Wednesday, September 8, 2010

Gouge Away

James Kwak is incensed at how ECON 101 has warped people into thinking it is appropriate to let prices rise following a sudden shortage in supply, such as after a natural disaster.  He decries the fact that "Econ 101 is diametrically opposed to human beings’ intuitive sense of fairness. Yet public policy largely follows the dictates of Econ 101."  I was surprised to read this coming from the normally thoughtful James Kwak.  I was even more surprised to see that the best he could to justify such price gouging was the following:
They [the folks who believe a price increase is okay] know enough to know that if there is a demand shift, not only is it OK to raise prices, but you should raise prices in order to clear the market. In this case, supply is fixed in the short term, so raising the price won’t increase supply; the Econ 101 argument is that raising the price allocates the shovels to people who will derive more utility from them (because they will pay more), thereby increasing social welfare.
Of course, he quickly dismisses this line of reasoning:
But this rests on a huge assumption: that willingness to pay is the same as utility. Unfortunately, however, this assumption fails in the real world; poor people simply can’t pay as much for snow shovels as rich people, and as a result a price increase will allocate shovels to rich people, not to those who need them the most.
As noted by Adam Ozimek this analysis is woefully incomplete.  Here is an edited version of the comments I left at Kwak's blog:
The analysis is grossly inadequate here. First, the supply may be fixed in the short run, but by allowing prices to rise there will be eventually an increase in supply. For example, a town hit by a hurricane does have a fixed supply of generators. If prices are allowed to rise  then at some point they get high enough to induce suppliers from outside the city to start bringing additional generators to the devastated area. If there is no price increase they have no incentive to send their extra generators. Likewise, good old boys from out of town may decide it is worth their while to throw some chainsaws and other tools in the back of their pickups and head down to disaster-hit town if they think they can earn higher fees. If price gouging laws are put into place these good old boys stay at home and the recovery takes longer. In short, by allowing higher prices there is a dynamic effect on supply that ultimately improves human welfare.  

Second, the critique that willingness to pay is not the same as utility similarly misses some important points. It ignores that the “rich” people may be banks, grocery stores, and hospitals–the very entities we want scarce resources like generators going to in a crisis so that we can get money, food, and healthcare. It also ignores the fact if resources aren’t allocated by price they will be allocated by other means that will not seem anymore fair. For example, owners of hardware stores might allocate by first come, first serve or by who they know. One can easily imagine the “rich” getting to the hardware store first or the connected getting the goods because they know the owner. The big point here is that Kwak's analysis offers up no meaningful alternative allocation method and that is because there is none.
ECON 101 also tells us that if folks like Kwak want a more equitable outcome then give out income vouchers or some other kind of income subsidy during the crisis. That way you get relief to those in need without distorting the price system, the very thing which works to hasten the recovery.  If you truly care about improving human welfare in such circumstances your battle cry should be "Gouge Away!"

4 comments:

  1. David
    My preffered example, coming from an unexpected quarter. is the Bank of England October 1999 (if I remember correctly) decision to raise interest rates. One reason given was the home price increase in the southeast region (the London-Dover corridor).By raising interest rates for the whole country they made a lot of people suffer, when the problem was local and had to do with differential marginal tax rates between France and England, with lots of French coming over to enjoy a 30% tax gain(and pushing house prices up in the short term)! Over the years the area developed as France´s "Silicon Valley" across the English Channel!!!

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  2. Kwak's analysis is bizarre.

    Demand curves are derived from consumer choice theory. There are therefore two factors that are captured by the demand curve: utility and income. In other words, the demand curve captures the amount that consumers are willing and able to purchase. Willingness is determined by utility. Ability is determined by the budget constraint.

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  3. Pity Kwak didn´t take the time to read White´s piece on the "German Miracle":
    http://online.wsj.com/article/SB10001424052748703369704575461873411742404.html?KEYWORDS=ludwig+erhard

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  4. Isn't this guy (Kwak) a law school graduate? It confirms that the intellectual levels required for a JD are not that high.

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