Wednesday, 11 April 2012

Price Gouging

All of us take great displeasure when the price of a particular good rises. In the deflationary world we live in its very easy to dismiss rising prices as companies simply "profiteering" or believe that we are all being short changed in some form. Persistent price rises as I have explained can only occur when the Government inflates the monopolistic control of the money supply, however price rises can still occur in free market system usually only for short periods of time. Allowing the freedom for price discovery is a vital concept in economics. Never should a Government implement price controls or rationing. 

The theory behind a price is simple. Generally it represents the costs of inputs into producing a product be it the labour, the raw materials, transportation to sell it and so forth. Part of the price represents the a small margin of profit that goes to the owner (or shareholders) or in many cases is re-invested back into increasing production. Prices find a natural point due to competing businesses that offer similar products and a buyers intention to find the best quality product for the price. Costs are lowered, through the freedom of individuals along with the compounding of various innovations over the years.

How can a price rise under these circumstances? Possibly a natural disaster that can disrupt a socieities infrastructure, or as we saw recently in the UK at our petrol stations, a surge in demand caused by the spectre of a Union Strike. With Strikes looming in many segments of industry, the most recent of which was petrol tank drivers, the public did what is usually associated with socialist countries and that was stock up on as much of the product as possible. The direct outcome of the spike in demand was shortages and in some cases mild price hikes (I suspect the price hikes were not as large as would usually be expected in a true shortage situation as deliveries were still due on the normal times later in the week and strikes would have been some way off).

Peoples initial reaction to the price rises were one of the oil companies "profiteering" from peoples misfortune. Lets presume the Government passed a law to forbid price discovery ie fixing the price. In the recent situation people would consume the same amount as before. The product would run out even quicker as demand would not decrease. Even worse as the price remains low, supply would not increase to match the new higher demand as the profit dynamic, which would potentially be reinvested into increasing production, would not occur. As supply and demand are out of balance, either the product becomes available to the first come, first served, with nothing for everyone else, or the Government steps in and rations it to everyone. 

If the price wasn't allowed to rise then we couldn't buy a product under our free will and the decision is taken out of our hands. If the price of petrol rises it gives people options. Suddenly it becomes more economical to walk or cycle places, people may wish to car pool together, use public transport, avoid unessential journeys and so on. This acts to restrict demand as a resource becomes more scarce. Meanwhile on the supply side if the profit margin increases more of socieities resources are mobilised in meeting this new supply demand dynamic. Companies increase investment into getting more of the product to market, investing in production and distribution capacity. 

While all the above occurs the consumer can use as much petrol as they wish (or their wallet can stretch too). What should always occur is the above process, unfettered by any Government with prices channelling resources. "Price Gouging" as people wish to proclaim is part of this process and appears when supply and demand are out of step. 

A recent example of a natural disaster causing "Price Gouging" was the ash cloud that appeared over Europe, grounding many flights. Obviously this created a backlog of people who couldn't go back home and were stuck abroad, in places such as Hong Kong who were getting connecting flights back to Europe. The news reported prices of rooms going for double or triple the normal price and predictably people began moaning about price gouging when in fact this process was helping people. Quite clearly there were not enough B&Bs or Hotels to take in the stranded people, so prices rose to try and solve the supply demand imbalance created by the natural disaster. People would then be incentivised to opt for smaller rooms then they would usually stay in, one of many eventualities that would help control demand. As prices rise new sources of supply would appear, for example local citizens may feel it is worth the inconvenience of taking in a stranger for the night if the price is high enough. If the Government was to fix the price of a room then this option, one of many, would not occur. 

Sometimes companies (forced by political pressure) resort to rationing to solve supply demand problems. In the UK a large section of the country has a hose pipe ban (a country not known for its arid and dry climate). Rather than allowing the price to rise, the companies have resorted to an outright ban that prohibits the use of a hose pipe in the vein attempt to control demand. A ban is politically more acceptable than rising utility prices due to the delusional British peoples view that water on tap should be practically free (Ofwat like many other UK utility regulators put pressure on companies to not raise prices for political expediency).

Rather than a ban the water companies should be using prices to solve the issue. Rising prices would be the outcome, people would then naturally ration the resource under their own free will. People who still felt it was worth the price to water their garden would have the option, others could impose the ban themselves. With a higher price, the companies would have larger profits. Shareholders would either opt for these in the form of dividends, or to maximise their future returns put more capital back into investment to bring more water to market.  If our water market was truly run under free market principles then other competitors would enter the market noticing the profit discrepancy. More innovations would ensue as competition would increase in the sector. Desalination efforts, for example, could be looked at as it would become more viable with a higher price, therefore bringing increased scientific effort into the field. Ultimately this lowers the cost of a product over the long term and benefits the poorest within society. A number of market innovations and events could occur, that's not for me to comment on, that's for entrepreneurship to act and create on.

If you still believe that Governments can ignore prices for the common good, then be my guest, but as history and rational thought proves it always exacerbates supply demand imbalances. Some politicians actual realise this, and seek to introduce prices to solve state induced problems but this does not win votes. A politicians job is to gain power by making unrealistic promises. Arguing against Price Gouging is always a vote winner because without any rigor or understanding of the dynamics, only its primary effect is seen, that of lowering consumers purchasing power of a given product. As detailed, its all for our common good and helps increase supply over the long term thereby making products more readily available to all sections of society.

2 comments:

  1. Hi,

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  2. One interesting point is that when it comes to oil, people tend to forget that it is a global fungible commodity. It it not UK oil companies nor European oil companies that are determining prices, is the world market. Moaning about price gouging in that situation is at best uninformed and at worst just stupid.

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