Raising Prices Isn't "Gouging"
I've written a lot on price gouging and price controls lately, but the popularity of laws against higher prices after storms suggest that it's a lesson which hasn't been learned yet. Here's yet another article about gouging, this time for the Independent Institute and possibly forthcoming in a local publication, the Main Street Journal. The opening paragraph:
Why does the price of gas increase immediately when a hurricane threatens supplies, even though the gas at the pump has already been paid for? Why does the price of gas in Seattle increase immediately when a hurricane threatens New Orleans or Houston? A popular explanation for rising gas prices is that it happens because unscrupulous, hard-hearted merchants see disasters as opportunities to take advantage of people in their time of need. It's an emotionally attractive explanation that fuels popular outrage and inspires laws against "price gouging." It's also an explanation that is completely wrong. We can save ourselves a lot of angst, many of the pains associated with disaster recovery, and a lot of money in law enforcement resources by understanding why gas prices rise in the midst of disaster and by repealing laws against "price gouging."
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Comments (16)
Comments (16)
Don Lloyd
Art,
"...A lot of the confusion stems from a misunderstanding of “cost.” The cost of a gallon of gas is not what the merchant paid for it. The cost of a gallon of gas is the merchant’s next-best opportunity. If a gas station paid $3 for a gallon of gas yesterday and expects to be able to sell it for $5 tomorrow, the cost of that gallon is not $3. It’s $5. By selling the gas today, the gas station owner gives up the opportunity to sell it tomorrow for $5. Therefore, we can expect the gas station owner to charge $5 for the gallon of gas today...."
I don't think that this is correct.
If a station operator has 1000 gallons of gasoline remaining in his underground tank, the lowest price per gallon that he will be willing to accept will be his expected replacement cost on his next tanker delivery. Selling off his inventory at the same price that will be needed to replace it is a worthless activity, and selling for less is silly.
Effectively, the expected replacement cost sets a floor under current price, and selling at a higher price, even above local competition, may be needed to stretch current inventory until the next delivery.
Regards, Don
Published: September 16, 2008 10:09 PM
Walt D.
A room in the Hilton Galleria Houston costs me $150. The same room a the Hilton Manhattan costs me $250.
Is the NY Hilton gouging me to the tune of $100? No. Hilton owns the property they can charge $550. They don't have to sell, I don't have to buy.
If I book ahead, I can fly from LA to JFK the day before Thanksgiving for $299. If I show up on Wednesday with no reservation, I may have to pay $1200, if I can get a flight at all. Am I being gouged?
No - if I don't want to pay the freight, I don't have to fly. The pricing structure ensures that if I absolutely have to fly that I can get a seat by outbidding the person who wants to go shopping in NY but can wait for another week.
Published: September 16, 2008 10:54 PM
Charles Iliya Krempeaux
This reminds me of a comic I saw before...
"How The State Sees The Market"
-- Charles Iliya Krempeaux
Published: September 16, 2008 11:49 PM
Ron
From the first linked-to article:
Ah, the joys of democracy...it gives so few so much power over things about which they know so little.
Published: September 17, 2008 9:21 AM
michael
Don Lloyd is actually the first person in this forum to get the correct answer:
"If a station operator has 1000 gallons of gasoline remaining in his underground tank, the lowest price per gallon that he will be willing to accept will be his expected replacement cost on his next tanker delivery. Selling off his inventory at the same price that will be needed to replace it is a worthless activity, and selling for less is silly.
"Effectively, the expected replacement cost sets a floor under current price, and selling at a higher price, even above local competition, may be needed to stretch current inventory until the next delivery."
Correct. That's the reason pump prices rise at the first hint of an obstruction in the supply line. The station operator has to be able to pay for his next tank fill, to stay in business.
As has been discussed in the other thread, NC has a price gouging law designed to punish undue price hikes. And in this law, a grey area has been left around the concept "undue".
The excuse that added costs had to be anticipated is an acceptable one. Thus a station operator can support justification for his decision to hike pump prices. However we do have an attorney general who is elected by his fellows, whose job it is to adjudicate exactly where the line lies between an acceptable increase and "gouging".
Like it or not, that's our system. And a majority of consumers here support it-- as is commendable under a democratically determined system of government.
Published: September 17, 2008 10:02 AM
Ron
Don and Michael, your argument assumes that the price for the next tank fill will be the same as it was for the current tank of gas. A disruption in the supply of gasoline doesn't affect current inventories, other than to produce a run thereupon. The disruption impacts the next fill-up. The gas station owner, therefore, must be concerned about future costs of gasoline. If he anticipates that the next fill will be more costly he will sell the current tank for a higher price. Obviously, since he has no way of knowing exactly what the future cost will be, he may make a higher profit from current inventory than if he had such knowledge. To accuse him of a crime for simply guessing incorrectly seems somewhat draconian, don't you think?
Published: September 17, 2008 11:55 AM
Don Lloyd
Ron,
"...Don and Michael, your argument assumes that the price for the next tank fill will be the same as it was for the current tank of gas..."
Not at all. As a careful re-reading will confirm, the only thing that matters is the expectation of the station operator about the cost of his next re-supply.
The actual price charged above the floor is presumably a dynamic adjustment that controls the rate of inventory exhaustion in the face of variations in both consumer demand and competition.
Regards, Don
Published: September 17, 2008 12:17 PM
Michael A. Clem
I think Don's right on this. The problem when a major disaster strikes, though, is not knowing when the next supply will be able to come in, nor how much it will cost. Thus it can sometimes be impossible for the seller to know how much to charge, much less for the state district attorney to know how much they should charge.
Even so, the "correct" price is always no more than what people are willing to pay, regardless of the circumstances. All that a price-gouging law can do is help the early consumers get a bargain at the expense of later consumers, and at the seller's expense, of course.
Published: September 17, 2008 12:32 PM
magnus
Like it or not, that's our system. And a majority of consumers here support it-- as is commendable under a democratically determined system of government.
Remind me sometime to provide you with a sampling of the atrocities committed with the support of majorities.
Published: September 17, 2008 12:57 PM
josh m
"And a majority of consumers here support it-- as is commendable under a democratically determined system of government.--Michael
The majority of voters support criminalizing honest trade because they are economic illiterates. Woo-hoo !
Published: September 17, 2008 1:53 PM
Lowell Sherris
Don & Michael, I believe you are both incorrect in your belief that "... the lowest price per gallon that he will be willing to accept will be his expected replacement cost on his next tanker delivery."
There are many factors that influence an entrepreneur's asking price. Certainly replacement cost of one of them. However, predictions about future supply and demand, competition, personal finances, government regulations, etc. all are important.
As an example, if the station owner needed to raise cash quickly to pay a debt, he might be willing to sell below the replacement cost. On the other hand, if he anticipated a large demand and limited competition, the lowest price he might accept may be well above the replacement cost.
If one were able to anticipate the "correct" market prices, it would be possible to have a planned economy. But alas ...
Published: September 17, 2008 6:12 PM
Don Lloyd
Lowell,
The expected replacement cost is only a variable estimate, changing day to day, and is an approximate price floor, not an actual price under normal conditions.
It is normally the local conditions of supply and demand that set the range of prices that can be used to either speedup or slowdown the volume rate of sales to control the inventory rate of decline.
As competitors may raise their estimates of their replacement costs, and either shut down sales or increase their prices, our operator will see more sales and raise his prices as a result, and possibly his replacement cost estimates as well, assuming that someone else may now know more about the future
Regards, Don
Published: September 17, 2008 7:50 PM
DavidB
It seems like all your arguments all assume inflation. What if a guy paid $100 a gallon for his gas today and knew tomorrow that gas was going to 10 cents? Your arguments, because of inflation conditioning, suggest the guy would charge me 11 cents per gallon. Not only would he lose money he could not reasonably recover in an adequate time frame but there is no way he is going to charge me less than $105 to buy that gas in order to replace his original out of pocket expense. The only place he'd charge me next day replacement cost is in your economics textbooks.
It is also very likely that the next day he would again try to charge me $105 for gas even though he's only paying 10 cents for it. That is how the real world works. What would restrain him is what his competitors charge and whether or not his customers had an indication of what it was costing him for his gas. Face it, in times of trouble or in times of peace there is a set of people who will do everything in their power to stick it to their fellow man. They will do it to everyone's peril
Published: September 17, 2008 11:53 PM
Don Lloyd
DavidB,
"It seems like all your arguments all assume inflation. What if a guy paid $100 a gallon for his gas today and knew tomorrow that gas was going to 10 cents? Your arguments, because of inflation conditioning, suggest the guy would charge me 11 cents per gallon. Not only would he lose money he could not reasonably recover in an adequate time frame but there is no way he is going to charge me less than $105 to buy that gas in order to replace his original out of pocket expense. The only place he'd charge me next day replacement cost is in your economics textbooks. ..."
Replacement cost is an effective price floor, not an actual price. It is also the input cost for profit-maximizing procedures as economics is always concerned with the future, whereas accounting is concerned with the past and sunk costs. Actual prices are always what the market will bear, subject to competition and the considerations of profitability.
Regards, Don
Published: September 18, 2008 12:37 AM
michael
From magnus: "Remind me sometime to provide you with a sampling of the atrocities committed with the support of majorities."
Noted, that you disapprove of the democratic approach toward legitimising governance, as it is (in theory at least) responsive to the will of the public.
Please propose a better method. Dictatorship by economists?
From Josh M: "The majority of voters support criminalizing honest trade because they are economic illiterates. Woo-hoo !"
Odd... if you were to ask them, they'd all say they support honest trade but seek to punish predatory practises. Unfortunate that you seem unable to distinguish the two. The distinction lies in the moral realm-- and I would suggest that even from a purely monetary point of view, it would be short-sighted to rip off your customers. The emergency will shortly be over, but they won't be coming back for a long long time.
DavidB, your hypothetical about gas going from $100 one day to ten cents the next is an unlikely scenario. As of today, 2008, inflationary expectations have not yet taken off the way they did back in 1973. We expect prices to fluctuate within a narrow band, ratcheting upward. That is, gas will advance fifty cents, then drop back twenty. Then it will advance another fifty cents and perhaps drop back fifteen.
The other difference is that back in the 1970s we expected wages to rise to keep pace with prices. Today that is not an expectation. The anticipation is that buying power will erode as the cost of living increases.
All: listen to Don. He knows what goes on in the mind of the independent station operator. Your average Masters holder in econ wouldn't last a year in the business.
Published: September 18, 2008 12:14 PM
josh m
No. Any voluntary trade that does not involve deception (fraud) is an honest one. The distinctions you make are imaginary and exist only in the mind of the economically illiterate. Making such distinctions ('predatory', 'ripping off', etc.) indicates economic illiteracy.
Published: September 20, 2008 8:59 AM