The Dismal Science

Pump It Up

Don’t worry about price gouging now. Worry later.

Just before Hurricane Katrina hit the Gulf Coast, the president told the country he would punish lawbreakers and singled out a trio of evildoers: looters, charity scammers, and price gougers. Maybe because they didn’t do enough to stop the first two, state and federal governments have aggressively pursued the gougers. In doing so, they have embraced a radically expansive and unreasonable view of what gouging entails—when what they should focus on is what happens next, when prices ought to come down.

When Katrina hit, prices for gasoline rose dramatically throughout the country, in some places by more than a dollar a gallon in 48 hours. Scores of state attorneys general and governors launched investigations. The federal government’s gouging-complaint line received 5,000 calls on the first day after the storm. States tend to make their anti-gouging laws purposely vague, forbidding “unconscionable profiteering” during a state of emergency or the like. But rising prices don’t equal price gouging. Any reasonable definition of gouging must distinguish it from price increases that would exist in a competitive market.

Katrina contributed to driving up the price of crude oil to an all-time high of $70 per barrel, knocking out as much as 25 percent of U.S. oil production and 10 percent of its refining capacity. But increased demand as well as damage to the supply chain played a role. Consumers far from the disaster rushed to their local gas stations to fill their tanks before prices spiked more. Of course prices rose under those conditions. That would happen in any commodity market, anywhere.

What separates true gouging from other kinds of price increases is customer choice or the lack thereof—what economists term “monopoly power.” Companies increase their monopoly power, and may start gouging, when the demand from their customers becomes more “inelastic.” That means customers are less sensitive to price, usually because they have lost access to substitutes. This theory explains why popcorn is more expensive in movie theaters than in grocery stores—once you’re inside the theater, you either pay the premium or you don’t get to munch. Applied to hurricanes, the theory predicts that if desperate people will pay high prices for necessities, then a company without any competition will be able to take advantage of them. The idea behind anti-gouging laws is to help people who were stuck without alternatives, through no fault of their own.

This might explain a price-gouging investigation in Louisiana, where people buying gas were running for their lives. But it has nothing to do with most of the complaints in the rest of the country. Gas prices aren’t rising in Los Angeles or New York because drivers are desperate to get somewhere with potable water. They are rising because supply has become extraordinarily tight and people want to keep driving as much as they were before.

If gas prices did not rise across the country now, in fact, the short-term impact would be disastrous. Demand would vastly exceed the current supply. As people continued to buy as much or possibly more gas, stations around the country would run out because wholesalers would refuse to supply them at the lower price. Families who’d driven off on Labor Day trips would still be stuck out on the highway, looking for a place to fill up.

Somehow, hunts for gas gougers always seem to start at the wrong time. A classic economic study of the gasoline market (by Severin Borenstein and Richard Gilbert of the University of California at Berkeley and A. Colin Cameron of the University of California at Davis) looked at the extent to which retail gas prices respond to changes in crude oil prices and wholesale gasoline prices. They found that the immediate retail price increases essentially reflected the increasing cost of oil and wholesale gas. There was little evidence of increased profits on the heels of increased wholesale prices, like the hike that followed Katrina. Instead, the study showed that gouging, if it occurs, typically begins when the stations’ costs start to come down again. The stations in the study took about twice as long to cut prices when their costs decreased as they had to raise them on the way up. It was after a crisis ended that their profit margins shot up.

By that time, however, the federal gouging hotline has stopped ringing and government investigators have moved on. If the past is any guide, once the oil production and the refineries on the Gulf Coast ramp up again, only a few observers will notice if prices fall more slowly than they should, despite the studies that have consistently documented this pattern. In the meantime, economists will continue to cringe each time they hear an attorney general rant against “unconscionable” gas prices.