The virtues of price gouging

Ivo Vegter says that few understand that rising prices serve a crucial market function

The virtues of price gouging

19 March 2020

If you want shortages, all you have to do is prevent prices from rising in circumstances when demand outpaces supply. That’s exactly what’s happening in the face of panic buying as a result of the novel coronavirus pandemic.

Like the virus, the kneejerk response to price gouging began in China. In late January, the top market regulator in China began to crack down on face mask price hikes and “illegal production and sales”.

And what the Chinese Communist Party did, the rest of the world simply copied. In the US, Democratic Senator and self-described “voice for consumer protection” Ed Markey declared: “There are reports of massive mark-ups for products such as hand sanitizer and face masks on Amazon.com. No one should be allowed to reap a windfall from fear and human suffering. I’m calling on Amazon to stop and prevent coronavirus-inspired price gouging.”

In South Africa, retailers have also come under fire over alleged price gouging.

At the time of writing, a Google News search on price gouging turned up 47 articles condemning price gouging or announcing laws against it, before the first article that says “price increases in the face of sudden shortages are an important impetus to restore supply and demand market conditions that are closer to normal”.

Superficially, it would appear to be in the interest of consumers to prevent apparently opportunistic price increases and “profiteering” in the face of a crisis. However, one should always heed the warning of the economist Frederick Bastiat, who explained that for every policy, there are immediate effects which are seen (such as lower prices), and knock-on effects which are not seen and are generally ignored by policy-makers.

What is not seen, or rather, what is not understood as an effect of artificially limiting price increases, is that panic buying at low prices causes shortages and stock-outs, such as those emptying shelves in South African stores.

Overseas, eBay responded to allegations of price gouging by simply banning the sale of face masks and hand sanitiser, so its customers now cannot get them for love nor money. Talk about perverse and unintended consequences!

Rising prices serve two immediate and obvious functions. They signal to producers that there is more demand than supply, and reward them for redirecting resources towards increasing supply. Existing producers might ramp up production, or new producers might see a profit opportunity and enter the market in competition.

They also signal to consumers that there is a limited supply of the product in question, and reduces how much they’re likely to buy. The incentive to economise distributes scarce products more efficiently to those who most need it.

The combination of stimulating supply and suppressing demand is exactly how the market ought to respond in the face of a shortage, and the price mechanism ensures that both buyers and sellers have a motive to do so.

In an open and free market, the cure for high prices is… high prices. This really is a basic lesson about supply and demand that should be covered in Economics 101, a course which hardly any politician or journalist has taken, but frankly, should be mandatory in high school. As prices rise, supply rises and demand tapers off, until producers are forced to bring prices down again. The entry of new competitors to the market accelerates this response.

This is why shortages are so often seen in price-regulated markets, such as water, electricity, public transport and pharmaceuticals. When demand increases, suppliers cannot react by increasing prices, which allows demand to spiral out of control without providing much incentive to ramp up production to meet the demand.

Price elasticity – a measure of the degree to which products will be bought no matter the price – influences how quickly prices affect demand, but it does not break the basic operation of the price mechanism.

The exception to this rule occurs in makets controlled by a state-protected monopoly or cartel, where incumbent producers do not need to fear the rise of new competitors. The solution to this problem is not to control prices, but to open the market to increased competition.

If you denounce price increases as “gouging” or “profiteering”, or invoke laws to artificially keep prices at pre-crisis levels, then don’t complain when you’re faced with empty store shelves. That is a direct and predictable consequence of preventing price increases.

The armchair commentariat are also up in arms about hoarding, and the universal response appears to be to limit sales of high-demand items. But who is a retailer to judge how much loo roll or hand sanitiser I need?

I might be living in a remote rural area and shop in the city only once a month. I might be supplying a small business, or a non-profit that takes care of ill or elderly people. I might be justifiably concerned about the risk of infection at the supermarket, and seek to limit the number of times I need to visit it. I might be concerned that ill-advised rules against price-gouging will cause widespread shortages, so that I won’t be able to buy bog roll next week. I might have a large family. I might be worried about a catastrophic economic downturn caused by draconian emergency measures that might limit my ability to buy supplies in future.

There are many reasons to buy in bulk or hoard supplies during a time of crisis, and some of them are perfectly justifiable. The solution to this problem is not to impose arbitrary restrictions, but to limit buying by letting prices rise.

Conversely, placing limits on how much people are allowed to buy not only penalises those that have legitimate reasons to buy more, but also encourages those who need less to buy at the limit instead. Either way, the restrictions introduce allocation inefficiencies.

Increased demand volume is also an important market signal. Factories are already responding to panic buying by scrambling to retool their production lines to shift production from luxury items towards basic goods that are in high demand. Better price and volume signals can only help to accelerate this process.

Markey, in a letter to Amazon.com CEO Jeff Bezos, declared that sellers have “a right to a reasonable return”, but “they do not have a right to impose unjustifiably high prices on consumers who are seeking to protect themselves against the coronavirus”.

Sellers have a right to charge any price they want, or not to sell at all. Neither Markey nor Bezos are in a position to determine what a “reasonable” return might be, nor whether high prices are “unjustifiable”.

That’s why socialist command economies don’t work. All of them run into the economic calculation problem, which is that central planners simply do not have, and have no way to obtain, the information necessary to plan the rational and efficient allocation of scarce resources in a large, complex economy.

This information can only be produced by a free market, which translates the subjective wants and needs of every buyer, and the costs and constraints of every seller, into objective information through the price mechanism. If prices are not allowed to fluctuate to reflect changes in demand or supply, this mechanism breaks, leading to either shortages or surpluses, both of which exacerbate the crisis.

There is a role for government in protecting consumers from fraud and scams. In China, for example, there was concern about “fake” face masks. If by “fake” they mean masks that do not perform to standard (as opposed to masks made by people not licensed to do so), then there’s a good reason to intervene.

In all other cases, however, the market should be left free, because the market alone is best able to increase supply to meet demand.

If governments restrict markets, by capping prices or limiting volumes, rest assured that a black market will emerge. Politicians will likewise decry that, but that, too, would be a good thing. It is simply a sign that the market is responding to artificial constraints by routing around them. Again, one can see this effect most clearly in socialist economies, where many people would not get basic goods and service at all were it not for the existence of an illicit free market.

A free-floating price mechanism is always necessary to match supply to demand, and this is especially true in times of crisis. Higher prices in times of need is not a sign of market failure. It’s a sign that the market is working as intended. This is how the market resolves supply shortages and responds to panic buying.

Instead of railing against high prices, and calling it gouging or profiteering, we should view it as a reward offered to producers to step up and supply more of the things we urgently need.