Incentives and Price Gouging

Does price gouging create incentives to increase supply? Sure, but that doesn’t mean that children won’t die unnecessarily.

bottled_water_in_supermarket

I recently argued that Gregory Mankiw overlooked something simple but important in his defense of price-gouging: the fact that some people have more money than others, thus price gouging makes sure rich people will be the ones who end up with all of the goods being gouged. In making this point, I did not address another component of the economic defense of price-gouging. It’s worth going through that component, since I do not wish to receive angry letters from economists telling me to Take An Econ 101 Class (every time you question a dogma of economics, they tell you to take an Econ 101 class, on the assumption that you must simply not understand rather than understand and disagree). It goes, roughly, as follows:

The efficiency of price-gouging is not just about making sure those who want the good the most get the good. It is also about increasing supply. If there is a storm, and water bottles are in short supply, they may cost $500 at first. But the high price creates an incentive for profiteers to flood the area with more water bottles, to capitalize on the high prices. Soon, prices will come lower, and there will be far more water in the area, because “price gouging” created an incentive for new suppliers to find ways to get water to people. The same is true in the Hamilton example. Yes, only rich people will get to see Hamilton. But if Hamilton tickets are going for $2400, producers will realize how much money there is to be made on plays. They will therefore put on more plays, and ticket prices will go down. 

So high prices for goods in short supply create incentives to make more of those goods, and therefore lower prices. Price gouging is therefore good.

Now, the key thing here is the idea of a supply that can be expanded. If we assume a supply that cannot be replenished, then prices will continue to remain high, and a highest bidder process is just a guarantee that only the wealthy will have access to the thing.

The question, then, is whether it’s possible to make more of the stuff being demanded. In the case of Hamilton, that happens to be dubious. After all, you can make more plays, but you can’t easily make more Hamiltons. The people who most want to see Hamilton do not want to see something in the broad category “musicals.” They want to see Hamilton, the amazing show that simply everyone is raving about. There are such things as scarce goods of which more cannot be produced, e.g. Van Gogh paintings, or signed Elvis records. Or beachfront property, another classic economist’s example. Sometimes if the price is high, people will make more of a thing. But sometimes that’s simply impossible. So in the “water after a storm” example. It might be true that someone will bring more water to sell if water is going for $500. But not if the roads are flooded and nobody can get through. If it’s going to take two weeks for the gas station to get more water, and also two weeks for the entrepreneurs in trucks to sort it out and get things through, then by the time the profiteers arrive the price will be back to normal, and the only consequence of the gouging will have been to make sure that the wealthy (those who can pay $500 for water) rather than the committed (those willing to get up early to go and get water) will end up with all the water.

The “Econ 101” framework tells a plausible story, but ignores the fact that there are actually two equally plausible stories. Both of these stories probably occur under different conditions to different degrees, and it requires empirical research to sort out which of them actually occurs when. So if you and I and a team of people get stranded on an island, and I happen to be the one who has brought a trunk full of Doritos, I could charge you exorbitant prices per bag. Only the people who could afford it would eat. And any incentive to increase supply would be meaningless, because no matter how much you’d be willing to pay, nobody can get us any more food. Yet there are other situations in which supply is far more elastic and the temporary increased price will bring new supplies flooding in, restoring prices quickly to their original level just as the fable says will happen. Most of the time, the actual situation is between the two.

It’s important, then, to realize that we are dealing with a story about how we think reality will operate based on deduction from a certain set of axioms, rather than an observation of what reality actually does do. So we might expect supply to keep flowing in, as people in trucks bring water to the disaster area to make a killing, until water prices go down to their ordinary levels. But it could also be that, long before prices get down to the point where poor people can afford them, entrepreneur profiteers stop rushing in with replacements. The original water sells for $500. Then a bunch of guys come in trucks. They increase supply, so the cost goes down to $300. I (and my thirsty child) still can’t afford it, because I have $40. Then another wave of trucks comes. The price goes down to $200. I still can’t afford it. The next day, business as usual is fully restored and prices fall back to $2. But by that time, my child is dead.

In that scenario, allowing the free market to work has indeed increased supply. It has resulted in more people having water than would otherwise have had it. And yet it has also resulted in more children dying than would otherwise have died (if we had a “first-come, first-served” system, all the poor desperate dads would be first). So, as so often occurs with capitalism: we are in the aggregate better off, yet poor people are far worse off.

That doesn’t mean that anti-price gouging laws are generally a good idea, since there are circumstances in which the Econ 101 story does happen. After Hurricane Katrina, some guy got arrested for buying a bunch of generators in Kentucky and bringing them to Mississippi to sell at twice the price. It’s crazy to arrest someone in those circumstances, and criminalizing new things should generally be done cautiously. Nevertheless, there are perfectly plausible scenarios in which gouging doesn’t do anything to increase supply, it just enriches people who have had the good fortune to be in possession of the sole remaining supplies of a good. After all, when the zombie apocalypse comes, it will be very difficult for gougers to make the “incentives to supply” argument. I might go into the post-apocalyptic convenience store, and ask why soup is going for $400 a can:

“Because supply is scarce.”

“Yes, but I can’t afford it and I have a hungry child. Why should you get $400 just because you had the good fortune to be holding all the soup when the apocalypse arrived?”

“Look, don’t blame me. I’m helping you. I’m incentivizing others to come and slightly undercut my outrageous prices. If I sell soup at $400, and someone comes along selling it at $300, the price will go down and there will be more soup for everyone.”

“So when will someone come along with cheaper soup?”

“Well, never. The soup factory was swarmed by zombies.”

“So all of this incentives crap is pure fantasy, and you’re just trying to squeeze as much money as possible out of the last soup on earth.”

“Yes.”

Thus there’s not going to be any more supply forthcoming. All that’s left is to decide what to do with what we have left, and production incentives are irrelevant. It doesn’t seem impossible to me that many disasters are more like the zombie apocalypse, where new supplies do not show up magically, and that since it’s actually nearly impossible to bring new supplies, nobody does it.

Likewise, with Hamilton, the question is this: what actually happens? Well, it seems like what happens is that the Mankiws of the world buy up all the tickets, regardless of whether they care very much about seeing the show. And producers don’t necessarily think “Wow, people love shows, let’s produce more shows” leading to a reduction in price. They think “Wow, people love Hamilton, wish we had Hamilton” because demand hasn’t increase for “shows,” it has increased for this hit show.

Of course supply increases as a result of price hikes happen all the time. But it’s plenty plausible for there to be situations in which it does not happen, and in those situations, people with the most need can get deprived, with totally disproportionate and unnecessary distribution going to the people with the most preexisting wealth. Thus it’s important to recognize that gouging may not have the advantages economists say, and the question of whether it actually does should be evaluated empirically rather than with stories.

The primary point of the original critique of Mankiw was not to advocate a restriction on gouging, but to scold economists for treating “how much a person pays” and “how much a person values a thing” as identical, even though this would only be true in the absence of economic inequality. Regardless of whether the “gouging creates incentives to restore supply” argument works, one should acknowledge that gouging also makes sure that those with the least money get served last. That means that gouging reduces the degree to which the neediest get served. However, it’s also true that the incentives-creation argument is far less robust than it seems. Whether it’s true depends on what happens in the real world, a place that has a tendency to prove so many fables false.

Author: Nathan J. Robinson

is the editor of Current Affairs.