Supports: Hubbard/O’Brien, Chapter 4, Economic Efficiency, Government Price Setting, and Taxes
Apply the Concept: Should the Government Limit Price Gouging in an Emergency?
Here’s the key point: In the long run, the market will respond to an increase in demand by increasing supply without an increase in price, but in the short run consumers as a group lose from a sharp increase in price.
In early 2020, the coronavirus epidemic spread through many countries, including the United States. The Centers for Disease Control encouraged people to thoroughly wash their hands and disinfect surfaces to help slow the spread of the virus. People flooded supermarkets and pharmacies to buy hand sanitizer, disinfectant wipes, and toilet paper. By March, these products had largely disappeared from store shelves. People who hoped to buy them on Amazon or eBay found that sellers were charging prices far above normal.
For instance, sellers on Amazon were charging $99.95 for large bottles of hand sanitizer that normally sell for $9.95. One seller was even charging $459 for a two-ounce bottle! Such large increases in the prices of essential goods, particularly during an emergency, is called price gouging and is against the law in 34 states. Many people consider price gouging immoral because it makes it difficult for people to afford essential goods during an emergency. During the coronavirus epidemic, using hand sanitizer was an important safety measure when people lacked easy access to soap and water. (Note: A list of state price gouging laws as of March 25, 2020 can be found here: https://consumer.findlaw.com/consumer-transactions/price-gouging-laws-by-state.html)
Laws against price gouging are essentially price ceilings set at the price of a good before the emergency began. Recall that a price ceiling is a legally determined maximum price that sellers may charge. What economic effect do price gouging laws have? It’s useful to distinguish the very short run, during which it isn’t possible to produce more of the good, and the medium run when additional production is possible.
The effect of price gouging laws in the very short run
The following graph shows the market for hand sanitizer in the very short run of a few weeks. Assume that the price of an 8-ounce bottle of hand sanitizer prior to the arrival of the coronavirus epidemic in the United States was $3.99. The normal level of demand is shown as demand curve, D1. In the very short run, the supply of hand sanitizer is fixed at the quantity, Q1, currently available at retail stores and on online sites such as Amazon. We show this fixed quantity as the vertical supply curve, S.
The increased demand for hand sanitizer resulting from the epidemic shifts the demand curve to the right from D1 to D2. In the absence of price gouging laws, the price will rise from $3.99 to a higher price, which we’ll assume is $9.99. Laws against price gouging (assuming they are enforced) will impose a price ceiling at $3.99. The result of the price ceiling is a shortage equal to the difference between the new quantity demanded, Q2, and the fixed supply Q1. The price ceiling results in consumers receiving consumer surplus equal to the area below demand curve D2 and above the price of $3.99, shown in the figure as the sum of A and B. If there is no price ceiling and the equilibrium price rises to $9.99, area B will become part of producer surplus, reducing consumer surplus to just area A. Sellers have gained from the higher price at the expense of buyers.
Remember, though, that in a market system prices play an important role in directing resources to their most valuable use. If the equilibrium price rises to $9.99, at point A on D2, the marginal benefit from the last bottle of sanitizer sold is equal to its price, which is the economically efficient outcome. With the imposition of a price ceiling, some buyers whose marginal benefits are represented by the values along D2 between point A and point B may buy bottles of sanitizer while some buyers with a higher marginal benefit may be unable to. Consider a bus driver or police officer who does not have easy access to soap and water. These people would have been willing to pay $9.99 for sanitizer but may be unable to find any because of the shortage resulting from the price ceiling. Now consider someone who spends most of his or her time at home or who already has a supply of hand sanitizer and would be unwilling to buy a bottle at a price of $9.99 decides to do so at a price of $3.99.
Someone with a low income may have greater difficulty paying $9.99 than would someone with a high income and so, holding everything else constant, we might expect that without a price ceiling more high-income people will be able to buy sanitizer than will low-income people. This consideration leads many people to support laws against price gouging even if they know that the laws reduce economic efficiency.
The effect of price gouging laws in the medium run
The following figure shows the more familiar situation when the time period is long enough for firms to increase production of hand sanitizer. (Note that this figure is similar to Figure 4.9 in the Hubbard and O’Brien textbook.) In this case, as demand shifts to the right from D1 to D2 because of the epidemic, in the absence of a price ceiling, the price will increase from $3.99 per bottle to $5.99 per bottle and the equilibrium quantity of bottles will increase from Q1 to Q3.
The supply curve, S, is upward sloping because we would expect that firms’ marginal cost of producing sanitizer will increase as they expand output. For example, in March 2020, an article in the Wall Street Journal described how EO Products, located in San Rafael, California, quadrupled its output of hand sanitizer by “running extra shifts, speeding up lines, hiring temporary workers and converting factory lines designed for other products to make hand sanitizer instead.” These actions made it possible for EO to increase the quantity of sanitizer it supplied, but meant that its marginal cost of production was increasing.
A price gouging law that kept the price of hand sanitizer fixed at $3.99 per bottle would result in the quantity of sanitizer supplied remaining at Q1, causing a shortage equal to the difference between Q2 and Q1. Note that the price ceiling eliminates the incentive for firms to increase production of sanitizer. Because marginal cost is increasing, firms will ordinarily need to receive a higher price in order to increase production. In fact, though, that EO Products President Tom Feegel decided not to raise his price despite the firm’s higher cost: “Raising prices at this time would not be in alignment with our core values.”
The price ceiling causes consumer surplus to increase by the area of rectangle A and fall by the area of rectangle B. Rectangle A would have been part of producer surplus in the absence of the price ceiling. In that sense, the price ceiling benefits buyers at the expense of sellers. Compared with the situation in which the price is allowed to rise to $5.99, producer surplus declines by the area of A plus the area of C. The areas of triangles B and C represent deadweight loss or the reduction in economic surplus resulting from the imposition of the price ceiling resulting from the price gouging law.
We can summarize the effects of the price gouging law shown in the figure:
- Consumers who are able to buy the sanitizer at the ceiling price of $3.99 gain.
- Consumers who would be able to buy the sanitizer at the equilibrium price $5.99 but are unable to find any at the ceiling price of $3.99 lose.
- Sellers experience a loss of producer surplus.
- Economy efficiency is reduced by an amount equal to the deadweight loss.
What happens in the market for hand sanitizer in the long run?
Suppose that the demand for hand sanitizer permanently increases as a result of the coronavirus epidemic because many people decide that it is now worthwhile to routinely sanitize their hands. In that case, we would expect to see an increase quantity of bottles of hand sanitizer sold with price ending up back at the original price of $3.99. Why wouldn’t the price need to be permanently higher? Remember that we expect the marginal cost of producing a good to increase as a firm produces more of a good during a given period of time.
For instance, if EO products has to pay workers a higher hourly wage to work more than 8 hours per day or hires new workers who initially aren’t as skilled at producing sanitizer, the company’s marginal cost will increase. But over time EO’s new workers will become more familiar with their jobs and the company will be able to hire enough workers so that none will have to work more than 8 hours per day. We would expect that EO’s marginal cost of producing sanitizer will eventually fall back to $3.99 per bottle and that the same will be true for other firms in the industry. As a result, the price declines back to $3.99.
In addition, the price increase to $5.99 may give other firms an incentive to begin producing hand sanitizer. If more firms enter the industry, in the long run, the supply curve for hand sanitizer will shift to the right, which will contribute to bringing the price back down to $3.99. In general, in the long run the market will respond to an increase in demand by increasing supply without an increase in price.
Sources: Sharon Terlep, “One Company’s Hands-On Effort to Ramp Up Sanitizer Production,” Wall Street Journal, March 16, 2020; Sharon Terlep, “Amazon Dogged by Price Gouging as Coronavirus Fears Grow,” Wall Street Journal, March 5, 2020; and Jack Nicas, “The Man With 17,700 Bottles of Hand Sanitizer Just Donated Them,” New York Times, March 15, 2020.
Many state laws against price gouging apply only during emergencies.
- Why might state governments decide that the laws should apply during emergencies rather than at all times?
- What protects consumers from price gouging during times that aren’t emergencies?
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