Wednesday, November 8, 2017
Price Gouging Is Fine but Humans Are Better
Not surprisingly, when it became clear that massive hurricanes were going to hit Texas and Florida, the attorneys general of both states announced that they would prosecute "price gougers" to the fullest extent of the law. Many economists spoke out against the sheer economic ignorance behind that effort. Some of us took to Facebook, decrying the price-gouging hysteria and congratulating each other on our enlightened understanding of the price system. Any media that offered us an interview got an earful of Econ 101.
I even drafted an op/ed. The first sentence was, "Blessed be the price gougers".
What I wrote is that a law outlawing "price gouging" is nothing more than a crudely enforced price ceiling. I pointed out, as did many other economists, that if the government can impose an effective price ceiling, it will create massive shortages. Prices send essential information. When prices rise, they tell people to be more careful about how much they use. And, in the long run – which, in a disaster area, can be just a few days – higher prices create powerful incentives for outsiders to quickly bring in essential supplies.
What's more, I noted, price gouging has no clear meaning in economics. The Dallas Cowboys, for example, are owned by a billionaire, benefit from massive public subsidies, and have substantial monopoly power. In contrast, hundreds of convenience stores in Texas are owned by immigrants who pay taxes and operate in a highly competitive market. So why is it ok for the Dallas Cowboys to charge $6 for a bottle of water but not ok for a Quickie Mart in Houston to charge $144 for a case of 24?
The Virtues of People
Price controls in the aftermath of a disaster will make things worse, not better. And there's nothing wrong with saying so – especially if saying so can help stop publicity-seeking politicians from getting in the way.
But I'm not so sure that I should have written, "Blessed be the price gougers".
The reason that prosecuting price gouging during a disaster is bad is not that price gouging is so good. Prosecuting price gouging is bad because people are, for the most part, good. When economists like me take to the airwaves and op/ed pages to decry the heavy hand of the government interfering with markets, we always end up talking about the virtues of markets. What we also need to talk about is the virtues of people. Prosecuting price gouging makes things worse because it limits the ability of good people to do useful things.
So, what does this have to do with natural disasters and the way that human beings respond to them? We occupy our privileged place on earth only because we are exceptionally good at cooperating with one another. Because we cooperate, we don't have to do everything for ourselves; we can specialize in doing what we do best. Clearly, other creatures on earth cooperate – we see that on display in nature all the time. However, human beings have figured out how to cooperate with total strangers anywhere in the world. That's what markets are for: they permit people to coordinate their actions and specialize. Economists are people who specialize in studying how this all works.
But the truly great economists have always understood that markets, despite their huge value, have limits. Ronald Coase's seminal articles, "The Nature of the Firm" and "The Problem of Social Cost," explained that markets have costs and limitations. Adam Smith's most important book, The Theory of Moral Sentiments, explains that our societies work only because our big, adaptable brains imbue us with a strong sense of fellow feeling. Smith teaches us that culture and morality are as important as supply and demand in helping us understand how economies work.
So here's a little thought experiment.
On the Front Line of Demand and Supply
Imagine that you operate a motel on I-45, somewhere between Dallas and Houston. Your place is okay, but just barely – the carpet is worn, the swimming pool is cloudy, and the air conditioning makes too much noise. On a typical night, you'll rent about half the rooms for an average of $50.
Now Houston floods and many desperate people are at your front desk. You can't possibly accommodate all the people who want a room: at a price of $50, the quantity demanded far exceeds the quantity supplied. In fact, the market-clearing price for the crummiest room may be closer to $500.1
What to do?
Well, you could rent the rooms for $500. You acquired the motel through legitimate means. You're not using threats or any coercive measure to force people to rent the room. There are no negative externalities at play. The exchange is, by definition, mutually beneficial. You might believe that your own self-interest is all that matters and so you act in a way that achieves your immediate pecuniary goals.
But that's not what you're going to do – or at least it's not the reason why you're going to do what you do. You're not a caricature invented by some strange, sad novelist in order to celebrate "the virtue of selfishness". You're a real flesh and blood human. You care about more than yourself and your kinship group. It doesn't much matter whether your attitudes are a manifestation of evolutionary psychology, the Grace of God, or both. You want, in Adam Smith's beautiful phrase, "not only to be loved, but to be lovely".
So, as you stand behind the front desk thinking about the masses outside the door clamoring to be let in, you worry a lot about who in that group is most in need. You're not exactly channeling Jeremy Bentham and performing some sort of utility-maximizing felicific calculus, but you are absolutely not performing an econ 101 exercise in finding the profit-maximizing price.
If you're a really thoughtful innkeeper, though, you might end up behaving just like your greedy, selfish caricature. You might, for the noblest and most enlightened reasons, sell only to the highest bidders.
To see why, assume that you're not only good, but also smart. You know that good intentions aren't enough. You know that assigning a room to one family means turning another family away. And when every family is desperate, who is most desperate? Econ 101 doesn't claim to show that willingness to pay captures some deeper values – Mary and Joseph were, after all, unwilling to pay for a room at the inn – but maybe it's the closest thing you've got.
Remember, too, that lots of people are going to need all kinds of help. Sure, you could rent the room for $50 to someone who may or may not be deserving, but why not rent the room for $500 and then give the extra cash to someone who you know needs it? Suppose, for example, that someone in the mob out front has relatives with a spare room in Dallas but needs gas money to get there. Why not generate extra cash and then give them some of the money?
There's a good chance, though, that if you really understand economics – if you really appreciate Coase and Smith – you won't just let prices do the hard work of rationing a precious resource.
Cooperation & Who Should Get to Set Prices
Consider, for example, the practical problems of running your motel. To begin with, you have to figure out the correct price. You know that on an ordinary weeknight, $50 is about the right rate for a standard room. You know that fact because you have years of experience managing a motel, not because the Market Fairy drew a supply and demand curve in the clouds. But this is not an ordinary weeknight. How can you know the true equilibrium price in these new and desperate conditions?
Remember, too, that in ordinary circumstances, customers signify willingness to pay by offering cash or some other legitimate means of payment. But after a disaster, the ATMs may not work and credit cards may be impossible to process.
This is not an original idea. Those who favor prosecuting price gouging are eager to point out that in extraordinary circumstances, markets sometimes break down. But so what? The question is not whether markets always work or whether willingness to pay is always the best measure of value. The question is: who should decide? Should we trust the innkeeper standing in the rain listening to the crowd clamoring for the room, or should we trust the politicians in the state capital listening to the crowd of reporters clamoring for a sound bite?
If you have any doubt as to the correct answer to that question, think about what actually happened in Texas and Florida. In the immediate aftermath of the destruction, people needed each other far more than in ordinary times. Cooperation with others wasn't just a good way of securing material comfort; it was necessary for survival. But it appears as if people mostly chose not to use prices and markets to coordinate their activities. When the waters rose, neighbors helped neighbors without any expectation of reciprocity, let alone an employment relationship. In fact, strangers came from all over the South to help. Business owners didn't generally radically raise prices: for every story about "price gouging," there were multiple reports of merchants who just opened their doors to let people take what they needed and pay what they could.
Interestingly, Richard Thaler, who was announced last month as this year's winner of the Nobel Prize in economics, pointed out something similar in 2012. Like most economists, Thaler argued that a law against price gouging is a bad idea. His pithy response was "Not needed. Big firms hold prices firm. 'Entrepreneurs' with trucks help meet supply. Are the latter covered? If so, bad."2
In other words, Thaler was saying, large firms won't be constrained by price-gouging laws because they wouldn't be inclined to raise prices anyway whereas laws against price gouging by small entrepreneurs would discourage them from providing badly needed supplies. Unfortunately, in a recent interview,3 Thaler seemed to have backed away from that thinking although he didn't give a clear reason why.
Since at least the Scottish Enlightenment, classical liberals have understood that "spontaneous order" – order that develops from human action but not from human design – is critical to understanding how societies work. Markets and prices are one example of spontaneous order, but they're only one example. Economics doesn't teach us that markets are always good; it teaches us that people are really good at figuring out when to rely on markets. And that's what we should be teaching our students and our politicians.
1. To make the thought experiment simpler, let's just assume that charging the market-clearing price really does maximize firm value. We can certainly tell stories about markets in which long-term relationships and reputations matter, and so charging the market-clearing price may not be a good idea. But roadside motels probably don't fit these stories.
Michael L. Davis is a senior lecturer in business economics at the O'Neil Center for Global Markets and Freedom at Southern Methodist University's Cox School of Business.
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