Price Gouging Can Boost Supply

A blog about business and economics.
Nov. 2 2012 10:15 AM

When Supply Is Elastic, Gouge Away  

Some more words on price gouging, as New York and New Jersey are increasingly afflicted by gasoline shortages. There are three issues we need to look at here. One is allocation, one is short-term supply, and one is long-term supply.

A lot of people seem to want to look at this purely as an allocative question. Should scarce resources go to those who are willing and able to pay the most for them, or should they go to those who manage to get in line soonest? That's the appropriate frame only if supply is genuinely inelastic.

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Like suppose the reason gasoline is scarce is that we're fighting a major war. Here the majority of available oil is being reserved for military use and wartime production. If any new oil is found, that's where it's going to go. The priority is to win the war, and civilians are making due with a fixed supply. Here allocating by price might be genuinely inappropriate. But note that allocating by queiung isn't the right idea either. That's just a huge waste of everyone's time. What you want to do is explicitly ration the supply and then probably let people freely trade so that if poor people would rather have money than gasoline they can make the swap.

In the case of the hurricane, the commodity where supply is inelastic is probably hotel rooms. They're not going to build any new hotels next week just because lots of people are trying to get out of the blacked out areas.

And in New York City at least, even the long-term supply of hotel rooms is in effect inelastic. The rooms that exist are already really expensive by national standards, and the supply of rooms is limiting by the zoning code and the permitting process rather than by a lack of market demand or profit opportunities. One thing we're seeing here is that policies that prevent the construction of the market maximum quantity of hotel rooms can have surprising hidden costs in unusual situations, but this is an issue of long-term development policy and not emergency management as such.

But when it comes to things like gasoline and bottled water, neither the short-term nor the long-term supplies are genuinely fixed. Transportation routes into the area have been severely disrupted and many gas stations' supplies are hard to access due to power outages, but it's not impossible to transport this fuel from where it is into people's cars and generators. It's just much more annoying and difficult than usual. But the possibility of windfall profits is exactly the lure we need to get people to start making extraordinary efforts to get more fuel to the people who need it. There are things people will do to sell gasoline for $10 a gallon that they won't do to sell gasoline for $3.40 a gallon (note that in Norway this is what gas costs all the time) and that's what we need.

For other emergency supplies like flashlights, batteries, small gas stoves, bottled water, etc. the same logic applies and we also have to worry about long-term supply elasticity. Say you own a hardware store. How many flashlights should you keep on hand at the beginning of any given week? The correct answer to that question depends in part on what happens if there's a sudden surge in demand for flashlights. If you get to jack up prices and reap windfall profits, then you want to maintain a fairly large inventory even if most weeks there isn't that much interest in flashlights. But if you need to maintain standard low margins no matter what, then the possibility of rare events that lead to huge demand surges shouldn't really factor into your inventory planning. That results in an overall more brittle system in which local supplies aren't very resilient to disruptions in transportation.

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