So my last post was about a critique of free markets so lets change direction. So what is price gouging? Its sort of like a limit on the profit margin you can charge, some states in the US have laws about how much margin you can make if there’s a disaster. So say a 10% margin limit means that if it cost you 100 dollars to come up with something you can’t sell it for more than 110. So why is this good? So you don’t get ripped off during a disaster, when your house is flying above your head, you probably don’t need some guy charging you 100 dollars for a bag of ice. On to the story:
A group of friends hear about a disaster hurricane event a couple of hundred miles away from where they are driving. So they decide to go buy packs of ice for about a dollar each and drive down to the distressed area. They then stop in front of some residential neighbourhoods and start selling the packs for 12 dollars a pack. Lots of people run to them and start buying, then the police shows up and arrests them for price gouging. The people of the neighbourhood see this happening and they start clapping to support the police.
So what has price gouging accomplished? Its easy to think that these guys were being immoral and taking advantage of the people. But now lets use economics… there’s a finite amount of ice… so what’s the best way to give it around? The way to maximize utility, so give it to the people who need it most… so how do we do that? Some people want the ice to keep their baby formula the right temperature, others want it to keep their beer cold, others might want it for their medication.
We are actually fortunate that the price system comes pretty close to achieving maximum marginal utility, how does it do that? by maximizing profit, the seller’s profits are probably maximized by selling all the ice at the maximum price he can get away with. People who just want to keep their beer warm won’t be willing to pay so much as someone whose health could be on the line. Would those friends even have showed up if the profit was capped at 10%? Would they spend hours driving to leave with a couple of dollars each?
The one disadvantage of the price system is that richer people will be negatively influencing the maximum marginal utility mechanism but in a given neighbourhood inequality probably isn’t very high and rich people might in fact still be inclined to think in terms of long term “value for money”.
So all this not to say that all price gouging is bad, since there are many times were it is used to prevent fraudulent activity or times where everyone could have the same marginal utility.