In praise of price gouging, revisited

By Eric Crampton 31/10/2012

There are no laws against price gouging in New Zealand. Nevertheless, there really wasn’t very much of it when it really really was needed – after the Christchurch earthquakes.

With the New York hurricane, price gouging is again making the rounds of the Econ blogosphere. Michael Giberson summarises things. Jeff Ely has concocted a scenario in which he thinks gouging worsens outcomes. I’m going to disagree with specific reference to the Christchurch experience.

Ely argues that we can have cases where supply is effectively fixed. Consequently, the only gains we get via gouging are in ensuring that goods are allocated to their highest valued use; we don’t get increased supply. In that case, we weigh the gains from improved allocation against the losses to inframarginal consumers who have to pay more. Now, Ely’s effectively ignoring producer surplus; he says producer surplus should only count when it can bring forth more supply. The better argument would simply specify that producers have lower marginal utility of income so the transfer is utility decreasing. I don’t see why we otherwise would want to say that consumer surplus is so much better than producer surplus.

But, the Ely scenario really doesn’t fit hurricanes. You get tons of prior warning for hurricanes and the opportunity to price gouge can bring in plenty of new supply. Not like an earthquake. And so let’s go back to the Christchurch earthquakes.

After the February 2011 earthquake, we were in a zero-supply-elasticity world for a few goods, most notably petrol. More petrol was coming, but it wasn’t going to be here for a few days. All of the petrol stations on the east side of town were out of commission due to power outages; it was very hard to figure out where you’d be able to find a petrol station with power if you lived in the east. Worse, because everyone knew that petrol was scarce, everyone panicked. If you had a car with half a tank, you filled it up. If you had two cars, you made sure both tanks were full. If you had empty jerry-cans, you filled those up too. A student this year told me that he was working as a security guard at one of the petrol stations after the quake. People were filling up barrels with petrol to keep in the garage. Eventually, the station started enforcing some rationing.

What radio reports we could get in the east noted very long petrol queues at the working stations in the west, with some selling out. We were in South Brighton, no power, a quarter tank of fuel [getting home post-quake took 5 freaking hours in traffic], and absolutely no clue whether our quarter tank would be enough to get us to a working station on the west side of town when we bugged out for a house with working sewerage, water and power.


There were no laws against price gouging. But the petrol stations knew that every single customer would hate them if they were the only station to let prices rise such that supply and demand came back into equilibrium. And so because the stations didn’t gouge, we were in a terrible equilibrium where everyone’s rational response to the below-clearing price was to hoard, because there was real risk that the stations would run out of fuel. And there was real risk of running out of fuel because of the hoarding. Breaking the hoarding equilibrium would have required a coordinated price hike that both allocated fuel to its highest valued uses and told everyone that there would be fuel available for them in an emergency if they really really needed it. That latter part is crucial – it kills the incentive to hoard.

I take the Roth stuff on stupidity constraints seriously – we can’t assume those away.* Any station doing the right thing would have taken a reputation hit that outweighed the private benefits to the station because customers are resentful idiots who do not understand how prices work. If the stations had gotten together to coordinate it, there would have been massive pressure for Commerce Commission action. The second-best alternative, given consumers who are idiots about price gouging, would have been a temporary very large hike in the petrol tax for Christchurch, with money raised being dedicated to earthquake relief. This, I think, is the right response when supply is perfectly inelastic and stupidity constraints bind. I argued for it as soon as I was again able to blog post-quake.** It should be a standing contingency plan for similar emergencies.

If there are big worries about hardship on poorer communities from the price increases, get a helicopter, get a bag of money, and drop the money over the poorer communities while letting prices rise. A better option, if stupidity constraints of another form didn’t bind, would be to give everybody an emergency debit card pre-loaded with $200 that would only activate if a state of emergency were declared. But there’s awfully strong odds that the folks who’d most need them would lose them or sell them prior to the emergency.

I really think Ely is underestimating just how much value there can be in getting to the right allocative solution, and how a good dose of gouging can break hoarding equilibria.

* He calls it “repugnant markets”, where people view some kinds of transactions as being repugnant. When those kinds of preferences prevent efficient trades, I call them stupidity constraints. Semantics.

** Other posts on price-gouging summarised here.

0 Responses to “In praise of price gouging, revisited”

  • Just curious, why wouldn’t rationing “cure” the hoarders?. Knowing that additional supply was imminent, 20L per vehicle with vehicle number plates recorded could be effective.

    • I like prices over rationing for a couple of reasons.

      Let’s split out two main demand components. First, that portion of demand that’s based on expected use over the interval until fuel next shows up; second, that portion of demand that’s motivated by fear that there won’t be any fuel tomorrow should it be needed. The best system addresses the second with minimal cost to the first.

      Specify for now for assumption that rationing or price hikes would have equivalent effects on the second precautionary motive for holding fuel balances. I don’t think that’s the case, but we’ll specify it for now. Then, compare the two mechanisms.

      With rationing, everyone can get 20 litres (or whatever) and no more. Those who need to get out of town face strong constraints; those who weren’t going to need to drive anywhere can get more than they really need. If it weren’t difficult to set up secondary markets, we’d expect some people to fill up, siphon the extra fuel out of their tanks, and on-sell it to those who were constrained by the 20-litre limit (the folks bugging out of town). Anybody filling up would get the full 20 litres.

      With prices, suppose prices doubled and suppose further that the 20 litres per person really reflected how much people needed unless they were bugging out of town. That’s $40 per car. Those who needed less than 20 litres would refrain from getting 20 litres, knowing that the prices would be halved in a couple days. Anybody who needed more and needed it now would pay more. The market clears.

      Now we add on the psychological element where I’m less confident in predictions. I expect, but cannot be sure, that a price hike that’s well publicized to be temporary does more to convince people to abate precautionary demand than does rationing that’s known to be temporary. Here I’m relying more on introspection. If John Key came on tele and announced that, temporarily, I could only have 20 litres, I’d run out and get 20 litres whether I needed it or not, just to be safe; if he came on tele and announced that, temporarily, prices were double and would be back down again on a fixed date, I’d curb my consumption and be more certain that others would also be trying hard to avoid buying any.