An economic analysis of market prices v. price controls post-natural disasters reveals superiority of market prices | American Enterprise Institute

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Natural disasters like hurricanes create huge disruptions to the local markets that are affected by those events. Destruction of property, temporary shortages of key goods, and human suffering are all natural consequences of those market disruptions. The crucial issues society face is how to minimize human suffering and speed up the recovery process in the post-disaster period. There are often long delays before emergency agencies like FEMA and the Red Cross can deliver critical supplies like water, food, clothing and building supplies to the affected areas. There are also long delays before retailers like Home Depot and Walmart can re-start their supply chains and re-open stores in the affected areas re-stocked with the supplies local residents desperately need. It also takes weeks if not sometimes months for local utilities to restore electric power to the damaged areas.

During those transition periods from post-disaster to when critical supplies like water and food can be delivered in adequate supplies and when power can be restored for most residents, there is often a “gap period” when critical supplies and electric power are scarce or not available at all, and prices are therefore temporarily higher than their pre-disaster levels. It’s during those critical “gap periods” that profit-seeking entrepreneurs from outside the affected area can play a critical role in the initial recovery period by providing much-needed supplies and provisions like water and generators before emergency agencies and national retailers mobilize their large, often bureaucratic organizations to deliver those critical supplies to the disaster areas. But because there is a huge increase in demand for many critical supplies in the affected areas, and to offset all of the many uncertainties, financial expenses, risks and time involved to provide those emergency supplies as quickly as possible to the disaster victims, there are inevitably large increases in prices, at least temporarily, during those transition periods.

The public policy response of many cities and states following a disaster is to enact, or enforce existing, “anti-price-gouging” laws that prevent post-disaster prices from rising above their pre-disaster levels, or that limit how high those prices can rise before they are considered to be illegal gouging. Obviously, once normal supply chains of national retailers are restored and once supplies from emergency agencies like FEMA are delivered, the prices of critical supplies like water return to their pre-disaster levels, the “price gougers” are out of business and the anti-price-gouging laws are no longer necessary.

But a key political and economic issue, and one that has been debated after every natural disaster for at least the last half century, is this: Should we allow market prices to rise temporarily following disasters and allow entrepreneurial “price gougers” to temporarily play a role of providing critical supplies during the “gap period” at elevated prices, or should we suppress market prices with government price controls?

To help answer that timeless, perennial, post-disaster issue I offer some thoughts below on the advantages and disadvantages of market prices compared to government price ceilings via anti-price-gouging laws during the temporary “gap periods” following natural disasters – those temporary, and often very short periods, before normal supply chains are restored and when prices are temporarily high.

A. Advantages of Allowing Market Prices to Rise after Hurricanes

2. Market-determined prices and wages require no legislation or enforcement mechanisms. In contrast, government price controls do require enforcement mechanisms and prosecution, which can be costly and time-consuming.

3. Higher market prices will discourage over-consumption and encourage greater conservation of scarce resources and supplies. In contrast, government price controls do the opposite – encourage over-consumption and discourage conservation.

4. Higher market prices will attract needed supplies as quickly as possible from outside the affected area. That is, the temporarily high prices give “price gougers” a financial incentive to provide critical goods to residents of affected areas and “fill the gap” until those goods are later supplied in sufficient quantities by national retailers like Home Depot and Walmart, and by emergency organizations like FEMA and the Red Cross. For example, once FEMA and the Red Cross deliver water to areas affected by the disaster, and once retailers like Home Depot re-open and can stock generators and plywood for sale, the “price gougers” are out of business. But until those supplies arrive in sufficient quantities through traditional sources, the price gougers assist the recovery efforts by “filling the gap” and providing those much-need, critical supplies to affected residents while they wait for normal supply chains to be restored.

It’s also important to point out the huge legal risks and uncertainties that “price gougers” face, in addition to the large investments they make in terms of financial outlays and personal time. To illustrate those risks and costs, consider the case of John Shepperson of Kentucky, who in 2005 took time away from his normal job to buy 19 generators, rented a U-Haul truck, and drove it 600 miles to the Katrina-damaged area of Mississippi. Suppose Shepperson paid $500 at his local Home Depot in Kentucky for each generator – that would have required an initial investment of $9,500 upfront plus another $570 for Kentucky’s 6% sales tax. Then Shepperson had to rent a U-Haul truck for a week at a cost of about $1,000 for rental charges and gas (and adding more than $50 to the cost invested in each generator), drive 600 miles, and find a place to stay while traveling. It’s obvious that Mr. Shepperson invested a lot of his money and took a lot of risks in his entrepreneurial venture. For example, what if he drove to Mississippi and found out that he wasn’t able to sell all 19 generators, either because there wasn’t enough demand, or he wasn’t able to access all of the willing customers for generators because the roads were impassable due to flooding? What if other entrepreneurs got to the affected areas first and satisfied all of the demand for generators, leaving John with no customers? Or what if the competition among sellers was so intense that the market price for generators was only $600 and John was barely able to even cover all of his costs?

John made it to Mississippi and offered to sell his generators at twice the price he paid, to help cover his costs of almost $600 per generator, and maybe make a profit. Instead, Shepperson was arrested by local law enforcement officers for price gouging and his generators were confiscated. He was held by police for four days and the generators were kept in police custody for evidence and never made it to consumers with urgent needs who desperately wanted to buy them.

The John Shepperson case illustrates the great financial and legal risks faced by “price gougers” and why higher prices are often justified just to cover some of the additional costs required to bring supplies quickly to disaster-stricken areas. Without some possibility to cover out-of-pocket costs and make a profit, there would be no incentive for entrepreneurs like Shepperson to bring critical supplies to residents in disaster areas who are desperate for those supplies.

5. Higher wages will attract workers from outside the affected area to provide the labor necessary for the construction and rebuilding efforts. If wages are not allowed to rise, there will be no financial incentive to attract construction workers to the disaster area from non-affected states to help with the recovery efforts, and there will be significant worker shortages that will delay the necessary rebuilding.

6. Higher market prices efficiently allocate scarce goods and services to those most willing to pay and those who value the critical goods most highly. For example, businesses (grocery stores, gas stations, hospitals and banks) are often willing to pay higher prices than individuals for scarce goods like generators when there is no electricity, which allows them to re-open for business as soon as possible (or stay in business). Once open, those merchants, gas stations, banks, and hospitals can better serve the local residents communities by providing food, gasoline, medical services and cash withdrawals than if local residents had purchased those generators for individual use.

7. Higher prices give some affected residents a choice they would otherwise not have. If affected residents are without supplies and a “price gouger” arrives offering those supplies for sale, an option is presented to the resident that might not otherwise exist. Even though the prices might be high, the residents at least have a choice and can decide whether or not to make a purchase. At least temporarily, the post-disaster choice is not between water or plywood at low prices versus high prices; rather, the reality is that the choice is between goods offered at high prices that ARE available and those same goods at low prices that are currently NOT available. Voluntary exchanges at high prices are still win-win transactions that benefit both the buyer and seller.

8a. Higher market prices following a disaster provide a more accurate measure of the true scarcity of a good than an artificially low price than would result from a government-imposed price ceiling in the form of an anti-price-gouging law.

b) Therefore, higher market prices and wages will do a much better job of eliminating post-disaster shortages than price ceilings.

The diagram above illustrates how market prices for many goods naturally rise following a disaster, to reflect the increase in demand (from D1 to D2 above) for goods like water, plywood and generators at the same time that there is a decrease in the supply (from S1 to S2) of those goods. The market price naturally rises from P1 to P2 as a result of the disruption to the market and the new market conditions in the post-disaster period. The higher market price is only temporary, and will fall once supplies are brought to the affected area. If prices are not allowed to increase and are forced to remain at the pre-hurricane level (P1) by price-gouging laws, we can see graphically above that a guaranteed large shortage will result (see bold blue line), because the Quantity Demanded (QD) by consumers at the artificially low price will greatly exceed the Quantity Supplied (QS) by sellers.

As the graph helps to illustrate, there are really only two options: a) Higher market prices that accurately reflect the new market conditions and eliminate shortages, or b) artificially low government-mandated prices at pre-disaster levels (or prices that are restricted from increasing to the market price) that are guaranteed to create shortages. If the goal is to minimize suffering and minimize the time it takes to recover as quickly as possible, then we should allow temporary higher market prices. Keeping prices artificially low with legislation will do the opposite: increase suffering and lengthen the recovery period.

B. Disadvantages of Allowing Prices to Reflect Market Conditions after Hurricanes

1. It might be considered unfair, unethical or immoral by some that certain residents now temporarily pay higher prices than before the disaster.

 

C. Advantages of Preventing Prices and Wages from Rising Following Hurricanes with Anti-Price-Gouging Laws

1. Some goods and services will be more affordable to certain residents because of the artificially low prices.

2. Many scarce goods will be allocated on a first-come, first-serve basis rather than by price, which will benefit those who are at the front of the line and obtain goods before they quickly become unavailable.

D. Disadvantages of Preventing Prices and Wages from Rising Following Hurricanes with Anti-Price-Gouging Laws

1. Requires costly enforcement and prosecution using scarce resources of law enforcement agencies, attorneys general, and court systems. Further, individuals convicted of price-gouging may have criminal records, see example above of John Shepperson, which may have life-long negative effects on their employment opportunities.

2. Anti-price-gouging laws are inherently problematic because of the arbitrary and subjective definition of what precisely and legally defines “price gouging.” If a given quantity of water normally costs $10 before a disaster, what higher price will be illegal “gouging” and outlawed? $11, $15, or $20? Who decides?

3. Keeping prices artificially low encourages over-consumption of critical supplies like food, water and plywood and fails to promote conservation of those scarce resources. In contrast, higher market prices have the exact opposite, and highly desirable effect of discouraging over-consumption and encouraging conservation.

4. Keeping prices and wages artificially low discourages and/or prevents needed supplies and workers from being attracted to the affected areas from areas that weren’t affected. Price ceilings guarantee shortages of critical supplies and workers and a much longer time for the recovery and rebuilding period compared to temporary high market prices. Supplies from FEMA, the Red Cross and retailers like Home Depot and Walmart will eventually reach the affected areas, but the critical role of entrepreneurial “price gougers” will no longer help fill the gap in the recovery process.

5. Artificially low prices allocate scarce goods and resources on a “first-come, first-served” basis rather than on a willingness to pay basis that gets those scarce items into the hands of those who value them most highly. See the example above of scarce generators, which would be allocated inefficiently under price controls, rather than getting into the hands of businesses, hospitals, banks, grocery stores and gas stations.

6a. Compared to market prices, artificially low prices following a disaster provide an inaccurate measure of the true scarcity of a good and transmit false information about market conditions.

b) Therefore, those artificially low prices are guaranteed to create significant shortages.

As the graph above shows, artificially low prices following disasters that are a consequence of government price ceilings that prevent prices from rising above P1 (or prevent them from rising to the market price) are guaranteed to create shortages for critical goods. At the artificially low price P1, the Quantity Demand (QD) by consumers will far exceed the Quantity Supplied (QS) by sellers resulting in a significantly large shortage (bold blue line). The artificially low prices from government price controls transmit false and inaccurate information about the true scarcity of critical goods and supplies, and therefore send the wrong signals to the market. Artificially low prices encourage over-consumption and discourage conservation, while at the same time providing no incentives to increase the supply of critical goods and supplies necessary for recovery. Those false signals transmitted by inaccurate, misleadingly low prices will slow the recovery, guarantee significant shortages (as illustrated in the graph above) and greatly increase suffering.

Bottom Line: As the analysis and graph above help to illustrate, there are really only two options for prices following disasters like hurricanes: a) Temporary, higher market prices that accurately reflect the new market conditions and increased scarcity, discourage over-consumption, provide incentives for entrepreneurs to bring critical supplies to the affected areas, and eliminate shortages, or b) artificially low government-mandated prices at pre-disaster levels (or prices that are restricted from increasing to the market price) that inaccurately reflect the new greater scarcity conditions and are guaranteed to send the wrong market signals and create significant shortages (see graph). If the goal is to minimize suffering and minimize the time it takes to recover as quickly as possible following a natural disaster, then we should allow temporary, higher market prices and accept “price gouging” as a temporary “best case” solution during a short “gap period.” Keeping prices artificially low with government price controls and anti-price-gouging legislation post-disaster will do the exact opposite: increase suffering, make the market disruptions worse, create guaranteed shortages, and delay the recovery period.


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