Price Gouging in the Wake of the Coronavirus?

The story was carried in the media about a US producer of surgical face masks being bombarded by phone calls from representatives of foreign governments requesting large quantities to be supplied pronto. The business executive turned down their offers.

They couldn’t meet the demand.

Being interviewed later on a media talk show program, he lamented the situation saying even if his company, Prestige Ameritech, based out of Fort Worth, Texas, ran production round the clock, they still wouldn’t be able to meet the global requests.

This is the coronavirus state of the market for products including face masks, hand sanitizers and similar products, which have experienced very high demand and in some places even shortages.

How are market economies expected to react to this state of affairs, the one where demand far outstrips available supply and where replenishing stocks in unprecedented quantities at a much quicker pace is desired?

The answer is through price increases. Prestige Ameritech for example would have to increase the price of its surgical masks as it also ramps up production.

But that is unconscionable, some might quip. How can businesses take advantage of a pandemic to gouge consumers by raising prices significantly? How will the most vulnerable who are poor afford these products? This debate typically goes viral in the mainstream media and on social media as businesses on the supply side who raise their prices are castigated and portrayed as insensitive. Calls are often made to boycott these businesses, perhaps not now, but in the future.

The opportunity sometimes does arise for some well meaning supplier or philanthropist to step in and make units available at “affordable” prices or even free, or some aspects of government step in to put a ceiling on prices and invoke price gouging laws to rein in business attempts to raise prices. These actions then become hailed in the public media as reflecting a model of sensitivity and selfless generosity and contrasted against the demonized actions of any businesses insistent on raising their prices.

So how might we, in light of the answer I provided earlier about price increases, think clearly about these contrasting perspectives?

First, a little theory...

The allocation of scarce resources is at the heart of why we have the field of economics to begin with. The conceptualization that any economic unit, be it a person, household, a business, the government, a state, country or even the world faces the problem of not having enough resources to meet its wants and needs:

Individuals might be happy with their incomes but sometimes wish they had some extra in order to get some things done. Similarly, businesses perhaps want to expand into other markets, or engage in some costly innovation but might not have the means to do so. Governments are harangued by various interests wanting spending to improve the air, rivers and lakes, roads and bridges, schools, healthcare etc. all of which cannot be done simultaneously at levels desired given the limited budget it has to operate from.

What is to be done? Especially for society as a whole, how do we make choices from limited resources, when that means we must give up other desirable activities or outcomes? Should we put all preferences in a pot and pick randomly? Should we choose the first preferences that are presented (that come to mind) and ignore subsequent ones? Should we pick those preferences that come from particular groups or demographics in society first and work our way to others until we have depleted resources? Should we attempt to satisfy all preferences even if what we allocate to each is well below what is desired, or in some cases even meaningless when it falls below some critical threshold? The choice of an allocative mechanism could go on.

The core economic approach is to suggest that we do not waste resources, in a very economic sense of that word - if we cannot get every preference satisfied, then let us try to make every single resource count the most. While this does not allow us to escape the philosophical conundrum of identifying the best allocative mechanism, it is one we interpret narrowly in the sense of our preferences first having some explicit or implicit monetary valuation, then we allocate resources to where they are valued the most.

Markets are the economic institutions that make these types of allocations feasible.

While the economic approach is not necessarily superior per se to possibly other alternative allocative mechanisms, there is a reductionist argument that suggests that we are simply thinking about how we make decisions at the individual personal level and aggregating that into how we should, as a society, make such an allocative choice given an analogous scarcity problem.

The point is, suppose we are somewhat agreed that this is the way to go and have therefore chosen to organize economically through markets. How would markets make the allocative choice for us? Quite simply: Competitive markets will allocate the demand for goods to businesses that can supply them at the lowest cost, and allocate the supply of those goods to those who value them the most.

Only those products for which benefit valuations exceed cost valuations will be provided, and in quantities for which this holds, at the margin. So markets will necessarily exclude preferences, characterized as being inefficient, because they are preferences where cost exceeds benefit valuations at the margin.

To provide a familiar example, when I go to buy a product say a surgical face mask. If my preferences are such that I would like to purchase 10 of those, but having to pay a price of say $2 for each, I am only able to afford 4, because my benefit valuation associated with the fifth mask happens to be less than the price of $2, which is perhaps the cost at the margin associated with its supply.

The reason for my low valuation for the fifth may be related to my income, how much I really like or want the face masks or some other things going on in my life for which I would rather allocate the next $2 of my income to rather than buy the fifth mask, but my valuation is lower than $2 otherwise I would purchase it.

The price of the protective face mask sort of settled at $2 in a competitive setting as a result of the overall level of demand and supply for the product. In lay terms, as a result of the strength of preferences reflected in the public for the product coupled with how costly it is to produce them, given the other choices businesses have, to produce other desired products that use the same resources.

Now let's bring in the crisis...

The assumedly normal activity whereby we face prices and make choices is something most market economies are accustomed to. What suddenly seems to be troubling is the feeling that businesses seem to be taking advantage of a crisis to raise prices. This is in part because we normally think of businesses as choosing their own prices and not as in textbook models taking prices as given when operating in a competitive environment.

So why did these businesses not raise prices prior to the crisis? Well, it was not because of goodwill on their part. It was because the process I described earlier meant that they couldn't. The ability to raise prices would mean they would want to supply more, but no one would be willing to buy that extra provision, given their existing preferences. People may not even consider their previous quantities as justified anymore given all the other things that compete for their money incomes. The businesses would be left with excess production for which they have incurred costs but which no one is willing to buy.

So what has changed with the onset of the crisis?

Well, now people want the product. They really really want the product. It seems like everyone wants the product, and in perhaps unlimited quantities. The scarcity problem shows up again, and in an even starker fashion.

Recall though how this scarcity problem is addressed?

We allocate the products to those who value them the most. That was, is, and will remain the standing rule by which markets operate.

This is why the price has to go up, and will keep going up until the shortage from the increased demand has been eliminated. So nothing in the fundamental market process has changed.

This is true whether businesses have already incurred costs associated with providing existing quantities and cannot change their supply, or if they can increase their supply, since in order to supply more than they had planned they have to be offered a higher price for all units they will sell in order to cover the associated increase in their marginal costs.

Elasticities loom large

One more thing about prices. An important technical concept in economics with very real implications in the real world has to do with the price elasticity associated with a product. That is, given the nature of the product, what might be the magnitude of the reaction of potential buyers and sellers of the product when the price of the product changes (say, goes up).

When production has settled to some expected level of demand it may be difficult in the short term for suppliers to ramp up production to meet a sudden spike in demand. The product's supply is said in this context to be inelastic. This supply inelasticity was alluded to in the comment made earlier about the production of surgical masks at Prestige Ameritech: Ramping up supply would still fall short of meeting the requests being made for surgical masks, at least in the immediate short term.

Similarly an increase in the sense of urgency for the product akin to a life or death need for such a product makes the demand more inelastic, that is, more unlikely to change by much if the product's price changes. So when you couple a fairly inelastic supply with an increase in demand for a product where the demand becomes more inelastic, the result is a potentially very big spike in the price of the product as the normal market reaction.

This is perhaps why sellers may have tripled and quadrupled prices on surgical masks, hand sanitizers and similar products. Since there is no coordinated effort on setting a price some might simply be taking a rough guess at how high they should price them, but as sellers compete across open and accessible markets, the price should adjust to reflect the accurate valuation in the market, which may still be very high.

Price gouging?

It may seem unfair at first blush, but you have to think again about the situation. How is the allocation to be made when everybody wants the product and there is only so much available? Some would suggest that at least for existing quantities, there was an existing price of say $2 for the protective face mask. Those who come in first and order as many as they need should still be sold the product at $2.

Perhaps. But now we have to keep in mind that we are moving the allocation from markets to a first come first serve rule. To allocate to the quickest, the most mobile, and they may not be the ones in most need of the masks. For instance, suppose a supplier, realizing that there is a surge in demand, and having 100 masks left, sells them to a customer at the pre-crisis price of $2 per mask, and immediately some other customers come in seeking the buy the masks and ready to pay even higher than $2 because of an urgency associated with a need for the mask. Too bad for them? I guess.

More generally we would frown at a situation where you are about to buy a product and because it is the last item on the shelf the store keeps you from buying it and sells it some other "preferred" customer, preferred for whatever reason. We would be outraged if the preference bordered on race, affluence, or some other characteristics that diminishes your worth as a human in comparison with the preferred customer. This is something that the law therefore prohibits and tries to enforce.

To avoid this, ideally the price of the product should stay same if people are currently buying, but if the price change occurred out of foresight and before the rush, then perhaps nothing might be wrong with this. In any case even if we still have to frown on this because we cannot separate the normal market process from the potentially higher profits being earned on sales of existing supplies (that would have sold previously at the lower price), then here are two things to keep in mind.

First, additional supplies will require higher prices. This is because the additional production will come at higher marginal costs of production. We cannot presume that we know the profit margins being made by businesses, and even if we did and thought of them as being high, that is the incentive behind their willingness to supply in that business, and that margin may also be taking into account the reality that demand may fall as sharply as it has risen once the pandemic is past and the excess or backlog of supply (including workers hired to increase production) will have to go to waste (workers will be let go and might need to get paid severance packages).

Second, black markets will probably fill in the gap. The saying that everyone has a price may have importance in this context. Some who may have purchased the masks at the low price and believing that they have better odds of not contracting the virus may opt to take a risk and sell those masks under the counter, or even openly, to those in dire need of the masks and willing to pay any price. So again, the end user allocation of the product goes to those who value the product the most.

So while some businesses may accumulate social capital in the form of goodwill for not raising their prices given the increased demand for the products, the allocation may end up going to those with the means to pay the most for them, which is, recall, exactly how the market system works under normal circumstances.

A Role for Government?

It can be argued that perhaps the proper role of government in this setting should be rather to facilitate competition in these key markets by removing any market power that would enable businesses to hoard the product and inefficiently raise prices in tandem.

Another policy intervention would be to help subsidize the provision of additional masks and similar products so that businesses being incentivized by the subsidies will keep their prices from going up. An economic argument for a role for government to provide subsidies here could be because the face mask use provides positive benefits to others in society since the use by an infected person limits the spread of the disease to others in the public.

Further, to facilitate any social justice concerns about the increase in prices for those who are low income and vulnerable, part of the $8.3 billion package provided by Congress to fight the virus could include spending on the now higher priced masks and similar sanitizing products to make them freely available or at a reduced price to those who meet certain income guidelines.