Shopping carts filled with toilet paper. Empty shelves. Shaming on social media. The Coronavirus has upended daily life and prompted a debate between the importance of individual and economic health. Yet one topic has near-universal agreement: price gouging is bad. At first glance, this makes sense. Price gouging combines two things Americans love to hate, increased prices and corporate profits. Take a closer look, however, and it becomes clear the effects of price gouging are nuanced. In certain circumstances, it is not reprehensible, but in fact, necessary.
It is important to remember that prices are not set at random, nor are they the result of the secret deliberations of a shadowy cabal. Instead, prices are generally set by the free market. Thousands of sellers and millions of consumers interact with each other, with sellers trying to maximize profits and consumers trying to maximize welfare. The famed invisible hand of Adam Smith acts as if a benevolent social planner was maximizing the benefit of society, at least in theory. The result is an efficient way to allocate a scarce resource to those that have the highest value.
Today, the news has been filled with images and stories of a nationwide toilet paper shortage. Usually, shortages occur because of a breakdown in the supply chain or a vast increase in usage. Instead, this shortage occurred because a few consumers thought they should have a personal inventory. Once a few shelves emptied, more people thought they should also have a personal supply, and it snowballed from there.
All of this could have been prevented if stores were allowed to do what they usually do when the demand for a good increases - raise prices. Then, only those who actually needed toilet paper would buy it, and those who otherwise are buying entire pallets to store in their basement, or resell themselves, would not bother.
With everyday items, price gouging during a crisis, far from being malicious, helps ensure that those who most need a good are the ones who get it. Again, this is the entire point of prices in the first place. No one would advocate for a government order that all supermarket items must be sold at a 90 percent discount. The result would be hoarding on an unprecedented scale and empty shelves for weeks. Yet this is exactly what the government does when it prevents price gouging. The price of toilet paper should have been allowed to double, quadruple, or increase to any factor of magnitude the market sees fit.
Some will quickly point out that it allows businesses to profit from the misery of others. This is true to some extent. Somewhere along the supply chain, there would be large profits to be had. On the other hand, these profits would again serve a purpose, the allocation of a scarce resource. Furthermore, if any business sets the price too high, making profits well above any other firm, then consumers would shop elsewhere. This is what allows gasoline prices to fluctuate widely through time but hardly at all in a localized area. If one gas station charged notably more than another down the street, the market will respond. Most importantly, those high profits allow firms to reinvest some of their earnings to increase production, which will then help prices stabilize.
The second criticism is that certain goods, such as those relating to health care, do not exist in a free market. The invisible hand ceases to work in non-competitive industries and thus prices must be regulated. This has my full support. Where price gouging should be allowed is only in markets that are relatively open and unregulated.
A third concern is that price gouging would result in a somewhat efficient allocation among those with disposable income, but low-income citizens would be forced out of the market. This is a valid criticism and needs to be taken seriously. If some cannot afford a good, then prices no longer allocate resources solely based on need. The US government already has methods to deal with this, and EBT and other social safety nets help avoid undue hardship for low-income individuals.
Compared to the rows of empty shelves, however, a world with price gouging is the preferable option. When prices are not allowed to increase, the allocation of goods is random. Consumers who happen to be in the right place at the right time are those who obtain that scarce resource. Only by allowing prices to function as an allocation mechanism can we ensure the best outcome for society.