Thursday, September 22, 2005

Price Gouging: Nuisance or Necessity

In the aftermath of Hurricane Katrina and during the advance of Hurricane Rita, consumers have been confronted with an economic anomaly: “price gouging”. In its simplest form, “price gouging” is known commonly as an instance where, under extraordinary circumstances, the price of an item of extreme importance to a consumer is raised far beyond the market price. This phenomenon shows up regularly wherever there’s a natural disaster or an extreme shortage of a vital commodity.

In the current crisis, the good experiencing a rise in prices is gasoline. After the threat of Hurricane Katrina forced many of the Gulf Coast’s refineries to shut down, gasoline prices surged 38 cents to $3.04 between August 26 and September 9 according to the Lundberg Survey of 7,000 gas stations around the country. This sudden surge hit consumers hard, but it also caught many off guard when they reached the pumps expecting to stock up on cheap gas and found the prices high already. Many legislators blame this premature hike on greedy oil companies gouging prices to take advantage of the precarious situation. An AP article yesterday outlined a letter by eight Democratic governors sent to President Bush and congressional leaders asking them to investigate “excessive profits being made by oil companies who are taking advantage of this national crisis” and asking them to refund the profits to consumers.

The eight governors cite a study by UW economist Don Nichols which finds that for the price of gasoline to be $3 a gallon, crude oil would have to be $95 a barrel while it only peaked at $70 following Katrina. What the study doesn’t take into account is that the correlation between gas and crude oil prices doesn’t hold up under a drop in refining capacity. According to Ed Murphy of the American Petroleum Institute, refining capacity was tight when Katrina hit and the storm only put further upward pressure on petroleum prices. Furthermore, in the same period that saw gas prices jump 38 cents, the gasoline futures price for October 2005 rose from $1.85 to a high of $2.40 before settling down to $1.95 in the aftermath. The explanation why this is so important is summed up beautifully by economist Walter Williams, “[T]he fact of business is that what a seller paid for something doesn't necessarily determine its selling price.”

Further analysis of “price gouging” leads to another conclusion: “price gouging” forces the rationing of goods that would otherwise sell at an unusually quick rate. Take this emergency-based scenario from 20/20 co-anchor John Stossel:
You are worried that your baby is going to become dehydrated. You find a store that's open, and the storeowner thinks it's immoral to take advantage of your distress, so he won't charge you a dime more than he charged last week. But you can't buy water from him. It's sold out. You continue on your quest, and finally find that dreaded monster, the price gouger. He offers a bottle of water that cost $1 last week at an ‘outrageous’ price -- say $20. You pay it to survive the disaster. You resent the price gouger. But if he hadn't demanded $20, he'd have been out of water. It was the price gouger's ‘exploitation’ that saved your child.
In the case of gasoline, no seller is going to want to risk running out during a period of bloated prices so they hike it to a point where they feel consumers will be forced to only buy what is absolutely necessary. Through this rationing, the gas station will in turn be able to serve more customers and hopefully hold on to their reserves until prices drop again. By keeping prices low, as producers in Russia agreed to do this week, you force suppliers out. If you let competition do its work, suppliers will come in at the lowest price the challenges of the disaster will allow. As Stossel sums it up, “It's the price ‘gougers’ who bring the water, ship the gasoline, fix the roof, and rebuild the cities. The price ‘gougers’ save lives.

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