Tyler Cowen linked to a post (Jeffrey Ely?) that tried to refute the standard economic argument that price gouging is beneficial:
Suppose that an unexpected shock has occurred which has two effects. First, it increases demand for, say bottled water. Second, it cuts off supply lines so that in the short-run the quantity of bottled water in the relevant location is fixed at Q. A basic principle of economics is that if you wish to maximize total surplus then you should allow the price to adjust to its market-clearing level. This ensures that those Q consumers with the highest value for water get it. The total surplus will then be the sum of all their values.
This simply assumes away one of the two major rationales for price gouging. The whole point of allowing higher prices for water is too encourage producers to truck in water from outside the disaster zone. So yes, if you assume away any supply response, then the case for price gouging becomes somewhat weaker, but it doesn’t entirely go away. There’s still the advantage of allocating water to those with the highest need, which is likely to be an extremely important advantage during a natural disaster.
[And don’t say it’s still an allocation argument, as the water trucked in will reduce consumption elsewhere. In fact, much will come from warehouses. The high prices will induce warehouses to run a bit closer to the edge, while frantically calling for Poland Spring to ramp up production. People will drink more water in aggregate, if some is trucked in.] Jeff continues:
But in fact it is quite typical for the consumer surplus maximizing solution to be a rationing system with a price below market clearing. I devoted a series of posts to this point last year. The basic idea is that the efficiency gains you get from separating the high-values from the low-values can be more than offset by the high prices necessary to achieve that and the corresponding loss of consumer surplus.
Why would we only care about consumers’ surplus and not also the surplus that goes to producers? We normally we care about producer’s surplus because that’s what gives producers an incentive to produce in the first place. But remember that a natural disaster has occurred. It wasn’t expected. Production already happened. Whatever we decide to do when that unexpected event occurs will have no effect on production decisions. We get a freebie chance to maximize consumer’s surplus without negative incentive effects on producers. And just at the time when we really care about the surplus of bottled water consumers!
This is wrong for two reasons. We care about producer surplus because producers are people. Except for the unemployed, people have dual roles; they are both producers and consumers. So 100% of the loss of “producer surplus” is actually borne by consumers! It hurts producers who happen to be consumers. And since all producers are consumers, the net effect on consumers in aggregate is negative, contrary to his argument. He made the common mistake of (implicitly) equating the effect on “consumer surplus” with the effect on “people who happen to be consumers,” which is everyone.
Now I expect some commenters to jump in with some absurd income distribution argument. One common mistake is to assume consumers who are non-water producers (like Bill Gates) are poor and consumers who are water producers (like the guy who delivers water to my college, or the immigrant with the 7/11 store) are rich. But producers and consumers are simply two sides of the same coin. If a society has a policy of “no price gouging,” then competitive industries like water supply have to figure that into their pricing system. They must charge more during non-emergency periods, knowing they won’t be able to price gouge during emergencies. Contrary to Jeff’s assertion, in a world of rational expectations there is no free lunch to redistribute to consumers. If there were, we could simply have the government expropriate any unexpectedly large crop harvest, or an unexpected mineral discovery, and share the proceeds with “consumers.” Does anyone think that if a country behaved that way producers wouldn’t begin to anticipate the future expropriation, and act accordingly? Believe me, producers know price gouging is currently illegal, and that already factors into their pricing decisions during good times.
There’s no free lunch, so efficiency is the only relevant criterion to use here, unless you believe the government should also be setting water prices in non-emergency periods, due to some other factor like monopoly power.
And remember, producer surplus goes to consumers—100% of it.
Update: Suppose Massachusetts decides to discontinue the state lottery. It will do one last $100 million jackpot. After the winning number is announced, should the state go “nah nah nah” and take back 99% of the winnings in a special unexpected tax, and spend the money on poverty programs? After all, the poor need the $99 million more than the guy who would still be left with a million. And there’s no effect on the future demand, since the lottery is being discontinued. Or would governments that behaved that way eventually pay a price? (Hint: consider the history of Argentina.)