The moral case for Price Gouging
Posted by Robbie53024 9 years, 3 months ago to Economics
Nobody likes to pay more for goods and services than they need to, so the title of this piece likely causes you to question my sanity. Never fear, if you read through and follow my reasoning, you will see not only that "price gouging" is moral, but that it actually will lead to greater availability of needed items at the lowest costs.
First, it is necessary to define our term - price gouging. This would be a situation whereby a seller increases the price on goods and services in response to a sudden and unpredictable shortage of said goods and services. We see this typically after a natural disaster such as a tornado, flood, hurricane, snow storm, etc. It is necessary that the situation be relatively sudden and unpredictable, otherwise a shortage would not likely occur, thus removing the ability for the seller to raise their prices since supply would be plentiful.
How do sellers of goods and services set their prices? It may come as a surprise to many that it is not on the basis of what they procured them for with some added profit. While "cost plus" pricing is rampant in governmental operations, in the free market this does not work. A purchaser of a good or service cares not a whit what you paid for it, they only care about the value that such good or service has to them. They will pay as much as they value it for, and no more. If the seller prices their goods at or below the buyer's willingness to purchase, they are likely to make a sale. The lower the price is in relation to the willing purchase price of the buyer, the higher the perceived value and the higher the likelihood of purchase. If they price them higher, the likeliness of selling goes to zero, since the purchaser does not perceive a good value in the purchase.
Thus, the seller does not in fact set the price at all, rather they choose a price based on their perception of the willingness of their potential customers to purchase at varying prices, along with the needed profit to make such business viable. For example, a seller may have an item in which there is one customer who will pay $1,000, once every year. The item costs the seller $100 to procure, so they would make $900 for a year. However, there are 1000 purchasers who would be willing to procure that item if priced at $150, which would net the seller $50,000. So the purchasers cause the price to be set at $150 instead of $1,000. So, the seller can sell one item at a tremendous profit but very low volume, or they can sell a lot at a lower profit, but a net total of a lot more.
There is another factor that also needs to be included, and that is the competition. If a good amount of profit is available, this will undoubtedly lead to others who wish to partake of some of that themselves. Thus, competition will ensue. In order for the new seller to break into the market, they will have to price their offering at or below that of the first seller, otherwise the customers will continue to purchase from the first seller, so long as that seller has sufficient supply to sell. This leads to price competition between the sellers to entice customers to purchase from them instead of the competitor.
So far, I've not discussed anything about price gouging, but having these concepts firmly understood is necessary prior to moving on. Customers set prices based on the value that they perceive of the goods and services that they desire. So long as there is sufficient supply, competitors drive down prices in order to entice customers to purchase from them instead.
What happens when a sudden and unexpected disruption happens? Because it was sudden and unexpected, none of the suppliers were able to stock ahead those goods that their customers will demand. Now there is a shortage of supply, and a demand for those goods. Suddenly the value to the customers increases as the competition switches to being between different customers instead of between different sellers. That customer that was willing to pay $1,000 now has the advantage as they will willingly fork over much more than will other customers. Again, this is the customer setting the price, not the seller, the seller merely is allocating the limited supply to those customers with a higher perception of value for those scarce goods. This is good, as not all customers can be satisfied due to limited supply and a mechanism for allocation must be established.
The question arises, then, why is supply limited? If there were more supply, then more could have been sold, and as we have seen, selling more even when at lower prices often results in a greater net revenue. But there are costs in procuring and stocking inventory of goods. There is the money that must be used to purchase the goods in the first place. This can result either in the loss of interest that could have been gained by keeping the money in the bank instead of spending it to purchase the goods. Or it may more likely be the result of paying interest to the bank for a loan that was used to pay to purchase the goods to be sold. Once the goods are procured, they also must be stored, necessitating some sort of warehouse, at a capital cost if owned, or a rental cost if leased, but in either case there is a cost to hold these goods.
There are also potential costs for obsolescence or spoilage (when newer goods are available, this makes the stored goods less desirable, or they get damaged or lose desirability to the customer due to age). The result is that procuring and holding goods incurs costs that the seller must take into account in determining how much to have and what price will result in satisfactory sales to cover all these costs plus make a profit. Procure too little, and a competitor will sell more and you will not satisfy enough customers. Procure too much, and you will have excessive costs that will make you less profitable.
By legislating that excessive price increases are not permitted, the incentive for the vendor to incur those additional costs is reduced. With less incentive, less of the potentially scarce item is available, thus ensuring its scarcity. Scarcity of needed items results in more people being harmed or enduring conditions that are harsher than otherwise would need to be. By allowing "price gouging" the first time that a shortage occurs some with the scarce goods will make a very good profit. This will entice others to want to participate in that good profit and they will make plans to participate - stock more of the goods or be able to get the goods readily. When the next event occurs that causes a shortage, now there will be more participants to provide those goods. The additional availability will reduce the overall price for all, yet still provide enough profit for those who have taken on the additional risks of the increased availability.
Let's take a very simple example. Electric generators are a rather high cost item with low continual demand but high demand after many natural disasters. The high costs and low demand typically would call for the inventory levels to be kept low. A tornado is a very sudden event and very localized. In an environment where price gouging laws are in place there is no incentive for a business to stock more generators than they would normally sell, so they don't Without any incentive to incur greater costs, the business will not do so.
First, it is necessary to define our term - price gouging. This would be a situation whereby a seller increases the price on goods and services in response to a sudden and unpredictable shortage of said goods and services. We see this typically after a natural disaster such as a tornado, flood, hurricane, snow storm, etc. It is necessary that the situation be relatively sudden and unpredictable, otherwise a shortage would not likely occur, thus removing the ability for the seller to raise their prices since supply would be plentiful.
How do sellers of goods and services set their prices? It may come as a surprise to many that it is not on the basis of what they procured them for with some added profit. While "cost plus" pricing is rampant in governmental operations, in the free market this does not work. A purchaser of a good or service cares not a whit what you paid for it, they only care about the value that such good or service has to them. They will pay as much as they value it for, and no more. If the seller prices their goods at or below the buyer's willingness to purchase, they are likely to make a sale. The lower the price is in relation to the willing purchase price of the buyer, the higher the perceived value and the higher the likelihood of purchase. If they price them higher, the likeliness of selling goes to zero, since the purchaser does not perceive a good value in the purchase.
Thus, the seller does not in fact set the price at all, rather they choose a price based on their perception of the willingness of their potential customers to purchase at varying prices, along with the needed profit to make such business viable. For example, a seller may have an item in which there is one customer who will pay $1,000, once every year. The item costs the seller $100 to procure, so they would make $900 for a year. However, there are 1000 purchasers who would be willing to procure that item if priced at $150, which would net the seller $50,000. So the purchasers cause the price to be set at $150 instead of $1,000. So, the seller can sell one item at a tremendous profit but very low volume, or they can sell a lot at a lower profit, but a net total of a lot more.
There is another factor that also needs to be included, and that is the competition. If a good amount of profit is available, this will undoubtedly lead to others who wish to partake of some of that themselves. Thus, competition will ensue. In order for the new seller to break into the market, they will have to price their offering at or below that of the first seller, otherwise the customers will continue to purchase from the first seller, so long as that seller has sufficient supply to sell. This leads to price competition between the sellers to entice customers to purchase from them instead of the competitor.
So far, I've not discussed anything about price gouging, but having these concepts firmly understood is necessary prior to moving on. Customers set prices based on the value that they perceive of the goods and services that they desire. So long as there is sufficient supply, competitors drive down prices in order to entice customers to purchase from them instead.
What happens when a sudden and unexpected disruption happens? Because it was sudden and unexpected, none of the suppliers were able to stock ahead those goods that their customers will demand. Now there is a shortage of supply, and a demand for those goods. Suddenly the value to the customers increases as the competition switches to being between different customers instead of between different sellers. That customer that was willing to pay $1,000 now has the advantage as they will willingly fork over much more than will other customers. Again, this is the customer setting the price, not the seller, the seller merely is allocating the limited supply to those customers with a higher perception of value for those scarce goods. This is good, as not all customers can be satisfied due to limited supply and a mechanism for allocation must be established.
The question arises, then, why is supply limited? If there were more supply, then more could have been sold, and as we have seen, selling more even when at lower prices often results in a greater net revenue. But there are costs in procuring and stocking inventory of goods. There is the money that must be used to purchase the goods in the first place. This can result either in the loss of interest that could have been gained by keeping the money in the bank instead of spending it to purchase the goods. Or it may more likely be the result of paying interest to the bank for a loan that was used to pay to purchase the goods to be sold. Once the goods are procured, they also must be stored, necessitating some sort of warehouse, at a capital cost if owned, or a rental cost if leased, but in either case there is a cost to hold these goods.
There are also potential costs for obsolescence or spoilage (when newer goods are available, this makes the stored goods less desirable, or they get damaged or lose desirability to the customer due to age). The result is that procuring and holding goods incurs costs that the seller must take into account in determining how much to have and what price will result in satisfactory sales to cover all these costs plus make a profit. Procure too little, and a competitor will sell more and you will not satisfy enough customers. Procure too much, and you will have excessive costs that will make you less profitable.
By legislating that excessive price increases are not permitted, the incentive for the vendor to incur those additional costs is reduced. With less incentive, less of the potentially scarce item is available, thus ensuring its scarcity. Scarcity of needed items results in more people being harmed or enduring conditions that are harsher than otherwise would need to be. By allowing "price gouging" the first time that a shortage occurs some with the scarce goods will make a very good profit. This will entice others to want to participate in that good profit and they will make plans to participate - stock more of the goods or be able to get the goods readily. When the next event occurs that causes a shortage, now there will be more participants to provide those goods. The additional availability will reduce the overall price for all, yet still provide enough profit for those who have taken on the additional risks of the increased availability.
Let's take a very simple example. Electric generators are a rather high cost item with low continual demand but high demand after many natural disasters. The high costs and low demand typically would call for the inventory levels to be kept low. A tornado is a very sudden event and very localized. In an environment where price gouging laws are in place there is no incentive for a business to stock more generators than they would normally sell, so they don't Without any incentive to incur greater costs, the business will not do so.
