In Defense of Price Gouging

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Cataclysmic disasters routinely imply price spikes for gasoline and consumer staples. Price “gouging”, as it is called, has no friends: George W. Bush, Bill Clinton, Ted Kennedy, TV pundit Bill O’Reilly, and Florida Governor Charlie Crist have all inveighed against the practice, and at least 29 states have anti-gouging laws. As Hurricane Ike came ashore, President Bush stated that federal and state officials would be monitoring any “mistreatment” of consumers, while Governor Crist decried $5 gas in Tallahassee as “unconscionable”. Crist added that “this type of behavior will not be tolerated”, and Florida’s attorney general has already issued subpoenas to several retailers seeking documentation on wholesale prices and margins. Such populist critiques, however, impede economic understanding and beget harmful policy.

First, neither economic illiteracy nor a general prejudice against allegedly excessive retail prices is anything new: Governor John Winthrop of the Massachusetts Bay Colony reported the conviction of Boston merchant Robert Keayne for charging exorbitant prices in 1639. The guilty verdict and £200 fine so inflamed Keayne, a devout Puritan, that in 1653 he wrote a 158-page defense of his business practices for inclusion in his last will and testament. Keayne had reason to be angry, as Winthrop confessed that there were no existing relevant laws or commonly-understood definition of gouging in 1639. Winthrop conceded that precision here was impossible, and that Keayne’s conviction was due to popular jealousy of his wealth.

Similarly, today’s state laws define the practice in vague terms (such as New York’s “unconscionably excessive” pricing of consumer items in times of emergency), and wrath seems reserved for the very visible gasoline price. While the average government official is ignorant of retail economics, gouging seems unfair. For example, at one station in Knoxville, Tennessee, gasoline selling for $4.99 per gallon hours after Hurricane Ike hit Galveston had fetched only $3.59 the day before, and this sharp price increase is connected in consumer minds with oil company profits more so than the retail station owner’s P&L.

In fact, popular anger over price gouging is misplaced, and dangerous if it leads to price controls or taxes on producer profits. Public officials need reminding that the fundamental, inescapable economic problem is scarcity. All economic goods require rationing, and the price mechanism is by far the most efficient, wealth-inducing, and impartial method for this. Rising prices instruct consumers to conserve, exactly the behavior required in times of supply disruption or increased demand. The market mechanism of freely moving prices conveys seminal information, signaling consumers to alter plans while simultaneously inducing helpful changes in supplier output. All this happens with immediacy, without any government dictates, and serves to optimally coordinate consumer and producer use of scarce resources.

In the case of recent hurricanes, 20% of U.S. refinery capacity was shut down, several Gulf oil rigs sustained damage, and the storms caused billions of dollars of damage in Texas, Louisiana, and elsewhere. In our interconnected economy, foodstuffs, water, ice, gasoline, batteries, building materials, and generators were rushed to the affected areas, causing retail supply shortages nationwide. As a general matter, retail prices for these items increased as supply distribution shifted, but given the circumstances, this was a blessing for the millions of affected storm victims.

Anti-price gouging statutes harm the aforementioned market-coordination process and inflict misery on consumers. The inability to raise gas prices in the face of both decreased supply and increased consumer demand guarantees shortages, outages, long lines, and distribution to the politically-connected or favored. Further, producers are not incited to bring new supply to impacted areas, exacerbating shortages. As in so many other cases of government regulation, the law of unintended consequences applies.

Additionally, retail gasoline marketing is an extremely low-margin business, with little pricing power in an industry with thousands of independent competitors and 170,000 locations nationwide. With oil at $100 per barrel, according to the Department of Energy, about 72% of the retail price of a gallon of gasoline is taken up by refining crude oil, with another 12-14% or so for distribution and marketing costs. About 11% of the current average retail price, or 40 cents per gallon, goes toward federal, state, and local excise taxes, leaving less than 5%, typically, for retailer profit. Or, a few pennies per gallon.

In fact, many retail gas stations average zero profits on gasoline, using it as a draw to other transactions such as consumer purchases of bottled water and drinks, cigarettes, confections, or other services, all of which have far higher profit margins. This explains the quick jump in retail gas prices, particularly in areas remote from the storm. Retailers announce pump prices based on replacement cost, and many have anticipated wholesale price increases soon. In fact, even if the global price of oil itself does not rise, refinery damage repair and constricted output temporarily necessitate higher wholesale gas prices nationwide.

This is no different, ultimately, from selling a house today for double its purchase price of ten years ago, yet no one accuses home-sellers of “gouging” when they might accept a price entailing a lower capital gain.

The price mechanism is indispensable to a well-functioning market economy, and a key impetus to the entrepreneurial energies which foster wealth creation. Its curtailment portends harm for consumers, and it is therefore fortunate that federal price-gouging legislation is stalled. State laws should be repealed, and politicians should instead salute owners of the 170,000 stations serving consumers. Many are small businesses eking out modest profits in a highly competitive industry, where uncertainty means pricing is volatile guesswork.

John Chapman is an economist and merchant banker at Hill & Cutler Co. in Washington, D.C. 

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