Thursday, 6 December 2012

Prices, Hurricanes and Rationing: Why prohibiting price increases can be a bad thing.

A petrol station on Staten Island after the Hurricane: Courtesy ITN 

Just as the Presidential Campaign was entering its final stages in the US, hurricane Sandy ripped through the west coast, creating extensive damage to the East coast. Republican New Jersey Governor Chris Christie was praised for his work both before and during the hurricane, as well as his close collaboration with the Democratic President Obama in the midst of elections.

The governor has stated publicly even before the hurricane made landfall that anti-gouging laws will be enforced to their fullest.  What are anti-gouging laws? They are laws that state that no business can take advantage of an emergency to charge higher prices for its product than it did before the emergency.  In fact the governor acted on his statement, sending lawsuits against many businesses that increased their prices, including petrol stations and other vendors of what were deemed essential goods.
But are such laws a correct way of tackling issues that arise from an emergency? What Governor Chris Christie and other politicians seem to forget is that a cap on prices does not ensure sufficient quantity: it ensures a deficit of products, causing additional hardship and social unfairness.  Let us take the case of petrol as an example. There is no doubt that the Hurricane created a Demand shock (sudden increase of the quantity demanded) and a supply shock (a sudden reduction in the ability to provide additional petrol). As a result the market clearing price would have to rise at substantially higher levels than previously. A price of 25 dollars a litre would not be unthinkable in such conditions. People used to paying less for petrol would be upset and demand action.

The governors of New York and New Jersey decided to enforce laws against rising of prices in an effort to make sure the people had petrol. The result was disastrous: there was a prolonged shortage of petrol in all New Jersey for substantial time after the hurricane hit; strategic reserves were released that did not alleviate the petrol deficit. Since there could not be a significant increase in prices the result was incredibly predictable: mass shortages, long queues and general unpleasantness.  

As a result of the anti-gouging laws there was no incentive for the petrol station owners to bring in more petrol; consumers on the other hand would not just buy how much they need but they would hoard, knowing that the price was lower that it should have been and that there was uncertainty of future supply. The governor of New Jersey tried to stop the selfish desire to hoard by rationing the available gas. New York decided to give gas for free and found itself overwhelmed by the people who wanted it. The intuition missed by the Governors of New Jersey and New York is serious and happens often by politicians – you just cannot use the price mechanism to introduce social values.

Economics has evolved its understanding of markets to form a general system for an economy, using general equilibrium analysis. The intuition is that consumers adjust to the changes of prices between goods; these price changes will allow the consumers and suppliers to make the best choice for them, but that choice will also lead to a socially efficient outcome. Thus allowing price of petrol to rise to $25 would achieve the aim the governors of New York and New Jersey found difficult to tackle: Consumers would self-ration, since they would be unwilling to spend so much of their budget on petrol and only take as much as they needed. Suppliers would bend over backwards to re-establish the networks that would supply them with more gas, rapidly reducing the price for petrol.

Does that mean that Governors should let consumers suffer in the hands of what are perceived as opportunists? There is an efficient way of alleviating the situation: but it is not through the price mechanism. It is through changing who owns the supply of petrol. An economist would not enforce the anti-gouging laws, but he would provide one litre of gas to each citizen and give them the right to buy and sell it as they chose. The result would be that consumers who wanted gas would buy it from those who did not want it, putting pressure of petrol station owners to lower their prices to the lowest possible. Social fairness has to be addressed through the re-distribution and the increase of competition and not though enforcing price law edicts.

My thanks to Econtalk which inspired this article, and my ECO 310 students who challenged me to find a theoretically robust way to stop gouging.
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