Price Gouging: Reality vs Fiction

In a previous post I comment on a too common economic fallacy, that a natural disaster is good for the economy because of its alleged impact on GDP. Economic fallacies are not the only misconceptions gaining momentum during a natural disaster, but a confusion between reality and fiction becomes also quite common. The issue of price gouging provides a good example of this situation.

After a natural disaster, the price of certain goods such as water or gas, increases significantly. This is seen as an immoral exploitation by merchants who are taking advantage of the people affected by the natural disaster. Even though in this post I want to comment on another issue, it is worth mentioning that the now limited resources should be allocated to those in most need (rather than, for instance, to whoever happens to be the first one in line.) And unless someone has a crystal ball, there is no way of knowing who is in most need without changes in relative prices.

The mention to reality versus fiction refers to the fact that the critics of price gouging seem to (implicitly) assume that the natural disaster did not occur. It is plausible to assume that an event like this would (1) shift the supply to the left [reduce supply of goods] and (2) shift the demand to the right [increase the demand of goods.] At the usual (or “normal”) price these goods are in serious shortage.

This means that in the event of a natural disaster the option is between (1) having goods at a higher price or (2) not having goods at the “normal” price. This is the new reality. The old and normal reality does not exist anymore. To limit price gouging results in a lower price in the store, but not goods on the shelf. This would not help those in need. The fiction consists in thinking that a larger supply can be secured without an increase in the price (why should we assume supply is horizontal when these goods usually have a low elasticity?) An efficient policy would secure the provision of goods rather than secure a low price without the goods. Reality, rather than fiction, should be the first driver of a policy designed to assist during a natural disaster. As Milton Friedman insisted, a policy is to be valuated by its results (or design), not by its intentions.

The first rule for an efficient policy should be to not get in the way of changes in relative prices. Otherwise help will become erratic and inefficient. It might be more efficient, for instance, to make use of firms specialized in logistics (i.e. firms such as Walmart) and subsidize the demand than start a price control policy. For instance, a tax credit or a check can be sent to those affected by the natural disaster allowing them to pay the now higher prices. Similarly, a subsidy can be given to those firms bringing goods to the damaged areas (who says the government has the monopoly of charity or that the only one who can do it efficiently?) A policy on these lines would be more efficient than interfering with relative prices.

However, some opponents of price gouging seem to be more interested in damaging merchants than in making sure resources will be efficiently allocated among the ones affected by the natural disaster. Those who do not oppose price gouging do so because they have the affected ones first in line. It is not about merchant’s revenue, it is about allocating goods efficiently. Damaging the merchants should not be more important than worsening the situation of those in need.

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No, natural disasters are not good for the economy.

Every time there is a natural disaster old economic fallacies make their appearance. And they are usually always the same. In particular, the argument that a natural disaster is good for the economy. This should make little sense. Wealth is not created by destroying things. A natural disaster destroys wealth, doesn’t create it. I doubt anyone affected by a hurricane would argue that he is better off after the natural disaster than before.

The argument that an event such as a natural disaster is good for the economy rests in the positive impact seen in GDP (as is argued) after the natural event. If GDP increases, then the economy is doing better. But this is a misreading of GDP. This variable is a flow of wealth, it is not a stock of accumulated wealth. It is possible that wealth creation (flow) increases at the same time the stock of wealth is decreasing. And this is what happens during a natural disaster.

Imagine that someone’s house caught fire and burns down. Because of this situation, this person decides to start working extra hours to increase his income and be able to buy a new one. The extra hours makes his income (GDP) increase. But his situation is considerable worst because he lost his stock of wealth (remember Bastiat’s broken window fallacy…?). Arguing that a natural disaster (or a war, etc…) is good for the economy is like arguing that this person is better of because he has to work extra hours to recover his loss.

This is just another case of a too common fallacy in economics. We know that if the economy is doing better the result will be better GDP and unemployment indicators. But from observing a better GDP and unemployment indicators we cannot, and should not, conclude that the economy is doing better. More important than observing what is happening to GDP is understanding why is changing its behavior.

It could be argued that one of the problem of the Keynesian view of the world is the focus on what happens to output and unemployment rather than why these variables are moving. Not surprisingly, we get to the conclusion that going to war (or having a natural disaster) would be a good way to achieve full employment.