Pricing under pressure

(featured image credit: Alex W)

Should morality, rather than the market, dictate the right price of goods and services in emergency situations?

In his book Misbehaving, behavioural economist Richard Thaler relates an interesting experiment he conducted with Daniel Kahneman and Jack Knetsch. In the days when Amazon’s Mechanical Turk was but a mere twinkle in Jeff Bezos’ eye, they got a bunch of randomly chosen Canadian citizens to give their views on the fairness (or lack thereof) of economic transactions. In one famous example, they asked whether it is fair for a shop to raise the price of a snow shovel from $15 to $20 the morning after a large snowstorm.

The responses showed most people would find this a despicable action: 82% thought it unfair (and 18% saw no problems with it). This goes against conventional economic theory: when supply is outstripped by demand, prices will rise to a level that will just clear the market. Everyone who is willing to pay at least the market price gets a shovel, and no shovels remain unsold.

shovelmommy

Selling shovels, not pole dancing! (And not a genuine picture)

This is one important role that market prices play. They ensure that scarce resources, in this case the shop’s limited supply of shovels, are allocated where they are valued the most (measured by the willingness to pay of the buyer).

Do higher prices lead to a better outcome?

Yet that economic “law” clearly does not find favour with non-economists. This was apparent again as hurricanes Harvey and Irma devastated Houston and much of Florida. According to a New York Times article, more than 8,000 complaints of price gouging for supplies like fuel and food were made. Many people tend to have a strong intuitive concept of a price: it should be production cost plus a modest profit margin (this is captured in the labour theory of value).  Rising prices, especially if they are manifestly not related to a rise in production cost, look like profiteering.

The problem is that this does not address relative scarcity – the imbalance between supply and demand. If prices are frozen, the allocation of scarce goods and services will happen in other ways, but it is unlikely to be optimum. In The Ethics of Price Gouging, Matt Zwolinski, an ethicist at the University of San Diego, illustrates this with a story about a hotel owner accused of gouging by doubling his room prices to $100 after hurricane Charley in 2004. At the ordinary price, a family might have rented a separate room for the children, for example, while at the actual price they might share one room, thus making the available supply go further.

Something similar can apply to consumables like fuel. Higher prices mean people will only buy what they need (reducing hoarding and leaving more for others), and will be careful not to waste it on relatively frivolous journeys. This applies especially to the behaviour of people who are less affected by the emergency.

High prices are also a signal to increase supply. In an article in Reason, then president of the John Locke foundation, John Hood, relates how his neighbour, a construction worker, took time off after hurricane Hugo in 1989. Loading up his tools and chainsaw in his truck, he said he was off to Charlotte, having “heard that one could make really good money cutting trees and clearing debris.”

Wisdom from the past

Talking of John Locke, the economists’ argument that the market should set the price has authoritative support. More than 300 years ago, the famous 17th century philosopher examined the morality of market prices in a short essay, Venditio (well worth reading). Through four examples, he shows that a supplier selling at the market price is acting morally and justly. For example, if the market price for wheat is 10 shillings per bushel, consumers would not benefit from a supplier selling at last year’s 5 shillings per bushel. “Others would buy up his corn at this low rate and sell it again to others at market rate, and so they make a profit off his weakness and share a part of his money.” However, making “use of another’s ignorance, fancy or necessity” to sell them things at a higher price than to others is cheating.

Locke even describes an emergency situation in which a merchant in Danzig (now Gdansk) sends one ship with wheat to Dunkirk, where the market price is 20 shillings per bushel because there is a shortage, and one to Ostend, where it is 5. Is there any injustice in selling the same wheat at four times the price at which it sells “20 miles off”? No, says Locke. Provided he sells at the market price – the same to Thomas as to Richard – he is acting justly. Again, selling at a lower price would immediately see others buying it up and reselling it at the market price. If the buyer tries to buy as cheaply as possible in the market, and the seller tries to sell as expensively as possible, the market (“the mutually and perpetually changing wants of money and commodities in buyer and seller”) will settle on a “pretty equal and fair account”.

But the market price clearly jars with the general public. And that reflects in particular on the reputation of the companies trading in the run-up to, and the aftermath of emergencies. That means suppliers must weigh up future damage and short term gains, as Richard Thaler suggested on twitter:

Even if there are no mandated price caps and anti-gouging measures, consumers can punish suppliers who appear to raise prices in response to market demand. Social media can seriously dent the image of a company. A tweet accusing Delta of price gouging (by increasing the price of a ticket sixfold) was retweeted nearly 40,000 times (and liked nearly 60,000 times). Nevertheless the airline was actually capping prices for their tickets, and the cheap airfares were no higher than in normal times a couple of weeks before. What people actually saw was the usual hike of last-minute walk-up fares, typically designed to accommodate desperate business fliers, as the founder of AirFareWatchdog.com told the New York Times.

hebstore

It’ll be a while before we can reopen this store. (source: LinkedIn)

Planning ahead is of course one way of avoiding supply problems, and hence redress the imbalance between supply and demand that gives rise to scarcity and price rises. This is what H.E.B., a grocery chain in Texas and Mexico, and Walmart did. And maybe the threat of a consumer backlash, however misguided, will encourage more companies to plan for emergencies. But that is not always possible – there are hard capacity constraints on airline seat availability, and there are only so many planes, and only so many slots at airports.

The inevitable trade-off

Market pricing is the lousiest mechanism for allocating scarce goods or services in an optimum way, and to signal demand increases to potential suppliers… except for all the others. There are extreme circumstances in which rationing is better to ensure that everyone gets some essential goods, economist Tyler Cowen says in his Bloomberg column. But most of the time we have a choice between empty shelves and high prices. We can’t have our cake and eat it.

And that is ultimately the trade-off we, the general public, must face, reluctant as we may be to make it.  Keeping prices down artificially is doing nothing to address the scarcity, and it is doing nothing to ensure that what is available goes to those who need it most. But it seems to satisfy our sense of morality.

Maybe we collectively value apparent moral behaviour more highly than reduced scarcity, even if – as Locke reminds us – there is nothing immoral about selling at market prices. Wise businesses will respond to this and safeguard their reputation, even if it costs them money – but more importantly also, even if it maintains the scarcity and leads to inefficient allocation.

That is the price we, consumers, need to bear.

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About koenfucius

Wisdom or koenfusion? Maybe the difference is not that big.
This entry was posted in Behavioural economics, Cognitive biases and fallacies, Economics, Emotions, Ethics, Morality, Philosophy and tagged , , . Bookmark the permalink.

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