Should Price Gouging in the Aftermath of Catastrophes Be Punished?--Posner

Hurricane Katrina has produced a mass of interesting revelations. One is that more than half the states have laws forbidding "price gouging," often defined with unpardonable vagueness as charging "unconscionably" high prices. These laws are rarely enforced. But the sharp runup in gasoline prices as a result of Katrina (and also Hurricane Rita, which followed almost immediately), impeding imports of crude oil and causing a number of refineries in the path of the hurricanes to shut down temporarily, prompted a flurry of enforcement threats and even a few fines. It also prompted denunciation by politicians of greedy refiners and gasoline dealers, and proposals for federal legislation prohibiting "unconscionably excessive" gasoline price increases. What prompts such reactions besides sheer ignorance of basic economics (a failure of our educational system) and demagogic appeals by politicians to that ignorance is the fact that an unanticipated curtailment of supply is likely to produce abnormal profits. The curtailment reduces output, which results in an increase in price as consumers bid against each other for the reduced output. In addition, the reduction in output is likely to reduce the sellers' unit costs; the reason is that sellers normally sell in a region in which their costs are increasing--if they were decreasing, the sellers would have an incentive to expand output further. With both price rising and cost falling, profits are likely to zoom upward. (Some gas stations are reported to have seen their profits increase by 400 percent shortly after Hurricane Katrina struck.) In times of catastrophe, with consumers hurting, the spectacle of sellers benefiting from consumers' distress, while (it seems) deepening that distress by charging them high prices, is a source of profound resentment, and in a democratic society profound resentments trigger government intervention. Such intervention is nevertheless a profound mistake, and not only from some narrow "economic" perspective that disregards human suffering and distributive justice. If "price gouging" laws or even merely public opinion deters refiners and dealers from charging the high prices necessary to equilibrate demand and (reduced) supply, there will be shortages. Consumers will still be paying a higher price than before the shortage, but they will be paying the higher "price" in the cost of time spent waiting on line at gasoline stations, or (if they drive less because of the shortage) in the form of restricted mobility. And those who need the gasoline the most, not being able to express their need by outbidding other consumers for the limited supply, will suffer the most from the shortages. The only beneficiaries will be people with low costs of time and nonurgent demand. But here is an interesting wrinkle. Admiralty law and common law (both are systems of judge-made law, but they are classified separately by lawyers because they used to be administered by separate courts) alike forbid certain practices that might be described as "price gouging." Suppose a ship is sinking, and another ship comes along in time to save the cargo and passengers of the first. The second ship demands, as its price for saving the cargo and passengers of the first ship, that the owner of the ship give it the ship and two-thirds of the rescued cargo, and the captain of the first ship, on behalf of the owner, being desperate agrees. The contract would not be legally enforceable; under the admiralty doctrine of "salvage," the second ship would be entitled to a "fair" price for rescuing the first, but to no more. In a parallel case, also maritime but governed by common law rather than admiralty law (the Alaska Packers case, well known to law students), seamen on board a ship that was fishing for salmon in Alaska waters went on strike, demanding higher wages. The captain of the ship agreed because, the fishing season in these waters being very short, he could not have hired a replacement crew in time to make his quota. Again, however, the court refused to enforce the contract, in essence because it had been obtained under duress. These cases, it turns out, are subtly but critically different from the "price gouging" alleged in the wake of Katrina and Rita. The refiners and dealers who raised prices after the hurricanes disrupted gasoline refining had not created the situation that resulted in a reduction in supply. If they had, say by agreeing to increase price above the existing level, they would have been punishable for violating the antitrust laws. (There were some accusations of price fixing, but as far as I know they have not been substantiated.) Similarly, in the salvage case, the rescue ship is not being asked to ration a limited supply by raising price; there is no one else competing for the rescue service--there is just the one ship in distress. And in Alaska Packers, there was no labor shortage, which would have justified seamen in demanding higher wages; the seamen created the shortage by refusing to work. From an economic standpoint, their workers' cartel was symmetrical with my hypothetical refiners' or dealers' cartel. Both are examples of opportunistic behavior--behavior designed to take advantage of an unforeseen opportunity to charge a monopoly price by threatening to withhold output. The hurricane-induced scarcity of gasoline that pushed up prices was not an artificial scarcity, but a natural one. The price increases generated by a natural scarcity (or indeed any scarcity not created by the person or firm imposing the increase), while they may generate "windfall profits," are unavoidable in a way that price increases due to a shortage created by a cartel are not. A further exception to taking a hard line against responding to a natural scarcity by imposing price controls, some would argue, is the rare situation in which the consequence would be an intolerable gap between wealth and welfare. Suppose there is a highly limited supply of human growth hormone, so that if price is allowed to ration demand, all the hormone will be purchased by rich people who would want their sons and daughters of average height to be taller, and no hormone will be purchasable by poor people, or even people of average income, who have children who will be dwarfs unless they get the hormone; they simply are outbid by the rich. In such a case, there may well be a compelling moral argument for allocation of the limited supply on a basis other than price, presumably some utilitarian concept of welfare: aggregate happiness would be promoted by allocating the hormone on the basis of need rather than ability to pay. This was not a factor in the market's response to the incipient gasoline shortage caused by the hurricane. Not only are the duress and welfare objections to price allocation inapplicable to the run up in gasoline prices but higher prices for gasoline are a source of substantial external benefits (that is, benefits not conferred on the parties to the transaction, so that the parties do not have an incentive to consider them in deciding on the price and other terms of the contract). By reducing the amount of driving and (if the higher prices persist) a switch to more fuel-efficient cars, higher gasoline prices cause a reduction in the amount of carbon dioxide emitted into the atmosphere--a major cause of global warming--while also reducing more conventional forms of automobile air pollution. A reduction in driving also reduces traffic congestion, which imposes costs in the form of delay on all drivers in congested areas. Finally, a reduction in the amount of oil consumed in the United States would make the nation more secure by reducing the wealth and economic leverage of the vulnerable, unstable, or hostile nations, such as Saudi Arabia, Iran, and Venezuela, that control so much of the world’s oil supply. In short, the social benefits of gasoline "price gouging" appear to exceed the social costs by a large margin.

Comments

[Thomas]

I don't think there is such a thing as "price gouging." I think the market will eventually correct itself. And plus why would a company risk bad publicity which would far outweigh the benefit from raising prices beyond what the market calls for?

[Grumpy Old Man]

Posner and Becker don't seem to agree on WHO made extra profits during the gasoline shortage.

Whatever the case, I agree that price controls are rarely a good idea. They just create "black markets."

However, given the ignorance of the public, the frequent ethnic differences between the price-raisers and the customers, and our penchant to regulate everything and for certain people (lawyers like me included) to profit from more regulation, I am not optimistic that we can prevent price controls, or avoid silly demagogues of all parties screaming about "gouging" whenever prices go up.

I suspect that class-conscious corporate sellers may recognize the risks involved, and refrain from raising prices as high as they could, in order to avoid the political consequences of doing so. If this creates what amounts to a lottery, so be it.

In any shortage where the market is restricted, the Moscow rules of shopping from the old Soviet Union apply--if you see if for sale, buy it now, whether you need it or not. You'll never know when it will be available again. You'll fill a half-full gas tank if you pass a station with a short line, thus increasing the shortage.

[Joe Merchant]

Although the oil companies profits may have been a fair and just windfall, a structured return of that windfall profit to the economy in the form of a period artificially lower fuel costs would return that windfall to the economy in a fair and just manner - benefiting those who the high prices injured, whether that injury was fair and just or not.

If the cost of energy is allowed to remain at these significantly higher levels for long (a 50% increase in one year cannot be considered insignificant), general inflation and/or recession is likely - which would ultimately hurt the oil companies more than a simple return of their windfall to the economy.

Whether or not government intervention is warranted or necessary to prompt this action is a political question. I wouldn't call it simple pandering to the electorate for our legislators to mandate a return of the windfall.

[ben]

Joe

Returning profits via low artificially low prices post-shortage is a nice idea but would not work. Here's why.

If consumers know prices two weeks from now were going to be, say, 50% lower as post-shortage profit-returning prices arrive, consumers will delay fuel replenishment until then. This is costly. It rewards that group of consumers who have the flexibility to put off consumption. This is probably not the same group who bore the brunt of the high prices.

Once the low prices arrive, consumers/gas stations/refiners will horde fuel in the knowledge that prices in x weeks or months will definitely be higher and they can make a profit by selling then. What happens? Either a) you have to queue to get low price gas, or go without completely, or b) prices that would have occurred x months from now are brought forward to today. Either way, somebody makes a killing, almost certainly not the people who bore the brunt of the high prices in the first place.

The intuition behind this is that prices below the market clearing rate are usually a bad idea with or without a shortage.

So while your idea is intuitively appealing I think it fails on fairness and certainly efficiency.

[Nate]

As a quick thought, while I certainly agree price controls are a bad idea in the long run, in the short run in these types of cases you're stuck between a rock and a very hard place. While price ceilings cause shortages, without them, prices can rise to a point where people who need gasoline (in this case) can't afford it. Low-income families and persons may not have been able to afford the gasoline without a price control (or not without a high relative cost to them), though a shortage certainlyh isn't good either.

[Michael Martin]

Assuming that scarcity in gasoline was really "caused" by Hurricaine Katrina, this analysis would make sense.

But I don't think the market for gasoline after Hurricaine Katrina was a well-functioning market. At least right before and after Katrina, prices were not reflecting good information about the scarcity of supply. They were reflecting consumers' fear that the supply would run out. Given the fact that in the midst of such a disaster the owners of the gasoline are in a better position to accurately assess how long they can stretch their supply out to meet consumers' demand, it makes sense to hold them liable if their assessments turn out afterward to be wildly off.

Opportunism is always going to be tough to identify. But I don't think the sweeping generalization that the effects of Hurricaine Katrina were "natural" is by itself enough to let the sellers in that market off the hook.

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[ben]

If you want to see how fortunate we are to live under a price rationing system, consider the performance of non-price rationing in the Soviet Union:

As of 1989, the average citizen spent 40-68 hours a month standing in line. In April 1991, "only 12 percent of respondents in a national survey claimed to have seen meat in state stores" and only 8 percent had seen butter.

From Shleifer and Treisman (2003), "A Normal Country", NBER Working Paper, available from http://papers.nber.org/papers/w10057

A glimpse of the effectivness and power of the price mechanism.

[Jahed]

I think that before any nutty politicians try to benefit politically from the imposition of price controls, we all need to think back to the 1970's, when the laughable Jimmy Carter instituted price controls. Let's all remember the disastrous results. There is no reason to think it will be any different this time around. I know this, and I wasn't even alive in the 1970's. I agree almost 100% with what Judge Posner is saying, and I hope the general public aren't goaded into price controls by some smarmy politician seeking votes.

[albatross]

Price controls aren't a reaction to an economic problem, they're a reaction to a psychological one--when some disaster or hardship strikes, people want to have someone to blame. Other than going outside and shaking your fist at the sky, there's not much point in blaming God or nature for hurricanes, but you can certainly blame gas stations or oil companies for raising prices. Acting on this by imposing price controls, or a "windfall profits tax," or whatever will almost certainly make everyone worse off in the long run. But not reacting to lots of angry voters may cost you an election. There's no shortage of historical examples of people getting mad and doing manifestly stupid things that hurt them later.

[Ken Zimmerman]

Posner,

Let me say first, there is no such thing as "basic economics!" There are no "laws" of economics, except those that people create. And the one created and enforced in the US, often by force, has been for quite some time that, "he who has the gold makes the rules."

And your comments certainly demonstrate a disdain for, if not total hostility, to democracy and democratic instituions. I do not disagree with the benefits of less driving and less consumption of gasoline you list. In this list you are on target. My disagreement is with how we achieve these goals and upon whose backs they are achieved. First, the goals should be pursued democratically. That is the decisions about how gasoline is allocated should be made in a democratic manner. In a representative democracy, as the US is, these decisions should be made by our representatives. Not by a market mechanism that never existed as protrayed to begin with. Second, the decisions about how the burdens of implementing these changes are distributed should also be made in the same manner. Democracy trumps economics, of any form, but certainly capitalist economics and its general hostility to democracy.

Having said all this, however, I worry about our democracy and democracy in the world when people such as yourself and I suspect many of the representatives I mention above believe that markets and competitive marginalism provide positive benefits for the US and the world. I've searched through economics textbooks for years with no luck finding any evidence this is so. This massive fraud of captitalism, economic laws, and the essential need for markets has made the US the most unequal society in the world, and now that same fraud is being forced on the rest of the world. There is no bright future for the US or the world in this fraud, only a future of lost democracy and even greater disparity in wealth and political power. This is the greatest danger facing the world, especially because its largely invisible to persons such as yourself and Dr. Becker.

[Jack Oneil]

I agree that price gouging is not an issue here, economic principle also tells us that unless there is some collusion on the part of sellers/makers of gasoline, the efforts to gain market share will force price competition, bringing prices in line with what users are willing to pay. In addition, is it not common sense to think that higher profits by either business in the chain will entice further entrants into the market? This is how the system works, the market will correct itself - leave it alone.

[Bill Harshaw]

Recently no one has known what the "right" price for gasoline is. We try to find it by various means--economists focus on the movement of prices and consumers' reactions in searching for the lowest price. The "market will correct itself" as a prior poster said. But the "market" is not real, it's the abstract result of millions of individual decisions. Just dismissing stories in the media and the speeches of politicians as "steam" is, in my opinion, an example of tunnel vision. Certainly the stories and speeches may be unenlightened, at least by the lights of economists. But they may serve a function nonetheless in modifying some of the individual decisions that make up the market.

Isn't it possible that the "steam" is also information to the retailers? If gas goes up 5 or 10 cents in normal times and no one notices, then the price increase sticks. If people talk about it and the media find it a story, then maybe the increase doesn't stick, because retailers think another raise is inviting trouble. Consumers may also be more likely to change their behavior and reduce demand when the media is focussing on the issue. In other words, treat the price setting as a game of chicken between politicians and retailers (remember when JFK jawboned down the Big Steel price increases in the early 60's?).

Saw some mention of the idea that retailers make more profit as prices fall because they go up fast but fall slowly. The article I read said that consumers stop searching for the lowest prices when prices are on the way down. But it's also true that the media and politicans have lost interest.

[albatross]

So, one way you could lean on me to lower my prices is to have politicians and journalists say bad things about me. Another is to change your behavior in ways that let you avoid my high prices--either by buying gas from someone else, or by arranging to buy less of it. I'm pretty sure this second way is more likely to change my behavior, because it costs me money. I'm very sure it's more likely to cause me to change my behavior in sensible ways--if politicians are threatening to nationalize my business if I don't lower prices, this can surely get me to lower my prices, whether this is sustainable or not.

All this blowhardism from various levels of politician will have a very small effect on gas prices and use of gasoline, long term. On the other hand, continued higher prices and the increasing viability of hybrid cars and telecommuting is going to decrease the use of gasoline, especially if prices stay this high.

[Tony]

You argue that the rescue case is distinguished because "the rescue ship is not being asked to ration a limited supply by raising price; there is no one else competing for the rescue service." I'm not sure this is strictly correct. Presumably the possiblity of extracting high prices for rescue may induce more ships to search for such opportunities during storms etc.

Maybe the rescue situation is best conceived simply as a case where there is no reasonably well-functioning market for emergency rescue services. Ex ante negotiation with all potential rescuers simply is not practical. (I don't think the issue is as Becker puts it, that there simply is not enough time to negotiate. Although rescuers stand to make 0 if no bargain is reached -- and thus are better of with a deal than without -- the crew in need of help stands to lose their lives. Even if there were a lot of time to negotiate, but no other rescue options, the rescuer presumably could extract a very high price).

The "salvage" doctrine solution of admiralty law then is an effort to approximate the deal that might be struck if ex ante negotiation were possible. (An additional constraint might be helpful: that the participants to the negotiation did not know if they were to be the rescuer or the rescued, i.e., a sort of veil of ignorance.)

The gasoline market, by contrast, is pretty well functioning and doesn't need this.

[Tony]

N.B. By ex ante negotiation above, I mean negotiation where the participants don't know if the rescue services will be needed or not, or when, or who may be in a position to provide them. Presumably if a sailore could negotiate with all other sailors beforehand under these contraints, they would reach something approximating admiralty law. (Ignorance of whether you were to be the rescuer or rescued also can be a constraint, though it wouldn't have to be if there were sufficient potential rescuers ex ante).

Simply negotiating ex ante on the ex post facts yields only "sufficient time to negotiate," which for the reasons I give above, I don't think is enough.

[Bernard Yomtov]

And those who need the gasoline the most, not being able to express their need by outbidding other consumers for the limited supply, will suffer the most from the shortages.

Posner is trying to slip one by here. Perhaps those who "need" it most will be able to express theri need by standing in line longer, or getting there earlier. Not that lines are desirable, but this casual equation of need with ability to pay is, in the world outside economics books, dubious.

[Joe Merchant]

If a "return of windfall" were executed over a one year period, it would hardly be possible to hoard cheap gasoline, or heating oil, or LNG, or any of the other affected commodities.

I doubt the oil industry is magnanamous or long-sighted enough to do that, though. We'll just have to start increasing cost of goods and salaries to compensate for the radically increased cost of fuel (and housing) that we've just gone through.

[ben]

If a "return of windfall" were executed over a one year period, it would hardly be possible to hoard cheap gasoline, or heating oil, or LNG, or any of the other affected commodities.

There are other ways to horde gas - like delaying international purchases of it while prices are supressed. US stocks of fuel were depleted by Katrina so these might be given priority over retail distribution.

However severe the cap, putting a price ceiling on gas makes clearing the market (potentially very) unprofitable, and doing so would be a breach of fiduciary duty. You can't expect oil distributors to arbitrarily cease being profit seekers en masse out of magnanimity. This is little more than a utopian ideal that has been demonstrated time and again to be unhelpful. Incentives matter.

[Elton]

I agree with all of Mr. Posner's post except for the "security" argument, where it's assumed that if the United States consumes less oil, it will be less vulnerable to the whims of oil-producing nations. I used to assume the same thing, but I've been swayed the other way recently, especially by the following two articles by economist Arnold Kling:

http://www.techcentralstation.com/012003A.html
http://www.techcentralstation.com/020405A.html

In a nutshell: trying to influence Saudi Arabia's wealth and influence by reducing American oil consumption is incredibly indirect and costly and inefficient. The economic, environmental and political problems are separate and should be treated as such. In Kling's words:

"If cutting off funding is critical to winning the war on terror, then we must press the Saudis on that point. We should tell them that we respect their rights as a sovereign nation, but they owe it to the community of nations to not fund terrorists. If that approach does not work, then it is a waste of time to wring our hands over our 'dependence on foreign oil.'"

[James Wetterau]

I agree with the thrust of your comment; I think it's also interesting to contemplate how such price controls affect preparation for future disasters. During one of the hurricanes this season I heard a radio news report about a related case:

A retailer in Florida, if I recall correctly, had stocked up on emergency supplies, including generators and fuel, which they stored in a special location for hurricane aftermath goods. The idea was that this small but vital cache of goods that don't ordinarily sell well could be rented out at an unusually high price to customers in need during an emergency.

The rental price they determined (I think it was set in advance) was high by the standards of prices that prevail at ordinary times, but still some low number multiple of ordinary prices -- I seem to recall it might have been four or five times the rental rate at ordinary times. This was based on the retailer's experience with previous emergencies, and naturally also their costs.

Predictably, once a big storm actually hit and the retailer started renting generators, some people called for laws to preclude such prices. But if such prices were precluded, this would wipe out the incentive for the retailer to purchase, maintain and set aside storage room for such supplies. The likely outcome would be to drive the retailer out of the business of hurricane preparedness.

My conclusion is that high prices at times of disaster probably can help fund the creation of emergency supplies, which act as a form of insurance. The emergency prices remind me of paying the deductible portion of an insurance policy.

[David]

I generally do not support price controls. But Posner is guilty of some bad economics here, as well as some bad policy. Two examples:

(1) Posner writes, "If 'price gouging' laws or even merely public opinion deters refiners and dealers from charging the high prices necessary to equilibrate demand and (reduced) supply, there will be shortages."

The fallacy here is that, when price gouging occurs, the price is not a true measure of supply and demand. Rather, sellers exploit a natural disaster, for instance, by charging higher than the equilibrium price. If regulation succeeds, it will restore the equilibrium price, and there will be no shortages.

Of course, regulation is imperfect, and the price controls imposed after a disaster might not reflect what the true market price would be. But short-term regulation following a disaster is arguably preferable to permitting the gouging of consumers for basic needs, like food, gas, or heating oil. Notably, for "luxury" goods, there is never a need for price gouging laws, because consumers can simply do without them.

(2) Posner writes, "a reduction in the amount of oil consumed in the United States would make the nation more secure by reducing the wealth and economic leverage of the vulnerable, unstable, or hostile nations, such as Saudi Arabia, Iran, and Venezuela, that control so much of the world's oil supply."

This is a fair point, but it is not an argument for price gouging. Rather, it is an argument for government-imposed conservation measures and perhaps a national oil or gas tax. A gas tax would encourage conservation and help fund the measures necessary to combat the security threats facing this country. This is a win-win proposition in many ways, though the increased prices would hurt consumers in the short term, while society adapts to the higher prices.

[Ben M]

In place of your "human growth hormone" example, I would use the example of organ replacements. There's a limited supply, which is allocated to maximize benefit-to-human-life rather than by wealth. As "Grumpy Old Man" comments, this leads to the possibility of black markets ...

I would also distinguish between three types of "gouging". The first is the creation of new supplies with high-prices as a motivation: Becker's rapid refinery repair example, or an bottled water salesman rapidly sending trucks into a disaster zone. The second is the "coincidental scarcity" of a preexisting resource: imagine there was a single functioning grocery store, with a limited stock, at the Louisiana Superdome after the flood. You cannot justify its raising prices arbitrarily; everyone (except the would-be profiteer) would be better off allocating the food according to need. The minor optimizations you could achieve from, say, auctioning off the stock, would pale in comparison to a triage or organ-transplant model. The third is the (apocryphal?) story of a Starbucks (?) charging $10/bottle for water for WTC first responders: there was no scarcity, no allocation, and no resource creation involved---like the admiralty law example, it's just defecting in one-round games against people who are in no position to seek alternatives.

[garygech]

"under the admiralty doctrine of "salvage," the second ship would be entitled to a "fair" price for rescuing the first, but to no more."

---

I think this is an excellent point about Admirality law. From my understanding, in Admirality there is an absolute duty to assist. This is different from a store. You don't go to a gas station and claim you have a right to assistance. This is why people contract for contigent situations. Personally, I belong to the automotive club. I read the magazine occassionally and use it as basic tow insurance.

Gasoline is a not an emergency commodity except in war time. Nixon tried price controls and they led to long lines.

I believe the best approach is very simple. Offer people a tax subsidy on fuel efficient vehicles. I think the Bush admnistration went the other way on this and offered people a deep tax subsidy on SUV's.

At one point, we have to recognize price has something to do with supply and demand not wishful thinking. Gasoline is pretty much a commodity. I had a girlfriend whose father believed that Chevron simply made the best gasoline. I like Chevron because the stations are clean. But Exxon and Chevron is no different when it comes to hydrocarbons.

When ever I see a Chevron, I still think of him. He was very nice and always offered to pay for breakfast. This is a good example of a subsidy. If you are nice to my daughter, I will buy you breakfast.

The government should develop a program called older father welfare. In this program, fathers are offered welfare to distribute to young men who would marry their daughters. The money could be used to encourage family time with propsective husbands.

The private program of fathers subsidizing their daughters for rent is not working so well. Many fathers buy into the idea that their daughters have to live better than them in big cities like New York, Chicago, or San Francisco. The worst market is Boston.

Pretty soon, you have a daughter that is unmarriable because the prospective male gets priced out of the market. Now if the government intervened and offered a cross subsidy to young men, this would change the market dynamics and promote family values.

Of course, people need a straw man. They want to blame the big oil companies. But come on, are the big oil companies to blame because your daughter or your son did not get married? Let's put this in perspective.

Economists and judges need more grandchildren. Any tax policy that promotes this legitimate and important goal, I am for. Let's be creative!

In California we might have a special lane for a hybrid vehicle. In Ohio, we might have a special lane for taking your grandkids to breakfast on Sunday.

In my opinion, I favor the grandchildren approach.

[josh]

"I believe the best approach is very simple. Offer people a tax subsidy on fuel efficient vehicles."

Although lesspolitically feasible, you could achieve better results by imposing an equivalent tax on gasoline, because you don't really care how people use less gasoline, you just want them to use less gasoline. You wouldn't want to give tax subsidies for hybrid vehicles becuase that makes inventing a solar or hydrogen or some other kind of gas-reducing car less attactive.