(Earlier versions of the following previous appeared on the econlaw mailing list and on my blog, Unenumerated)
Abstract: Both governments and volunary institutions respond quite poorly in emergencies. Price gouging laws may reflect insurance contracts buyers would have made ahead of time but for high transaction costs. However, price gouging laws also decrease incentives to make the abnormal investments required in emergencies. The author proposes to modify price gouging laws to maintain their implicit insurance function while removing their interference with incentives to make abnormal investments during an emergency.
Here are some alternative ways of rationing in an emergency. At least some of these have been written about by Yoram Barzel. We have witnessed all of them during hurricane Katrina:
(1) market prices ("price gouging")It's not clear that, even with perfect knowledge, with or without an emergency, centrally planned rationing could operate without using one of the other methods of rationing. In any case, our very poor knowledge about the needs of strangers is sufficient to ensure that, short of a perfect price system, we often can't get what we want without waiting in line, and sometimes we just can't get what we want (or even, the Rolling Stones notwithstanding, what we need). The worse the price system -- in other words, the higher the transaction costs -- the more we wait in line or do without, as East Germany once demonstrated (cf. West Germany) and as North Korea continues to demonstrate. Luckily for those of us in largely market price based economies, we need only wait in line when trying to do business with the government, call a toll-free service line, go to a hot movie on opening night, or during an emergency -- i.e. in the remaining situations where prices don't operate very well or at all, due to transaction costs imposed by law or otherwise.
(2) waiting in line
(3) centrally planned rationing
(4) don't ration: just let the resource run out
Mises and Hayek long ago demonstrated the weakness of centrally planned economies such as the old Soviet Union (or today's North Korea) -- the lack of knowledge the government has about peoples' needs and desires. Similarly, lack of the requisite detailed rknowledge of the needs of others, especially at specific times of crisis when they need our help most, is a huge problem even if we were perfectly charitable. Not even the local governments exhibited much knowledge of the needs of their neighbors, especially in New Orleans. Much less did the state or Feds (FEMA being only the most glaring example) exhibit even a tiny fraction of the knowledge that would be required for an optimal outcome. This is not the fault of the people in the government agencies to not act as knowlegeably as they are capable of acting, but rather the fault is in their implied promises and our expectations. For example, TV commentators, watching pictures of some Coast Guard helicopters, seem to have come to expect that government agencies will swoop down from the sky and rescue everybody and take on other attributes of God. Such as, for example, being able to knowledgeably evacuate people and distribute other scarce goods and services in a disaster.
Per Mises and Hayek, even if the Soviet Union had been run by an perfectly beneficient dictator, people would have, short of a matching omniscience of said dictator (and of enough of his underlings to receive and act on the knowledge) still have waited in bread lines. When price controls hit gasoline in the United States in the 1970s, people similarly waited in gas lines.
In emergencies rationing becomes extreme: people wait in long lines, pay "extortionate" prices, or, even worse, do without. We are thrown into economically unfamiliar territory and transaction costs balloon. Goods will always be rationed in one or more of the above four ways, and in an emergency the rationing can be quite severe. Our charitable spirit can temporarily overcome self-interest, but it can't overcome the knowledge problem or the scarcity of goods.
Given that waiting in line, or doing without, are very painful (even sometimes deadly) alternatives, and that allowing the charge of very high prices can largely prevent use of these extreme and wasteful forms of rationing, why do we have price gouging laws?
Can price gouging laws be explained as follows? In a zero transaction cost world, consumers would successfully negotiate with retailers for an insurance policy that caps prices in case of emergency. This may be, for example, because retailers are better able to bear the risk of emergency supply shortages than consumers are, or because consumers don't want to bear the risk of having to have an unusually large amount of money at hand during an emergency. (Katrina may be a good example of this -- it reportedly struck just before many paychecks were due, leaving many people who live from paycheck to paycheck without funds). More generally, if it weren't such a bother almost all of us would like to purchase insurance against volatile prices in order to make our budgets more predictable. However, the transaction costs for negotiating with consumers for such contracts are too high. Therefore, the default retail sales contract should include such insurance. Price gouging laws are a convenient way to do this.
Whether and when wholesale contracts include such price caps provisions would provide interesting evidence in favor of or against this hypothesis, and under what conditions it would have been rational to for consumers and retailers to have made such a contract.
As we have seen, there is a strong economic argument against price gouging laws. Consistent application of market pricing during an emergency would minimize the other inefficient, and occasionally deadly, rationing methods above, especially (4)actually running out of emergency supplies. Consumers could be confident that supplies will not run out, so stocking up on excess supplies based on fear of imminently running out of the supply (such as we've seen consumers do in some areas recently with gasoline) would be minimized. Given modern technology, perhaps we should work on improving the availability of credit and liquidity in emergencies via always-up wireless devices and immediately payable liquidity insurance policies instead of price gouging laws.
Furthermore, the promise of very high prices might motivate retailers to fly in special deliveries of emergency supplies at otherwise prohibitive transportation rates. On can even imagine for-profit organizations doing many of the tasks that the National Guard, Red Cross, and similar organizations are doing now. Of course, the moral indignation would be enormous. For this to occur, price gouging laws must not remove the incentives to make abnormal investments (e.g. in abnormally expensive and timely transportation) during an emergency. People, at least in political discussion, tend to be extremely averse to "windfall profits" and seem to have a strong psychological preference for an implicit insurance policy that puts a price cap during emergencies on retail contracts.
Instead of focusing on the price itself, or on "unjust profits" themselves, price gouging laws should focus only on profits abnormally proportionate to expenditures. The windfall profits of a seller who can better spread risks are a signal that the parties would have contracted to insure the buyer less able to spread risks against unexpectedly high prices. On the other hand, a seller who invested very high sums in transportation, in expectation of being able to sell at very high prices, will not have abnormally high profits (at least not profits of abnormal proportions). We can keep much of the implicit insurance function of price gouging laws, while maintaining normal economic incentives to distribute goods and services in an emergency, by focusing price gouging laws on profits of abnormal proportion, rather than on profits or prices of abnormal absolute magnitude.