Market Power

Musings by an academic economist on the power of markets and the power over markets.

Tuesday, April 05, 2005

Price Gouging

In Principles of Micro, my students have just finished covering material related to the efficiency of competitive markets. We examined why laws meant to keep prices artificially low bring inefficiencies into the market place and ensure that shortages will crop up. One can make a similar argument about artificially high prices. I suggested that during this summer's hurricane season, they should look for claims of price gouging after hurricanes come on shore and wonder what good laws against price gouging do.

For those who are impatient, we already have claims of price gouging:

With Pope John Paul II's funeral expected to draw up to 2 million people, at least one consumer group is accusing cafes, restaurants, grocery stores and hotels near St. Peter's Square of boosting prices to gouge tourists and pilgrims.
Keep in mind that this is a tremendously large and sudden change in demand:
In normal times, this would be a lull in tourism, after the rush of Easter and before the summer holidays. But consumer groups estimated Monday that local businesses would earn at least $122.5 million in about two weeks
Consider the market for restaurant meals. In a market system, what happens when there is tremendous and sudden increase in the demand for restaurant meals? Prices rise. Why do prices rise? Because an increase in the demand for restaurant meals increases the demand for the resources that produce them and these resources need to be compensated. In order to serve the influx of customers, restaurants will have to hire additional staff, food, cookware, chairs, tableware, etc. All these resources have alternative uses and to give these resources an incentive to temporarily relocate, restaurants have to give them an incentive to do so.

How do we ensure that adequate resources are there to meet the sudden, unplanned, and tremendous increase in demand?

We could take the bureaucratic route. We could schedule legislative hearings to determine whether or not the extra resources were needed and we could determine what the fair price for said resources would be. How long might this take? What are the opportunity costs of those in the deliberative process? Will the 2,000,000 people be adequately, quickly, and efficiently fed? How can we ensure that the government officials won't behave opportunistically?

A better way is to provide an incentive, via the price system, for people who own the necessary resources to divert them to where they are most wanted. Rising prices send a signal that more resources are needed in a market, resources that have alternative uses and, thus, opportunity costs. That way, we make sure that those who want to eat restaurant meals etc. can get them and get them efficiently.

But what about those renegade restaurants who are out there to screw the customer over? Aren't there going to be places that try to do this? Possibly. How do we ensure that the visitors don't get screwed?

Competition will help limit this. What happens to places that raise their prices "too much?" Restaurants that do so will have some potential customers "diverted" to other areas. Rome is a city of 3,000,000 and visitors have many choices in restaurants, meaning individual restaurants have little market power. I also imagine that these renegade restaurants will also be more likely to treat their customers poorly in other ways. When a business tries to screw over its customers (whether it comes through poor service or prices that don't match the quality that customers expect), markets tend to deal with them harshly.