Friday, September 02, 2005

Let's hope that was a slip 

Count me among the multitudes that hopes President Bush misspoke when he said this.

"I think there ought to be zero tolerance of people breaking the law during an emergency such as this, whether it be looting, or price-gouging at the gasoline pump or taking advantage or charitable giving, or insurance fraud," Bush said in an interview on ABC's "Good Morning America."
What does one mean by price-gouging? I'm probably not Ed Lotterman's biggest fan ("probably" only because I have not done scientific polling on the question), but in one of his better columns he shows all the ways people misuse the term.

While we may not like it when a particular set of sellers charge what we think is a high price for a product we want, requiring government approval of a fair price for any particular transaction opens up a Pandora�s box of complications. Price controls lead to wasted resources and even greater unfairness than the market.
And Mark Kleiman, writing on Bush's comment, finds his way to the right conclusion as well.
The natural result of that situation is that the price of gasoline goes up. In the short run, that doesn't result in any additional supply, but it does reduce the quantity demanded, allowing the market to clear. Unfortunately, the short-run price-elasticity of demand for gasoline is low, so even a modest-sized supply crunch will naturally cause big price increases.

In economics, this is called "market clearing." In politics, it's called "price gouging." Of course, it's possible by law to keep prices below their market-clearing levels. In politics and law, that's called "price control."

In economics, the result of that policy is called "shortage." At any price below the market-clearing level, buyers will want to buy more gasoline than sellers have to sell. The result is either waiting in line, which is a very inefficient means of rationing compared to letting the price rise, or some sort of legal rationing system.

If you go back to my notes from my introductory class early this summer, you'll note I said all scarce goods get rationed somehow ("scarce good" meaning you must sacrifice some other action to obtain it. Remember, things don't have a cost; actions do.) The price gouging charge, as Lotterman and Kleiman point out, is a claim that in a situation of a negative shock to the supply of a good, price no longer is the best method for dealing with (increasing) scarcity.

That begs two questions: What's wrong with price, and what would be better? And what would be the mechanism that determines when we switch away from the normal use of price in our market economy?
What do prices do? They not only allow sellers to recover their costs, they force buyers to restrict how much they demand. More generally, prices cause goods and the resources that produce goods to flow in one direction through the economy rather than in a different direction.
Or consider this example of recovery from the 1906 earthquake in San Francisco, from his
Basic Economics.
When the San Francisco Chronicle resumed publicatioin a month after the earthquake, its first issue contained 64 advertisements of apartments or homes to rent, compared to only 5 ads from people seeking apartments to live in. Of the 200,000 people suddenly made homeless by the earthquake, temporary
shelters housed 30,000 and an estimated 75,000 left the city. Still, that left nearly 100,000 people to be absorbed into the local housing market. Yet neither the newspapers nor onther documents of that time mention any housing shortages, such as lengthy searches or bribes paid to landlords. Rising prices not only allocated the existing housing shortage, the provided incentives for rebuilding. (p. 31, from first edition)
So too with gasoline. Someone at my breakfast group this morning said that he had talked to a gas station owner yesterday and was told no gas came to us from Louisiana but from Canada. Another said it did come from Louisiana. I said, that doesn't matter. If supply is plentiful here but short elsewhere, prices will encourage distributors to send it to the places where gas is dear and not to where gas is cheap. Particularly since the EPA suspended clear air rules that turned the gas market into a series of islands with gas usable in one place but not another, the law of one price reigns. And David Brown points out,
If we expect customers to be able to get what they need in an emergency, when demand zooms vendors must be allowed and encouraged to increase their prices.
Supplies are then more likely to be sustained, and the people who most urgently need a particular good will more likely be able to get it. That is especially important during an emergency. Price gouging saves lives.
What other allocation system will provide for this result?
Thus legislators and presidents who want to view some prices as unconscionable may be doing greater harm than good, in diverting resources away from the places they are demanded most. Walter Williams makes this point discussing a Virginia anti-gouging law passed after the first of the big hurricanes of last year.
The Virginia Senate has provided a defense for sellers against charges of selling goods at an "unconscionable" price, saying, "Proof that the supplier incurred such additional costs during the time of disaster shall be prima facie evidence that the price increase was not unconscionable." That vision reflects gross economic ignorance on the part of the Senate. Costs alone do not determine price; demand plays a role as well. When there's a disaster, demand is likely to be the major element driving prices up.
And this is important: price is not determined by cost, but by the interaction of supply and demand. Let's hope that President Bush was just having an early-morning sleepy moment and that wiser heads prevail. Prices will allocate needed supplies for hurricane relief better than any government agency.
UPDATE: Would cutting gas taxes help? No, as James Hamilton explains. It's only obvious after you read it.
UPDATE 2: William Polley points out this post from Russell Roberts. It's harder to use the cool logic of economics when one's emotional about what's happening in New Orleans, but cooler heads will give us better policy.