The Economics of Price Gouging

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What Is Price Gouging?

man selling goods after tsunami
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Price gouging is loosely defined as charging a price that is higher than normal or fair, usually in times of natural disaster or other crisis. More specifically, price gouging can be thought of as increases in price due to temporary increases in demand rather than increases in suppliers' costs (i.e. supply).

Price gouging is typically thought of as immoral, and, as such, price gouging is explicitly illegal in many jurisdictions. It's important to understand, however, that this concept of price gouging results from what is generally considered to be an efficient market outcome. Let's see why this is, and also why price gouging might be problematic nonetheless.

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Modeling an Increase in Demand

When demand for a product increases, it means that consumers are willing and able to purchase more of the product at the given market price. Since the original market equilibrium price (labeled P1* in the diagram above) was one where the supply and demand for the product were in balance, such increases in demand usually cause a temporary shortage of the product.

Most suppliers, upon seeing long lines of people trying to buy their products, find it profitable to, in part, raise prices, and, in part, make more of the product (or get more of the product into the store if the supplier is simply a retailer). This action would bring the supply and demand of the product back into balance, but at a higher price (labeled P2* in the diagram above).

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Price Increases Versus Shortages

Because of the increase in demand, there isn't a way for everyone to get what they want at the original market price. Instead, if the price doesn't change, a shortage will develop since the supplier won't have an incentive to make more of the product available (it wouldn't be profitable to do so and the supplier can't be expected to take a loss rather than raise prices).

When supply and demand for an item are in balance, everyone who is willing and able to pay the market price can get as much of the good as he or she wants (and there is none left over). This balance is economically efficient, since it means that companies are maximizing profit and goods are going to all of the people who value the goods more than they cost to produce (i.e. those who value the good most).

When a shortage develops, in contrast, it's unclear how the supply of a good gets rationed- maybe it goes to the people who showed up at the store first, maybe it goes to those who bribe the store owner (thereby indirectly raising the effective price), etc. The important thing to remember is that everyone getting as much as they want at the original price is not an option, and higher prices would, in many cases, increase the supply of needed goods and allocate them to people who value them the most.

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Arguments Against Price Gouging

Some critics of price gouging argue that, because suppliers are often limited in the short run to whatever inventory they have on hand, short-run supply is perfectly inelastic (i.e. completely unresponsive to changes in price, as shown in the diagram above). In this case, an increase in demand would lead only to an increase in price and not to an increase in the quantity supplied, which critics argue simply results in the supplier profiting at the expense of consumers.

In these cases, however, higher prices can still be helpful in that they allocate goods more efficiently than artificially low prices combined with shortages would. For example, higher prices during peak demand times discourage hoarding by those who happen to get to the store first, leaving more to go around for others who value the items more.

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Income Inequality and Price Gouging

Another common objection to price gouging is that, when higher prices are used to allocate goods, rich people will just swoop in and buy up all the supply, leaving less wealthy people out in the cold. This objection isn't entirely unreasonableĀ since the efficiency of free markets relies on the notion that the dollar amount that each person is willing and able to pay for an item corresponds closely to the intrinsic usefulness of that item for each person. In other words, markets work well when people who are willing and able to pay more for an item actually want that item more than people who are willing and able to pay less.

When comparing across people with similar levels of income, this assumption likely holds, but the relationship between usefulness and willingness to pay likely changes as people move up the income spectrum. (For example, Bill Gates is probably willing and able to pay more for a gallon of milk than I am, but that more likely represents the fact that Bill has more money to throw around and less to do with the fact that he likes milk that much more than I do.) This isn't so much of a concern for items that are considered luxuries, but it does present a philosophical dilemma when considering markets for necessities, especially during crisis situations.