who would want their sons and daughters of average height to be taller, and no hormone will be purchasable by poor people, or even people of average income, who have children who will be dwarfs unless they get the hormone; they simply are outbid by the rich. In such a case, there may well be a compelling moral argument for allocation of the limited supply on a basis other than price, presumably some utilitarian concept of welfare: aggregate happiness would be promoted by allocating the hormone on the basis of need rather than ability to pay. This was not a factor in the market's response to the incipient gasoline shortage caused by the hurricane.
Not only are the duress and welfare objections to price allocation inapplicable to the run up in gasoline prices but higher prices for gasoline are a source of substantial external benefits (that is, benefits not conferred on the parties to the transaction, so that the parties do not have an incentive to consider them in deciding on the price and other terms of the contract). By reducing the amount of driving and (if the higher prices persist) a switch to more fuel-efficient cars, higher gasoline prices cause a reduction in the amount of carbon dioxide emitted into the atmosphere--a major cause of global warming--while also reducing more conventional forms of automobile air pollution. A reduction in driving also reduces traffic congestion, which imposes costs in the form of delay on all drivers in congested areas. Finally, a reduction in the amount of oil consumed in the United States would make the nation more secure by reducing the wealth and economic leverage of the vulnerable, unstable, or hostile nations, such as Saudi Arabia, Iran, and Venezuela, that control so much of the world's oil supply.
In short, the social benefits of gasoline "price gouging" appear to exceed the social costs by a large margin.
Comment on Price Gouging-BECKER
Protests against "price-gouging"in times of shortfalls in food supplies and other goods go back thousands of years. Alleged gougers and speculators have been hanged, assaulted, and ostracized. The recent energy bill passed by the House of Representatives has many good provisions, but also requires the Federal Trade Commission to set standards for "price gouging", and to punish offenders. Price controls emerged in virtually all countries, including the US, during World War II and other wars, when many products were in reduced supply. It might seem "where there is smoke there is fire", but I fully agree that prices should be allowed to rise to their equilibrium levels when supply is reduced due to natural and other catastrophes.
As Posner indicates, attempts to suppress prices of gasoline or other goods that experience a great reduction in supply will require using less efficient ways to allocate the limited supply. The main alternative to higher prices is rationing in some form of another, such as selling on a first come first served basis, selling to persons willing to bribe the suppliers, and so forth. All these ways are inefficient, and discourage production instead of solving the problem of reduced availability of certain goods. Anyone who remembers the long lines and waits of an hour or more to get 10 gallons of gasoline after President Carter imposed gasoline rationing can appreciate the wasteful costs created by non-price methods of allocating a limited supply.
Another example is the rent controls that many nations imposed during and after World War II. Most have since removed their rent controls, but certain cities like New York have kept them, although in a modified form. Most serious studies of the effects of rent controls in NY and elsewhere show that they speed up the deterioration of housing quality, they cause an inefficient allocation of the limited housing stock, and usually they harm rather than benefit the poor and the young who more frequently have to find housing in the rental market. Rent controls generally benefit middle class and older renters who often stay in large apartments at ridiculously low rents because it is too expensive to move to smaller apartments available on the open market.
The angry reaction of consumers to high prices caused by a major catastrophe usually is not directed at the persons or companies that profit. For example, customers are now very upset at owners of gasoline stations as they have posted continual increases in prices due to reduced supplies of gasoline resulting from Katrina, and the rising price of oil. But the profits of most gas station owners went down, not up, after Katrina. They have to pay more for the gas they buy, and the higher prices cut back on the demand for their gasoline. It ishould be pretty obvious that a rise in the price of a major input in production, such as gasoline is to retail gas stations, lowers rather than raises their profits since costs of production have risen.
On the other hand, profits have increased to operators of refineries that were not damaged by Katrina because the damage to Gulf oil refineries raised the wholesale price of gasoline, the main product of refineries. However, the higher prices and greater profits induced undamaged refineries to squeeze greater production out of their limited capacity, and companies hastened to repair the refineries that were damaged to cash in on the high prices. In fact, many were repaired in a remarkably short time. If price were not allowed to rise, profits of undamaged refineries would have been reduced, but the supply of gasoline would have increased at a slower, probably much slower, rate.
Faced with cutbacks in supply, companies often voluntarily sell at lower prices to their regular and best customers to increase the goodwill of these customers, and also because there may be an implicit long-term contract with these customers to keep prices relatively stable. They sometimes combine low prices to favored customers with rationing of the quantities they give them, while raising prices sharply to their customers who buy less, or more irregularly.
I have no problem with Posner's two examples of legitimate use of controls over prices. In the salvage at sea case, controls are warranted because there is not time during a rescue effort to work out what would be the appropriate sharing rule. The attempt of the Alaskan seamen to hold up the owners for higher wages while at sea presumably broke an implicit contract that wages are fixed for the duration of the fishing trip.
But shouldn't price controls also be used in poor countries when they experience a catastrophic shortfall in the supply of a food staple, such as rice or potatoes (the Irish potato famine is the best-known example)? The poorest families may be unable to pay the higher prices, and they could face starvation. Still, I do not believe price controls are a good solution, for they discourage greater production and imports of the scarce food, and they encourage farmers to hoard their food crops. Governments of these countries, and richer countries too through humanitarian aid, should instead become active in buying rice or whatever crop is involved, and reselling that to poor families at lower prices. Or these governments should increase income transfers to the poor that would enable them to pay the high market prices.
In the modern world, famines are caused not be high prices, but by bad governmental policies. Famines are virtually unknown in modern democratic societies. Yet famines and large-scale starvation are still sometimes found in dictatorships, such as in China during Mao's Great Leap Forward. The problem there was not high prices, but Mao's foolish policies. He first caused farm output to fall by his misguided attempt to leap forward,. He then forcibly took much of the limited supply of food from farmers, so that many of them starved to death, in order to feed city populations. In addition, he sold some of the reduced crop of grains abroad for hard currencies rather than importing grains to ease the food crisis.
Price Gouging in the Wake of Hurricanes--Posner's Response to Comments
There were many excellent comments. One asked who actually benefited from the shortage of gasoline resulting from Katrina and Rita--the gasoline dealers or the refiners? I had mentioned the first, Becker the second. Both gained, but the refiners more. The reason is, as one commenter noted, that once the gasoline station has sold all the gasoline stored on his premises and has to buy more from a refiner, he will have to pay the high price necessary to ration the limited output of the refiners, unless he has negotiated a fixed-price supply contract.
I was surprised by how many comments took issue with the basic proposition that price controls are inefficient. A number of questionable propositions, theoretical and empirical, were offered. For example, it was suggested that charging the market-clearing price in a shortage is inefficient because it is not the "equilibrium" price. I think what the commenter meant is that if the shortage is temporary, the price that clears the market will soon fall. But the point is that it is the market-clearing price. If a lower price is charged, supply will exceed demand and will have to be allocated by some nonprice method, such as queuing. It is quite right, as I had suggested in my post, that for people with low time costs, queuing may be preferable to paying a high (money) price. But the poorest people don't have cars, so they are not affected by a gasoline shortage. Above them are people of modest incomes, who can afford cars but are highly sensitive to gasoline prices; nevertheless, the number of people who would incur extreme hardship from having to pay an extra $2 or $3 a gallon for a few weeks is, I would guess, small (I would invite submission of evidence that it is large). Moreover, while their time costs may be low, they will not be zero. Queuing in a shortage situation can become extreme, because not knowing whether there will be any supply available people tend to queue when their need is not urgent, for example when they have a half-full gas tank but are unsure when, if they do not fill it now, they will be able to do so when the tank is almost empty. Fear of shortages also makes shortages worse and queuing longer by increasing hoarding. The worse that shortages are expected to be because of price controls, the more hoarding the expectation of shortages will induce--and so the shortages will be worse.
As I said in my post, in situations of extreme hardship, which I illustrated with the case of a shortage of human growth hormone and that one of the comments illustrated with the case of scarcity of organs for transplantation, the welfare effects of rationing by price may justify either nonprice rationing or a government subsidy to enable people of limited means to obtain a product much more likely to increase their welfare than that of affluent purchasers.
It should be noted also that some of the effects of shortages on the distribution of income and wealth are automatically corrected by the tax system: windfall profits of gasoline dealers and retailers are taxable as income, and so a part of them is in effect returned to the general public. More would be returned if an "excess profits" tax were imposed, as in World War II, in recognition of the enormous profits that shortages created by the nation's all-out war effect had generated for defense contractors.
One comment blamed the refiners for not having hardened their Gulf Coast refineries against catastrophic hurricanes. If they were negligent in failing to do so, this might conceivably support a tort suit to recover the refiners' windfall profits. (They would not be negligent if the expected benefits from such hardening did not exceed the costs.) For then there would be a sense in which the shortage was artifically induced. But the point does not support a general policy of imposing price controls during shortages.
One comment reported a rumor that Starbucks had charged $10 per bottle of water to firemen and police officers who responded to the 9/11 attacks in New York City, even though--the commenter said--there was no shortage of water. But the rumor, if true, describes a situation similar to that in the admiralty salvage case. The responders appear unexpectedly and need water; they don't have time to shop for it and anyway there are many more of them than are usually trying to buy water from a Starbucks store, and so its supply would quickly be depleted if it charged its normal price--so there would have been a shortage at that price. And, as one comment pointed out, price controls in shortage situations, for example in the form of fines for "price gouging," discourage merchants from stocking up with extra supplies for future emergencies. Keeping an inventory of items that will be demanded only in emergencies is extremely costly, and may be cost justifiable only if the merchant knows that should there be an emergency the items can be sold at a higher than normal price. This is an objection to a general windfall-profits tax.
Some of the comments challenge the most basic assumptions of a free-market society, such as that markets generally yield much more satisfactory allocative results than bureaucrats. One would think that the experience of communism would have disabused people of belief in the superior efficiency of "central planning." The issue is not philosophical--whether a market system of resource allocation is "just" or whether democracy should be used to allocate resources instead of markets because it is more--democratic. It is whether you like the consequences that "price gouging" laws would produce. The major consequences would be shortages, leading to nonprice rationing that would impose enormous costs, and thus augment and shift, rather than reduce, the price of the shortage item. I think the experience of queuing would change the minds of most intellectuals who think that resources should be allocated by nonprice methods.
Let me try finally to be more precise about the nature of the market failure in the admiralty salvage case. One comment suggested that the problem there is not monopoly at all, in the sense of an artifical scarcity, but transaction costs. In fact both monopoly and high transaction costs are present and they are related. The would-be rescuer creates an artifical scarcity by threatening to withhold supply (that is, refuse to rescue) unless the ship in distress agrees to the rescuer's exorbitant price--a monopoly price because it is based on the purchaser's lack of alternatives. However, the situation is actually one of bilateral monopoly because while the purchaser lacks alternatives, so does the seller; he has (at present) no other market for his rescue services than this particular ship in distress. Because price under bilateral monopoly is indeterminate within a broad range, negotiation (transaction) costs are high, which creates a particularly acute problem in a rescue situation in which time is of the essence. The case is completely different from that of the hurricane-induced gasoline shortage.
Response on Price Gouging-BECKER
Although I am a little late, I would like to respond to a few comments on my discussion of price gouging. Judge Posner's and my discussion of our new topic on childcare and paid leaves follows after this response.
Two of the comments questioned my assertion that President Carter introduced price controls on gasoline that produced long lines. I am right, as shown by the following entry from Wikepedia on the 1979 energy crisis: "In the United States, the Carter administration instituted price controls. This resulted in long lines appearing at the gas stations as they had six years earlier. As the average vehicle of the time consumed between 2-3 liters of gas an hour while idling, it was estimated at the time that Americans wasted up to 150,000 barrels of oil per day idling their engines in the lines at gas stations."
To be sure, Nixon introduced various inefficient controls over energy prices that Carter began to dismantle. However, Carter introduced controls over gasoline prices that produced I believe longer lines at gasoline stations than those under Nixon. Of course, I agree that Nixon had terrible policies on energy prices, especially his misguided efforts at price controls over oil, natural gas, and some of their products.
Although search is required to discover prices at different gasoline stations, in any major city or suburban area, search costs are small relative to the gain from sizeable differences in gasoline prices. This is why the retail gasoline market is on the whole very competitive, as indicated by the strong central gasoline price tendencies in major cities and other extensive markets. In such competitive markets with rather constant costs per unit of output, the effect of a rise in input prices on retail prices is largely independent of the elasticity of demand for the retail good.
Unfortunately, many Indians, Chinese, and others in poor countries live on the equivalent of less than a few dollars a day, and many of these suffer from malnutrition. But this has nothing to do with price gouging during crises since most of these persons live in rural areas and work on farms. It is the result of their very low productivity. As India and China have progressed rapidly during the past decade and half, the fraction of their populations living at such low levels has declined dramatically, and so has the degree of malnutrition.
Gasoline prices have returned close to pre-Katrina levels because most of the damaged refineries have been repaired, and the undamaged ones have increased their production. Both effects are in part responses to the (temporary) high gas prices. So my conclusion is that these high prices served a very useful purpose in increasing gasoline supplies more quickly that would have been the case if price controls on gasoline had been introduced again.