Thursday, May 6, 2010

Price Gouging

Earlier this week some water pipe broke in Boston, leaving a few million metro area residents without water. Everyone responded, naturally, by buying bottled water, which created a shortage. In Econ 101 students learn that the natural way to resolve a shortage is to raise the price--then only the people who need the water badly enough to pay the higher price will still be willing to buy it. You continue to raise the price until there is no longer a shortage. This op-ed sums things up nicely. (HT: Greg Mankiw)

Of course, raising the price like that is price gouging which is unfair.

I like this story because it brings up a few important points about economic analysis.

1. Most people don't understand some basic reasoning in economics.

If you don't raise the price for water, then you can end up with people who desperately need it without and those who don't care so much with. That is what we call inefficient (technical term, not in the ordinary sense. Also, if you don't let the price rise, there is no incentive to find more bottled water, say by buying up the stock in New York, transporting it to Boston, and selling it at a mark-up to cover the transport cost.

2. Fairness is a cardinal value in distributing resources

Fairness is very important to people's conception of how we should divide up our resources. Akerlof and Shiller discuss fairness as one of the five Animal Spirits in their recent book.

3. Economists tend to use theories that are based on ranking preferences as if they were direct measures of happiness

This one is a not-quite-dead horse I'm flogging. But it's a fair complaint that doesn't get enough discussion. The fact that an allocation of water is inefficient doesn't mean it doesn't make net happiness greater than some efficient distributions.

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