The International Economics
A Primer on Price Gouging in the Wake of Hurricane Katrina
September 6, 2005
The recent sudden surge in gasoline prices in the wake of Hurricane Katrina has resulted in the usual cries of price gouging and demands for the government to step in and "do" something to fix the problem. This response by the public and government, while expected and understandable, is also indicative of a strong lack of understanding by the general public of how the free market system can solve problems.
The problem at hand is the sudden realization that the supply of gasoline to the US market will be substantially reduced in the next few weeks and months. Hurricane Katrina has temporarily knocked out gasoline refineries and crude oil production in the Gulf of Mexico. Supply will be lower in subsequent weeks and months although no one is entirely sure by how much and for how long.
What follows below is a discussion of the different ways in which the gasoline shortfall can be handled. It will demonstrate that allowing the market to work, meaning leave the gas stations alone to set gas prices however they see fit, is the best solution to the problem. The worst solution is for the government to step in to try to solve it. Let's proceed with a series of questions and scenarios.
Q1: What happens if the price of gas stays the same in the face of a supply shortfall?
Many people argue that since the gasoline already under the ground at the service stations was purchased at the lower price prevailing last week, its price should not be raised despite new information about the coming shortage. The prices should only rise when the gas suppliers raise their prices, say next week. As for gasoline suppliers, those who have suffered no damage from the hurricane and whose plants continue to operate as before, they have no immediate extra costs and so should not raise the prices of gasoline again until their costs also rise. Other gasoline suppliers are simply cut off, unable to produce and supply to the market due to damage at their Gulf coast refineries. Their costs may rise but they shouldn't raise the price of their gasoline until the gas reaches the market in several weeks or months. Thus, according to this logic, gas prices should stay the same until several weeks after an imminent supply disruption.
Consider two gas stations. Phil's station is supplied by a refinery that is not affected by the hurricane. Phil's delivery is fine. He receives a gas delivery every two days to refill his near empty tanks. Dan's service station is across the street. He also receives a delivery every two days but his gas is supplied by a refinery temporarily shut down by the hurricane. Dan's supply is disrupted. Suppose 20% of the gasoline supplies are disrupted for an unknown period of time, it may be several weeks or months, nobody knows.
Now suppose all gas station owners maintain their prices at the same level despite the impending shortfall. What would happen?
First, since the prices remain the same, demand for gas would also initially remain the same. Cars and trucks would fill up on gas during the day and night and the gasoline supply would drop at the same rate as before. In a few days stations like Dan's will sell all its gasoline, but since his supplier is temporarily closed he cannot fill up in two days as he always did before. So he will have to shut down until he can get another delivery. The same will happen for all other stations with disrupted supplies like Dan's.
At first, Phil will sell his gas at the same rate and will run out of gas in two days just as his next shipment arrives. However, after a few days, customers who used to get gas from Dan, can't any longer, since he is shut down. So they will shift to stations like Phil's. With more customers filling up, Phil will notice that instead of running out of gas in two days just as the next shipment arrives, he will run out in 1½ days or 1 day. If his shipments continue every two days, he will have to close every other day or so and wait for his next delivery to arrive.
In this scenario, consumers will quickly learn that some stations have no gas and others are running out of gas and temporarily close. This will cause some worry and concern about whether the situation will worsen. If it gets worse, gas may become very hard to find.
Consumers will reasonably respond to this situation by hoarding. When they can find gas, they will fill up their tanks. Have an infrequently used vehicle in the family? Better fill that fuel tank too. Got any 5 or 10 gallon gas containers? Might as well fill up those, just in case. Everyone will envision themselves unable to get the gas they want and need in the next few weeks and will respond by purchasing as much as possible when allowed.
This behavior will actually cause a temporary increase in the demand for gasoline. People will want to buy 10, 15, or 20% more gasoline than last week at a time when the total supply has actually fallen 20%. This response will lead gas stations to run out of gas even sooner, inspiring even more worries and concerns raising the immediate demand for gas even more.
This is the point where panic often erupts. When a station is open selling gas, customers will flock to it lining up for blocks to fill their tanks. People will begin to follow tanker trucks to their next stop to try to be the first in line. And people will begin to line up at gas stations who expect to receive a delivery soon. The sight of gas lines will fuel more fears and begin to make people more desperate.
When lines form to buy a product, it is a sign of a market breaking down. It is also a dangerous, unfortunate and pointless circumstance; dangerous because tempers will rise and disputes will occur; unfortunate because it will waste people's time and lead to other negative economic consequences; and pointless because there is a simple method to avoid the catastrophe.
Consider these stories of people waiting in line for gas.
Pauline owns a pharmacy that delivers medicines throughout the neighborhood. She is sitting in a gas line early in the morning to be sure she can make deliveries especially for her elderly customers for the next few days. If she weren't there she'd be getting her kids ready for school but today they have to fend for themselves. Pauline is worried and guilty about that.
Randy is a retired veteran, he doesn't drive much, but wants to fill his tank up just in case. He would be at home watching the morning TV shows if he weren't here.
Alex works for an architectural company in the city. She drives 30 minutes to and from work each day. One tank is enough to last a week usually. Today she is late since she normally begins at 7am.
Clint is a college student planning a road trip to the beach for the weekend. One tank will get him and his friends there, but he is worried whether he'll be able to get enough gas to return. He brought a textbook with him to read in line but has decided to sleep instead.
Finally, Darcy just received a phone call and learned that her mother has been rushed to the hospital. Her condition is critical and she may not live for more than another day. Darcy's financial situation is poor and she cannot afford to fly to her mother. Besides her mother lives in a small rural community and the quickest and easiest way there is by car.
The gas line will be filled with people and each car and truck will have a different story or situation. Some people, like those in a hurry to get to work, or others with a true emergency, may try to cut in front of others in the line. This will raise the anger of those behind in the line. Fights may break out. In the past, (the 1970s) shootings sometimes occur. Gas lines can become ugly.
Gas stations owners in this situation may try to make their gas last longer, and serve more customers, by limiting the quantity each customer can buy. Stations may put a limit of $25 of gas, or a 10 gallon limit. This kind of limit may be fine for retired Randy, Alex the architect and college student Clint, but for Pauline the pharmacist, and Darcy whose mother is dying, limits on gas purchases will make their lives much harder. Each is expected to use gas quickly and will simply find themselves in another gas line, perhaps before the day is over. Limits on sales are likely to infuriate these customers, especially Darcy. This will add to the tension among those in line and create an even more volatile situation.
Rather than leaving prices at their original levels, an alternative response is for service stations to raise their prices suddenly to force a reduction in demand. Indeed, Dan's station may not be sure when its next delivery will be and may want its gas to last at least until then. In this way it can remain open for business and continue to make sales in its MiniMart. If it closes its doors, people are unlikely to use the Mart if they don't also stop for gas. However, it will not be obvious, in this case, how high he would have to raise his price to choke off a sufficient amount of demand.
The same problem will soon arise for Phil's service station. He recognizes that since future supply will fall, demand will exceed available supplies in the next few weeks. He too may wish to raise price to keep demand in check.
Now normally, the effect of an increase in the price is to reduce demand. However, in this case the price increase can have a perverse effect. As we saw in the aftermath of Hurricane Katrina, after gas prices shot up from about $2.60 to $3.20 or $3.40 per gallon, people immediately began to fear a new gas crisis was brewing. Some people remember the gas lines in the 1970s. For those who do not, there was a fear that an immediate increase in price to $3.40 might be followed soon by another increase in the near future. If this were the case, filling up one's gas tank now may be better than waiting till you really need it later, because the price may be even higher then. This is an expectations effect.
Thus, the effect of the price increase was to raise demand initially, and to set off a mini-panic. People did rush to top off their gas tanks, especially because of heavier travel plans over the labor day weekend. I was one of them with a short weekend trip planned. I also observed several people filling up extra 5 gallon gas tanks. The increase in demand caused some stations to run out of gas and also created a few short gas lines.
As the prices rose, one thing seemed clear, the station owners didn't know what the price for gasoline should be. The "right price" would be that which would lower demand sufficiently over the next few weeks to match the lower supply. However, no one really knows precisely how much less gas supply there will be. Also, station owners needed to contend with the expectations effect leading consumers to increase their initial demand. Thus some stations raised their price a little, others a lot. In a few places station owners raised prices to as much as $6 a gallon.
On the consumer side, despite some initial hoarding, consumers will also respond by reducing consumption. Thus, although retired Randy may initially fill up his tank once the prices rise, he is unlikely to drive much since the fill up was so much more expensive. College student Cliff also may fill up his tank but the uncertainty about whether gas would be easily available for the return trip may cause him and friends to stay closer to home for the weekend. Alex the architect may also fill up her tank, but may decide to take the city's metro into work for several days to reduce her gas consumption. Pauline the pharmacist still needs to make the same number of prescription deliveries, so may not change her demand. Finally Darcy, with the dying mother, will probably demand more gas than usual this week due to her unexpected trip. Although not at first, eventually and in the aggregate, the higher prices for gas will eventually reduce the nation's total demand.
Most importantly though, if gas prices rise fast enough and reduce demand sufficiently, gas stations will not close, gas lines will not form (except perhaps in the initial confusion), and anyone who needs gas will be able to pull up to a station and buy as much as they want. There will be no need to ration, or to assess who has a greater or lesser need. That rationing will take place by individual choice. Randy and Cliff and Alex will cut back their demand, while Pauline maintains hers and Darcy's demand increases. Darcy, whose need for gas this week is clearly the greatest among this group, will not need to suffer the hardship of waiting in a long line to get enough gas to drive to her sick mother. She will also not need to worry about filling up along the way. The gas will be there when she needs it.
This feature of markets is something most people take for granted. Generally, gas is available to the consumer to purchase whenever he wants (there's always a station open somewhere) and in whatever quantity he or she wants. Sure, sometimes the price is higher and we fret the cost while other times the price is lower. But when the price is set appropriately, supply of gas will just about equal the demand, and it will always be there.
Q3: What about the stations that raised their gas price to $6 a gallon? Surely that must be price gouging and needs to be stopped.
Well suppose Dan's service station learns that it is very unlikely it will receive another gasoline delivery during the next week. Suppose it also wishes to stay open for as long as it can. As prices are raised by stations around Dan and as the hording begins due to the initial uncertainty, Dan reacts by posting an extremely high price to ward off hoarders and maintain his supply. If anyone does stop in to buy, he, of course, will make a substantial profit on each gallon. But he will also maintain his stock for longer than anyone else.
If the initial shortfall in the first week is substantial, and the hoarding is excessive, one may witness some stations running out of gas and the formation of gas lines in panic. However, as lines are forming at stations pricing at $3.40 or $3.50, chances are good that no one is waiting at Dan's station. He may have a slow stream of customers, but they will be people who are more desperate for gas and do not want to wait. Wealthier individuals may take advantage of this easier option, thus Dan will gouge the wealthy. But others like Darcy may find Dan's station a godsend. Her only other option to get gas would be to wait in a long line and postpone her departure. She may become desperate and try to cut in line. This is the kind of desperation that can inspire an outbreak of violence. However, if Dan's station is open with a substantially higher price, Darcy will be able to fill up quickly and be on her way. Of course she won't be happy paying so much for gas, but it will still be cheaper than a plane ticket and most importantly she will not be delayed.
Similarly, Dan's high priced gas may benefit many others who need gas quickly and cannot afford, for either business or personal reasons, to wait in a long line. Thus, surprisingly, his "price gouging" actually has a positive effect.
If the long lines do not form with higher prices and if demand is curtailed sufficiently with prices around $3.50, Dan may soon find that no one comes in to buy his $6 gas. In this case, once his next gas delivery becomes imminent, he will have no choice but to lower his price to get customers to return. He will not be able to make a substantial profit since no one will buy his expensive gas. Thus, substantial price increases cannot be maintained for too long. They will be self regulating.
Finally, suppose the local or state government stepped in and threatened to punish Dan for price gouging. It is against the law in some states to raise prices to "unconscionable levels." Well, in the case when long lines form in the transition, Dan will have to lower his price, accept lines of customers and sell out. Customers like Darcy, with an unexpected and unusual demand for a full tank of gas, will be forced back into a long line with even greater despair.
Q4: But don't higher prices mean that someone is going to make greater profits, if not the service stations, then the gasoline refineries themselves?
Yes, that's absolutely right! Consider Phil's service station, whose supply is fine. Phil receives his gasoline from a refinery that was not affected by the hurricane. His costs have not increased, nor have the immediate costs of production at the refinery. Supply to Phil will continue at the same rate with a new delivery every two days. Thus, Phil will continue to sell the same quantity as before, only now he is selling at a substantial premium relative to the previous week. Same costs, same supply, but higher prices and revenues has to mean greater profit than before. So Phil will make more money as will all the other stations and suppliers whose supply is not disrupted. (Note: someone in the supply chain will make more money. If not Phil, then the gas company that supplies Phil)
For stations like Dan's, whose supply is disrupted, cost will also likely remain stable for awhile, but supply will fall substantially. Higher prices will allow for greater profit of the gas sold, but gas will be sold at a slower rate. For the refineries who must shut down for repairs, or whose supply of crude oil from the Gulf is disrupted, costs may rise. Thus, these suppliers who are most responsible for the gas supply reduction will probably not make greater profit. However, these stations might consist of just 20% of the total market. All of the rest is supplied by producers like Phil whose supply is fine. And they are all making more money.
This type of supply reduction actually allows producers to act more like a monopoly firm, or an effective cartel. A monopoly exists when there is one firm supplying a product to a market of consumers. To maximize profits, a monopoly would restrict its supply and raise up its price, relative to what it would do in a competitive market. A monopoly can't raise it price too excessively or demand would dry up completely. Thus, it must do so to just the right level to get the maximum profit. This level of profit will be substantially higher than it would be if there were lots of competition.
If there are a small number of producers in a market, the same monopoly outcome could be realized if the group all agreed to reduce their output and raise prices together. In this case we would say the group has formed a cartel to try to reap monopoly profits.
In the market for gas then, if producers could all lower their supply and raise price, they must be able to make more money by doing so. In effect this is what gasoline firms are achieving.
However, they are not achieving this outcome by forming a cartel or creating a monopoly. Instead they realize monopoly-like profit because a natural disaster knocks out the supply of some of the competition. Nature facilitates the making of monopoly profit for all the rest.
Q5: Ah ha! Then it is price gouging since gasoline firms will reap monopoly-like profits when the prices rise, right?
Well, not really. Price gouging accurately describes the behavior of a profit maximizing firm in a market; a firm with no competition that purposely restricts its output and raises its price to make a greater profit. This type of behavior is clearly detrimental to consumers in a market. However, this outcome arises because there is no competition. Competition by other producers is all that is needed to eliminate the conditions in which price gouging (or monopoly profit) can arise.
In the gasoline market there is plenty of competition. The latest supply disruption affected a handful of producers but leaves many others unaffected. Dozens of countries produce and ship the crude oil used to produce the gasoline. Hundreds of companies refine and produce gasoline around the world. Although the petroleum market is seemingly dominated by several well-known companies (Shell, BP, Amoco, Exxon-Mobil to name a few), these companies are competing fiercely with each other for sales and profit.
What matters here is not whether firms are making extra profit, but whether competition is continuing. In the aftermath of the hurricane, gas companies will all raise their prices to balance supply and demand, and will also reap monopoly-like profit for awhile. But, competition between these firms has not been wiped-out by the hurricane.
As long as competition continues and as long as there is no cartel formation, higher prices and profit to the gas industry is precisely the best medicine for the market. In the aftermath of Hurricane Katrina, these conditions apply.
Q6: OK, then what's the lesson in all of this?
There are several lessons. First of all we should recognize that any attempt to maintain lower prices in the wake of reduced gasoline supplies will lead to a scenario of gas lines, anxiety, angry consumers, and probably violence. This is not an outcome anyone should want. Price controls are a villain, not a friend!
The outcome we do want is gas stations that are always open and with every consumer free to purchase as much as he wants. Unfortunately, this outcome can only arise with higher prices. Higher prices will be aggravating to consumers, but they will force conservation while at the same time allowing those most in need of gas to get as much as they want, whenever they want.
To assure the better outcome there is a simple solution. Simply allow producers to seek profit. If gas suppliers act to make as much money as they can in this situation, then they will be driven to raise prices as soon as a supply reduction becomes likely. This immediate reaction will force the eventual conservation of gas and restriction of demand to come about much sooner. By the time the supply disruption really hits, demand will be lower. Gas stations will remain open and consumers will be free to buy any quantity.
The higher profit being made will also inspire a quicker supply response. Companies with damaged facilities will rush to repair them because their sooner gas supply resumes, the more monopoly-like profit one will make. Foreign gasoline suppliers, such as in Europe, may consider putting gasoline in a tanker and shipping it for sale in the US since higher profit margins means more money for them too. All of these actions will eventually raise total US supply, and reduce the prices back to their original state. In fact, the greater the monopoly-like profit, the faster firms will respond with greater supply. Eventually the monopoly-like profit will wither away due to the competition.
Profit seeking and competition are the keys to a successful and rapid adjustment.
Q7: Shouldn't the government step in and do something to ameliorate the situation? What about poorer people who can't afford the much higher gas prices?
No, all government interventions to try to correct the market will invariably make things worse. Consider the price gouging laws. These are meant to prevent firms from raising their prices excessively in response to a disaster. However, as we saw, when prices do not rise at all, supply disappears, lines form, and dangerous outcomes result. If the supply reduction is severe and prices rise, but not sufficiently due to price gouging laws, similar things will happen.
If the government attempts to invoke rationing, perhaps mandating that consumers only buy 10 gallons of gas at a time, then anger and anxiety among those in lines will become even worse. Those in desperate need for gas, like Darcy, will not be well served by the government's actions.
But what about the effects of higher prices on the poor? Well the best way to answer this is to consider Darcy again. She could not afford an airplane ticket to visit her dying mother and was forced to drive instead. If the government intervenes to keep prices down to help her, then she will face long lines and a long wait to see her mother. If the government does not intervene, then gas will always be available in any quantity. She may have to buy $6 gas, but at least it would be there.
Poor people are always affected to a greater degree when the prices of essential items rise significantly. This case would be no different. However, rich and poor alike are always better served when the products they want are always available. Darcy and all other poor citizens are clearly better off when the government stays out.
Last Updated on 1/18/07