The debate over the morality and efficiency of so-called “price gouging” during natural disasters and other emergencies provides a unique opportunity to explore some of the most fundamental ideas in economics. Understanding those ideas is important not just for the economics of emergencies, but for how market economies operate in more normal times and why they are superior to the alternatives.

The biggest advantage of market economies is the way in which they tie together how we decide who will get to purchase and consume goods with the way in which those goods are supplied. Market prices are not only a good way of determining who should get goods. They also work to encourage people to supply more or less of the good depending on how much in demand those goods are.

If Not Prices, Then What?

To see this, consider the various alternatives there are to allocating goods on the basis of people’s willingness to pay the market price for them. Suppose we have a big pile of stuff on the floor in front of us. How might we determine, other than through selling them at a market price, who will get to acquire those goods?

We could do “first come, first served.” We could have some sort of lottery system by which random people acquire the right to take goods. We could distribute the goods by dividing them equally among the people present. We could also use some sort of merit system, or distribution according to some concept of need. We could also do “might makes right,” and let people fight it out to get stuff.

All of these are at least possible ways that we might determine who gets to consume what. We can also identify advantages and disadvantages to each one.

Distribution by lottery or equality seems more fair in one sense in that it does not take into account people’s ability to pay the market price. However, it’s perhaps unfair in another sense in that it also does not take into account how important the want is that those goods will satisfy. If we were to allocate coats this way, it might not take into account whether someone lives in a colder or warmer climate, or the differences in their typical body temperature or how much they like or dislike being warm or cold. More urgent desires for the good have no way to be expressed and satisfied.

Systems based on merit and need run into all kinds of difficulty in both defining and demonstrating whatever notions of merit or need might be employed. A great deal of time and energy would have to be spent dealing with such debates, which counts as a cost against whatever benefit we might identify in such systems.

“First come, first served” also leads to people expending resources to get an early place in line. With market price allocation systems, those resources could be devoted to more valued uses. Queue-based allocation systems also favor those with the lowest opportunity cost of their time. It’s not clear why this is either more efficient or more fair than systems driven by willingness to pay.

“Might makes right” suffers from similar problems. It would favor some people over others for reasons that don’t seem connected to any real social benefit. In addition, once one person picks up a baseball bat to get his share of stuff, everyone else has an incentive to get either a bat of their own, or something bigger and more damaging, to ensure they get some stuff. Not only does this involve all kinds of socially wasteful expenditures, it will likely continue to escalate and it will waste a lot of human capital as well.

Astute readers might notice how this example is a very nice parallel to the way special interest groups and others lobby government to get legislation passed to help them or harm their competition. This activity, what economists call “rent-seeking,” demonstrates that allocation through the political process is a more subtle version of “might makes right.”

So each of these alternative non-price distribution systems has some advantages and some disadvantages. Even if we think the advantages outweigh the disadvantages I’ve listed above (and that seems unlikely), each and every one of these non-price systems has one huge disadvantage that we have not discussed: none of them provide any information or incentives with respect to supplying the good!

A Problem of Production, Not Just Distribution

Notice that I started my example with a “pile of stuff on the floor.” By assumption, the supply of stuff just appeared, and the challenge was to figure out who was going to get it. But in the real world, that’s not the problem we face. Stuff just doesn’t appear by magic – it needs to be supplied by human actors engaging in production plans.

All of those non-price allocation processes will eventually use up the existing supply of goods without incorporating any way to inform and incentivize people to then supply more of the goods. They “work” as allocation mechanisms only if we ignore the question of how to get more of the goods.

By contrast, compare this to how allocation by market price and willingness to pay works. First, the price enables people to make informed decisions about whether the want they wish to satisfy is urgent enough to justify using scarce resources to do so. When the price of a good goes up, we have to consider carefully whether our desired use of the good is worth it or not. This feature of market prices helps to ensure that goods get allocated to their most valued uses.

Second, changes in prices communicate to actual and potential producer/sellers how valuable the good is. If people begin to value something more intensely and bid up the price, not only does that mean that everyone else has to reconsider their use of the good, it informs and incentivizes people to produce more of the good.

More generally, the existence of a market price, regardless of how it might be changing, provides the information and incentive to produce. Again, not one of the alternative allocation systems even concerns itself with the question of supply. They all implicitly assume that stuff just “appears.” None of them has any way of assuring that once the current supply is exhausted that more will be available.

Emergency Economics

We can now see how these fundamental ideas apply in the context of emergencies and so-called price gouging. In the recovery from a natural disaster, things like gas and water are in greater demand than usual and may also face constraints on their supply. This drives up the market price to levels well above what is typical. Consumers and others frequently call this exploitative and most states have laws against raising prices “excessively” high during such situations.

One effect of the higher prices is to force consumers to consider carefully their use of the resource. If bottled water prices skyrocket, people will be far less likely to use bottles to give their pets a bath and more likely to use them for more urgent wants. Rising prices lead to better prioritizing of use, which is exactly what we want when resources have become more scarce. Enforcing anti-gouging laws eliminates the necessity to engage in this crucial prioritization process.

If such laws are enforced, they will cause prices to be unable to communicate the value of the good in question, forcing sellers to make use of one of the non-price allocation processes, most often “first come, first served.” But sometimes we see lotteries or attempts at equality through limits on how much people can buy. And we do sometimes see violence. In all of these cases, it doesn’t make the good cheaper. Rather it just shifts the costs away from paying money to all of the other things we discussed above (e.g., waiting in line, getting beat up, not getting goods you really desire, etc.)

The problem with laws that try to prevent monetary prices from rising is that they short-circuit the process by which more supplies of the good will be made available. Rising short-run prices work like a signal flare to alert existing and potential suppliers that there is money to be made by selling in that market. This encourages them to provide more of the good, which drives the price back down to more typical levels over time.

Rising water prices make it worthwhile for people from far away to bring water to the recovery effort in Texas and make people think twice about how they will use that water. If prices are capped by law, much less water will be supplied, and the existing supply will be used less wisely.

The laws of economics are not suspended in an emergency, no matter what the laws of politicians attempt to do. When goods are more scarce, they will be costly to obtain, whether those costs are in terms of money or something else. The importance of letting market prices do their job and determining who gets what is that this process is also the way in which we make sure that there is stuff to be allocated in the first place. The only way to make sure we have sufficient production is to let market prices determine consumption.