Tuesday, May 09, 2006

Price gouging or good business?

Since George “Pitbull” Moneo at Babalublog.com recently reminded us about Hurricane season I thought I’d talk about something that affects us all: economics. That’s what I got my bachelor’s degree in, but I don’t I don’t claim to be an expert. I do have a pretty good working understanding of the major economic principals that are taught nowadays though and I thought I’d share one of my pet peeves with you.

Every time a natural disaster or some other episode occurs we hear the news broadcasters and politicians complaining about “price gouging” and “windfall profits.” Hopefully I can convince you that there really is no such thing as price gouging and that “windfall profits” are not a bad thing. Warning: this material is pretty heavy but I’ll try to simplify it as much as possible.

Let’s say we live in Town X, Florida. Town X has 200 households. 100 of those households have generators leaving the other 100 without. The hardware store in town X sells generators for $400. Anyone that wants to buy a generator in Town X can just go down and buy one for that price.

Then one day Hurricane Henry comes along and knocks out all the power to Town X and it looks like it’s going to be several days or even weeks before the power will be restored to all the homes. Now the helpful hardware man sells generators, but he only keeps 10 in stock. That’s about $4000 worth at retail price. Let’s say he bought them for $200. That means his margin is 50%. Assuming he sells all 10 generators they will yield him a profit of $2000. So what happens when the power goes out? 100 homeowners run to the hardware store to buy a generator. But when they get there they find that the price of the $400 generator is now $1000.

“Foul!,” the consumers cry. Most of them go home without the generator cursing the storeowner. But 10 of them buy the generators for $1000 and the storeowner makes a handsome profit of $8000. The ones that went home empty handed write letters to their politicians saying they’ve been gouged. The politicians who never saw an issue they couldn’t demagogue pass a law saying that in a state of emergency certain products are subject to price controls and can not be sold for more than 10% more than the retail price before the emergency. The disgruntled customers feel vindicated and are very happy…

Until the next time a storm comes along and knocks out all the power. The owner of the hardware store has re-stocked his inventory and now has 10 generators selling for $440. That’s the most he can charge by law. Now there are 90 households in the town that have no generators and there are only 10 to be had. Who gets the generators? The answer is the first 10 that get to the store.

What’s the difference between these two scenarios? The reality is that the short-term need for generators is roughly the same. In both cases only 10 people were able to satisfy their need, leaving the majority without the generator.

But in the second scenario the shopkeeper is hurt. An artificial price ceiling on generators has cost the storeowner $5600 in potential profit. The price ceiling did not provide one additional generator to the populace of town X. In fact it kept generators out of the hands of those that valued them more because there were people in town X that were willing to pay a higher price for their generator.

In a market economy price is determined by a combination of supply and demand. When there was no demand for the generators, the limit to what the storeowner could charge was much lower. But when demand skyrocketed in the first scenario he was able to raise his prices to meet the new market realities. Eventually the supply shortage for generators would be alleviated as new supplies came in and power began to be restored to the households of the town.

The fact is that we all value products differently. We each think some things are a bargain and others are expensive. But some of us need/want certain products more than others do. I would never pay $4.00 for a pack of smokes. But we all know people that are hooked and have huge cigarette expenditures.

One of the people that paid for the $1000 generator in the first example may have owned a restaurant, and losing his power meant losing $20,000 worth of food. To him the $1000 investment was well worth the money. But under price controls, he would have more than likely not obtained the generator unless he was one of the first 10 people at the store when it opened.

A free market is the most efficient and equitable way to distribute goods. Price controls always create shortages because the price is always set below what the actual value of the product is to the market. That’s why you have chronic shortages of needed goods and services in centralized/planned economies. The natural mechanism for determining what society values is being screwed around with.

When Wilma struck south Florida, there were very few gas stations open in the first few days after the storm. The stations were subject to price controls that kept prices relatively close to their pre-hurricane prices. The result was long lines of cars, many of which were not running on empty but the owners wanted to “top off, just in case.” If the price had been allowed to reach the market price (perhaps $10/gallon or more in the short-term) many people would have waited until absoultely necessary to purchase gas, and then only a few gallons at a time, waiting for prices to return to normal. The result would have been a more equitable distribution of the commodity (those that needed it the most would get what they needed and pay a premium for it) with the owners of the gas stations making some short term profits and being rewarded for being open during a crisis.

It’s easy to say windfall profits are not fair and be swayed by emotional arguments for price controls but the fact is that it’s the business people of our country that invest their capital with the hope of making a profit. The hardware man, the gas station operator, they are just like you and me. Why punish them when society all of a sudden values their products more than previously? The problem with price controls is that it’s a slippery slope. Today it’s generators and gasoline and tomorrow it might be whatever you are selling.

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