The Short-Sightedness of Anti-Price-Gouging Legislation

Columnist Michael Hiltzik wrote a piece in the LA Times the other day calling economists’ opposition price-gouging legislation wrong “both morally and economically.”  By pure coincidence, I addressed the “moral” argument yesterday on this blog.  Allow me now to respond to a very large economic error he makes.

Hiltzik writes:

Another factor commonly overlooked by defenders of price gouging is that natural disasters tend to be (1) short-term and (2) not amenable to rapid response by market forces. If there’s no physical way to get a new supply of bottled water into some part of Houston, then allowing unrestrained price increases won’t produce a larger supply. Retailers lucky enough to have a few cases in the back room when the crisis hits, however, will reap a windfall. But who does that help, except the lucky retailers?

Strictly speaking, he is correct that natural disasters tend to be short-term, at least the disaster itself.  It may also mean that it is not amenable to a “rapid response by market forces.”  But that doesn’t necessarily mean that anti-price-gouging legislation is the way to go.

Take a look at the following diagram:

Source: Price Theory and Applications, 7th Ed., by Jack Hirshleifer, Amihai Glazer, and David Hirshleifer, page 214.

This is just your standard supply and demand chart with price on the vertical axis and quantity on the horizontal.  Let’s assume that curves IS (Immediate Run Supply Curve) and D (Demand) are immediately before Harvey hits Houston.  Immediately after, demand shifts to the dashed D’ curve.  IS doesn’t immediately change because there are now frictions (ie flooded roads) preventing new supplies coming in.  The price level now rises to PI (the intersection where the D’ curve intersects IS).  This increase in price is what people call “price-gouging.”  The “lucky few” retailers who have the inventory on hand may enjoy a brief windfall.  This is where Mr. Hiltzik’s analysis ends.  What he doesn’t consider is what happens as we move away from the immediate period and into the longer run (the days that occur after the disaster).  Higher prices induce more supply to the region, especially as entrepreneurs discover ways to overcome the physical barriers preventing supplies from arriving.  And, as the Second Law of Supply says, the longer prices stay relatively high, the more elastic the supply curve becomes.  We see the development of the LS (Long-run Supply curve) in the diagram above.  If there is no interference in the market, we now see increased supply in the market (represented by the delta-S section in the above diagram).

However, Mr. Hiltzik demands a price ceiling to be imposed to prevent this higher price level.  On the above diagram, that is represented by the original price level, Po.  In the immediate run, there is no deadweight loss to the community stemming from the price ceiling (eagle-eyed readers will notice this is identical to the question from my microeconomics comprehensive exam from three weeks ago).  There is no deadweight loss, but there is a shortage, represented by area H on the above diagram.  However, what is important to note is that with the price ceiling enforced, even as the supply curve becomes more elastic and more supplies can make it into the devastated area the shortage does not disappear!  No additional supplies make it into the market despite the need!  The quantity the market supplies never shifts off of Qo.  Nota bene: This means that, so long as the demand for goods and services are higher than the pre-disaster level (ie, so long as disaster conditions persist), there is a persistent shortage of needed goods in the market! This stands in stark contrast to the increase in supply created when prices are allowed to adjust.

In short, Mr. Hiltzik’s analysis is too short-sighted.  He looks at just the immediate run (which is dire) but fails to account for anything beyond that (including the very next day).  And we are already beyond the IS curve for Harvey; the supply curve is becoming more and more elastic every day.  And it is becoming that way because of the price signal.  Even in the immediate run, anti-price-gouging legislation has major negative consequences.

I’d also like to add that the situation described above is probably a bit optimistic.  In all likelihood, following Harvey, we saw both an increase in demand (D’) and a decrease in supply (a shift from IS to an IS’ curve somewhere to the left of the IS curve).  So the shortage, H, caused by the price ceiling would likely be larger than depicted here.

Where is the Protectionist Love for Harvey?

The damage wrought by Hurricane Harvey has been rightfully lamented by folks all over the spectrum as Houstonians and others suddenly find themselves without food, water, housing, etc (fortunately, according to a report I heard on 106.7 The Fan yesterday, electricity still appears to be available as the storm in Houston has been mainly rain).

However, there is one group who should be out celebrating the scarcity brought on by the storm (and no, I’m not talking about the “disaster relief creates economic growth” people): protectionists scarcityists.

The whole argument for protectionism is that it is scarcity, not abundance, that fuels economic growth.  Scarcity (in this case, preventing the inflow of goods from foreign producers), they claim, promotes growth by giving companies more profits.  This trickles down to us normal people in the form of jobs and higher wages (so they claim), which offsets any price increases.

So, why aren’t scarcityists celebrating Harvey?  The storm has created enormous scarcity of many goods and services, sending prices skyrocketing.  According to the scarcityist theory, this should be quite the boon to the economy!  The profits reaped by those who have the resources will surely trickle down to the rest of the Houstonians and make them all better off than before!  Furthermore, the scarcityists must be denouncing the (metaphorical) flood of bottled water, clothing, and other necessary supplies that charities are sending and distributing to the area (it’s just unfair price competition, you see.  These goods are being subsidized so they can be sold/given away below market price, and some even by the government!).

The scarcityist may object that I am strawmanning his argument, but I refute that charge.  I am not strawmanning, but rather taking it to its logical conclusion.  If the argument applies to trade with China, it also applies to trade with Houston.  Hurricane Harvey is just the scarcityist’s argument writ large and with the scarcity concentrated, and we see the folly of his claims as clear as crystal.  Fundamentally, there is no difference between tariffs erected and a flooded city.

A Smithian Look at Price-Gouging

As Hurricane Harvey hits Houston, Texas has invoked its price-gouging legislation, preventing prices from rising to meet the new levels of supply and demand.  As usual, lots of ink has been spilled by economists denouncing this legislation (for example, see here, here, and here).  On a recent post, Mark Perry asks: “It’s really not that complicated is it, to understand the adverse consequences of anti-price-gouging laws?”

Part of the issue is the price theory arguments against price-gouging are not complicated, but they are subtle.

I think the other issue is people take the positive analysis of economics and try to impute normative analysis onto it. That prices rise when demand rises/supply falls is neither good nor bad. It just is. Just like the sun rising in the East and setting in the West is neither good nor bad. It just is.

However, people will take this positive and try to make it normative. It is “bad” prices rise and people profit off of the suffering of others. Or it is “good” prices rise and lure in profit-seeking individuals and that increases supply.

These normative imputations get problematic because it is trying to answer a different question than the one originally posted. The question is not “how should people act when disaster strikes” (the normative) but rather “how to allocate needed resources to disaster areas” (the positive). Giving a normative answer to a positive question is neither helpful or insightful.

This is not to say that there is no room for the normative. I think that is an important aspect. Should people raise prices during disasters? Should there be discounts for those in absolute need? I think the answers to these two question is “yes.” I think Adam Smith’s “impartial spectator”  would be pleased to see prices rise in order to attract more goods/services to where they are needed, but also to see prices not rise (a discount) to those in absolute need. Indeed, the impartial spectator may frown if prices are “gouged” for those in the most need.

But does the disapproval of the impartial spectator, (“The heart of every impartial spectator rejects all fellow-feeling with the selfishness of his [the price-gouger’s, in this case] motives,” to use Smith’s words [The Theory of Moral Sentiments, page 78.3]), necessarily imply the need to anti-gouging laws? I’d argue “no.” Punitive legislation, Smith (and I) argue exists to serve justice:

“Resentment seems to have been given us by nature for defense, and for defense only.  It is the safeguard of justice and the security of innocence.  It prompts us to beat off the mischief which is attempted to be done to us, and to retaliate that which is already done; that the offender may be made to repent of his injustice, and that others, through fear of the like punishment, may be terrified from being guilty of the like offense.  It must be reserved therefore for these purposes, nor can the spectator ever go along with it when it is exerted for any other.  But the mere want of the beneficent virtues, though it may disappoint us of the good which might reasonably be expected, neither does, nor attempts to do, any mischief from which we may have occasion to defend ourselves (page 79.4).”

And the violation of justice is injury, that is: “it does real and positive hurt to some particular persons, from motives which are naturally disapproved of (page 79.5).” Since the price-gouger’s actions do no real and positive harm or a person, he cannot be punished: “To oblige him by force [ie, by legislation] to perform what in gratitude he ought to perform, and what every impartial spectator would approve of him performing, would, if possible, be still more improper than his neglecting him to perform it (page 78.3-79.3).”*

In short, the anti-gouging legislation both cause economic problems by creating shortages of much-needed supplies when they are already extremely scarce, but also invoke an injustice upon the society by punishing people, by inflicting harm on people, when no real and positive harm has been done.

*Nota bene: This conversation here revolves around price-gouging in general.  We could carve out all kinds of exceptions here that would allow for punitive legislation, but we are discussing the general case, not specifics.

The Uses of Price Theory

I want to go back and discuss more a post I had a few weeks ago on the difference between a model and real life.

As the question highlighted in the post shows, the model and reality can differ.  In the price theory model discussed, there is no deadweight loss from a price ceiling when supply is perfectly inelastic.  However, a more robust consideration tells us there are inefficiencies we need to consider.  A simple observation of the grocery store is another example: if standard price theory were 100% accurate, then supermarket shelves would always be stocked with just enough of each good to meet demand, no more and no less.  But this is clearly not the case.

This difference between the model and reality can lead us to the question: why have models at all?  Indeed, there are some forms of economics that do-away with models and theory altogether preferring to “let the data speak for itself.”

But price theory models serve an extremely important purpose.  Careful study of price theory provides the good economist with strong intuition about the “economic way of thinking.”  Careful study of supply and demand curves can reveal a lot.

Even if these price theory models do not model the world perfectly (and it is my opinion that they do not, although do provide a pretty decent approximation), then the models can still provide valuable insight.  Even though equilibrium is not a point that can ever truly be reached because the economy is dynamic and thus constantly changing, it provides us a good starting point for economic investigations.

Static price theory analysis (that is, all else held equal, including time) provides us many insights into the effects of monopolies, oligopolies, price manipulations (taxation, ceilings, floors, etc), market misinformation, etc.  But it is just that: static.  Adding a dynamic element to price theory makes it far more robust and interesting.  For example: What happens when there are price manipulations over time?  How do demand curves and supply curves shift over time?

But static analysis has its uses, namely that it provides strong intuition.  Intuition that can help answer questions like:

-Does minimum wage help the poor?

-Do anti-discriminatory laws protect women and minorities?

-Will tariffs “make America great again”?

Price theory intuition extends well beyond just the narrow world of “material” well-being.  Jack Hirshleifer has used price theory to explore conflict theory.  Terry Anderson and Donald Leal have applied price theory to environmental issues.  Armen Alchian and Harold Demsetz used price theory to explore discrimination and the development of property rights.  More famously, Gordon Tullock and Ronald Coase used price theory to explore the law and externalities.

Price theory is an extremely powerful tool, even in its static form.  It merits careful study and consideration because there are a lot of subtleties to it, but the logic of price theory is straight forward (unlike macroeconomics).

Today’s Quote of the Day…

…is from Page 82 of Adam Smith’s 1759 classic The Theory of Moral Sentiments (Liberty Fund Edition):

Every man is, no doubt, by nature, first and principally recommended to his own care; and as he is fitter to take care of himself than of any other person, it is fit and right that it should be so.

Models, Monopsony, and Minimum Wage

At Cafe Hayek, Don Boudreaux has an excellent post on models and their usefulness in economics.  Don’s gist is as follows:

Anyone can devise a model to show almost anything.  And economics is filled with widely referenced models that are useless (or worse than useless).  The Keynesian Cross comes to mind.  So, too, the textbook model of so-called “perfect competition” (which, in addition to being a model in which almost everything resembling real-world competition is either squeezed out or appears as a monopolizing (!) tactic, isn’t even logically coherent – for in the model no room exists for any agent actually to change prices).

The value of an economic model is found in its ability to make the world more understandable.  Devising a model is no evidence that the named concepts in the model have anything in reality to correspond to them, or that the model is a useful analytical tool.

I have made similar points in the past, noting that the results from models are, well, model-dependent.

In short, the mere fact that a model can show that some preferred policy will increase/decrease economic efficiency doesn’t mean said model is of any analytical use.  Sure, the minimum wage in a monopsony may improve the situation, but that information does us no good if the market is not a monopsony.

But let’s build upon this idea.  Let’s assume, for the sake of argument, that a given market where a minimum wage is considered is indeed a monopsony.  As such, it is theoretically possible that minimum wage would be beneficial, that we would not see, over a given price range, a decline in employment.  The poor economist stops here.  He might even advocate for minimum wage at this point.  But, as Bastiat reminds us, the economist looks for not just the seen effects (ie, what the model says), but the unseen effects, too.  The good economist is prompted now to ask “is minimum wage the most cost-effective solution to the problem we are trying to address (in this case, low wages for workers)?”  Minimum wage may be an option here, but it may not be the most beneficial option!  There may be other options, other institutional arrangements, other agreements that can be reached that will create a better outcome!

Gordon Tullock and James Buchanan drive this point home in their 1962 book The Calculus of Consent.  The following is from page 61 of the Liberty Fund Edition of the book (original emphasis):

The most important implication that emerges from the [analytical] approach taken here [in this chapter] is the following: The existance of external effects of private behavior is neither a necessary nor a sufficient condition for an activity to be placed in the realm of collective choice.

While Tullock and Buchanan are discussing externalities here, we can easily generalize their comment to any form of collective action including minimum wage or other methods used to “improve” monopsonies:  The existence of a monopsony market resulting from private behavior is neither a necessary nor sufficient condition for a minimum wage to be imposed.  The burden of proof requires the good economist to demonstrate that any proposed solution is the best of all available options.  Otherwise, the result of the market process, even if less-than-ideal, may be the best choice.

It is easy to play around with models, and any given model may have any number of policy implications.  But the mere fact the model suggests Policy A would work doesn’t necessarily mean that Policy A is the best choice.  If the costs of imposing A are high, then it may likely end up being a net loss!

 

The Good vs the Bad Economics, Part 2

The other day, I posted an exam question from my microeconomics Ph.D. preliminary exam.  Here is my answer:

Part A: Textbook price theory predicts there would be no loss in welfare in the community following a price ceiling; producer surplus would just be transferred to consumers.  Here we see the market in equilibrium:

Green represents consumer surplus, red is producer surplus.  Following a price ceiling, we now have:

Price has fallen from P* to Pc due to government fiat.  The amount of surplus in the rectangle between P* and Pc that was producer surplus is now consumer surplus.  Other than that, no other welfare transactions are going on, thus leading to no deadweight loss.*  From a purely welfare-economic viewpoint, the society is no worse off under the price ceiling than in laissez-faire.

Part B: In a more well-rounded sense, the society is now worse off.  Since the price of the good has fallen, we have more quantity demanded than can be supplied.  That means we will get some kind of non-price rationing and the product in question may end up with consumers who do not value it as much as others.  As such, the uses of the good may not be the most efficient uses, despite the fact the pure theory tells us there is no welfare loss.  We’d have allocative efficiency (no deadweight loss), but distributive inefficiency (the good is not used by those who value them highest).

*Some may ask at this point why is there no deadweight loss.  Why isn’t the triangle to the right of the consumer surplus transfer deadweight loss?  Simple: we have no change in quantity here.  The characteristic of a perfectly inelastic supply curve is that the same amount of quantity is produced regardless of the price.  Since the quantity in the market never changes, you cannot have welfare loss, just welfare transfer.

The Good vs the Bad Economics

The following is a question from the GMU Microeconomics Ph.D. Comprehensive exam I took last night:

A government is considering imposing a price ceiling on a good that has a supply curve with zero elasticity [perfectly inelastic].  The price ceiling would be binding, so the government-imposed price would be lower than the lassez-faire price.  In your two-part answer, explain:

a. What does textbook price theory predict about the implications of a price ceiling?

b. What would a more sophisticated, well-rounded economics, predict about the implications of a price ceiling?  Ignore public choice issues.

I particularly liked this question.  The difference between a good economist and a bad economist is the ability to see beyond just the seen (in this case, the model) and to see the unseen (in this case, the mix of things that affect people and resources beyond the model).  The poor economist (or poor econometrician) looks only at his model and treats it as the Gospel.  People will come up with all kinds of models to justify their various pet projects, whether it be tariffs, minimum wage, or what-have-you, and ignore all the economics around them.

Any good discussion of economic phenomena must involve a discussion beyond just the scope of the model and, as in the worlds of the GMU microeconomic committee above, involve “a more sophisticated, well-rounded economics.”

Sorry Scarcityists: Demand Curves Still Slope Downward

At Cafe Hayek, Don Boudreaux writes a response to the scarcityist argument, as he puts it:

[P]rotectionism is justified if enough consumers or voters are willing to pay higher prices in order to help workers.

Don lists three reasons why the scarcityists’ reasoning is incorrect.  Below is my addition of a fourth reason from the comments section of that post:

I’d add a fourth one, one which shows that this scarcityist’s plan to save jobs though higher prices cannot work:

When the relative prices of protected domestic goods rises, then some sacrifices must be made. Scarcityists assume, incorrectly, that all the goods where quantity demanded falls is from the importers rather than the domestic producers, and thus only foreigners’ jobs are harmed. But this is not so; we only import a fraction of our goods. If the relative prices of domestic protected goods X, Y, and Z rise, and if the scarcityists do not change their purchases of X, Y, and Z, then necessarily other purchases of domestic goods that were not subject to import competition (say, goods A, B, and C) will be cut back. For instance: if one has to spend more on sugar, steel, and toys, one has less to spend on dinner out, movies, and baseball games.

The scarcityist may respond by saying “But wait! I am not on my budget constraint. I don’t spend every penny I have. I can afford to spend more.” I have two responses to this: 1) Good for you, but for many of us, we are not that wealthy, and 2) Then that necessarily means you are saving less. By saving less, there are less loanable funds, which means less money for people to borrow to build homes and businesses, persue education, buy cars, etc. So, you’re taking jobs away from people in construction, business, education, automaking, etc. In short, as long as relative prices rise, quantity demanded of something has to fall. Why? Scarcity is still a thing.

In his 1971 book “Economic Theory,” Gary Becker has a neat little proof of this (see pages 21-23 of the 2007 edition). A more detailed proof and discussion can be found here: http://www.jstor.org/stable/1827018

 

Unintended Consequences of Protectionism: The Jones Act and Highway Congestion

In 1920, the US government passed the Jones Act, an act requiring all sea shipping between US ports be done on ships that were built, crewed, flagged, and owned by Americans.  The act is a clearly protectionist measure designed to protect domestic shipping from foreign competition (although there is also a national defense argument for it).  The idea is that a cheaper foreign shipping company could not undercut US shippers on domestic trade routes.  If I were to ship something via ocean from Miami to Boston, I’d have to do it on US built, crewed, flagged, and owned ships.

The Jones Act, to the extent it is binding, raises the cost of ocean shipping in the US (if this were not the case, say it were already cheaper to ship on US ships than foreign ones, then the Jones Act would not be binding).  When the relative price of something rises, it encourages the use of substitutes.  The main substitutes for domestic shipping are trucking and railroad (and air to a lesser extent).  With the rise of ocean shipping costs from the Jones Act, transporters would turn to trucking and rail.  Furthermore, since trucks take up a lot of room on the highways and freeways, it is likely the marginal increase in trucking from the Jones Act increases congestion on the highways.  In short, the unintentional result of the Jones Act is to increase traffic congestion (and, potentially, traffic accidents as well).

Some interesting thoughts for further research:

1. Do trucking and rail companies lobby in support of the Jones Act (bootlegger and Baptist)?
2. Has the Jones Act had a measurable impact on the level of traffic (this is an empirical question that would be extremely hard to answer because of the age of the Act)?