Potential Effects of Proposed Price Gouging Legislation

Hurricanes Katrina and Rita caused significant damage to the energy infrastructure of the Gulf Coast United States and interrupted the delivery of energy supplies not only in that region, but also to other parts of the country.  Gasoline prices rose to allocate the temporary reduction in available supplies efficiently among consumers of gasoline.  The higher prices stirred compassion for those in obvious distress and angered those who thought refiners, distributors, and retailers were taking advantage of the situation.   In response, federal legislation was introduced to make this perceived “price gouging” illegal in the future.  The new Congress may consider several bills of this kind.  This study examines the economics of such proposals.

If enacted, these proposals would function like controls on gasoline prices.  History teaches that price controls on gasoline exhibited unintended and undesirable consequences even when the controls were designed carefully and included very specific rules defining legal prices and mechanisms to allocate shortages.  When anti-price gouging legislation uses extremely vague terms or requires the enforcing agency to define key criteria then the resulting consequences can be even more counterproductive.

Under legislation that threatens to punish acts that are defined vaguely and ambiguously, the behavior of the enforcing agencies is inherently unpredictable, and businesses potentially affected by the legislation could form expectations of prosecutorial conduct that could discourage the efficient functioning of markets.  Excessively harsh penalties for setting the wrong price could give pause to market decisions that are critical to alleviate shortages especially if individuals, unsure about the actions of enforcers, were to adopt very conservative behavior so as to ensure compliance with the law.  The result could be exactly opposite to the good intentions of the legislation’s authors – disincentives to provide additional supply, the waste occasioned by gas lines, and the failure to allocate supplies to those who would benefit the most.

In contrast, a competitive market responds to a supply interruption1 in a well known, predictable, and efficient way.  Through price increases, the market allocates limited available supplies to their most highly valued uses.  Users for whom the scarce supply has the highest value are willing to pay the most.  The market price rises and consumers who value using gasoline less than the market price drop out.  Demand falls until it equals available supply, and the market price then will equal the lowest valued use that can be satisfied with the quantity of supply available.

Investigation of what actually happened after Katrina reasonably approximates this model. The Federal Trade Commission (FTC) investigated the gasoline market performance during the period of the supply interruption caused by Katrina.  The FTC found no evidence of widespread price gouging thereby casting grave doubt on the need for legislation. This FTC study is, in fact, only the most recent assessment of claims of gasoline price gouging.  In the last decades, the U.S. Department of Energy (DOE) and the FTC have investigated all of the numerous instances of regional gasoline price spikes.  Their conclusions in every case have been that gasoline price increases were due to the operation of supply and demand in light of an interruption of supply, and that the magnitude of price increases was consistent with the magnitude of the loss in supply.  There has never been a finding that gasoline price increases were caused by any manipulation of the markets. Conversely, just as the experience in relying on markets to allocate supplies efficiently and
resolve supply interruptions has been uniformly good, the experience with price controls has been uniformly bad.  Experience indicates that price controls can lead to the following consequences:

  • Savings to consumers from lower cash prices are dissipated by the costs of non-market allocation mechanisms such as gas lines.
  • The shortage is exacerbated because of diminished or eliminated incentives for producers to find replacement supplies and for consumers’ efforts to conserve.
  • Available supplies are not directed to their highest valued uses, but to users who have the lowest cost of waiting.

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In the longer term, the expectation of price controls during periods of tight markets could discourage refinery investment, leading to tighter capacity at all times, increased reliance on product imports, and larger and more prolonged price increases when supply interruptions do occur.

Finally, this study estimates how much price controls would increase the overall welfare losses associated with a supply disruption of the size of that caused by Katrina and Rita.  The study estimates that for a supply interruption of that scale, total welfare loss from imposing price controls would have totaled $1.9 billion for the September through October 2005 period.3  Additionally, under price controls, losses would have been much more localized in the regions that lost supplies, like Louisiana and Mississippi, because there would have been

no incentive to increase imports (of either crude oil or refined products)4, retain shipments that would normally have gone to other regions, and run refineries at costly and unsustainable levels of output.

In all, price controls would only have exacerbated the gasoline shortage during Katrina, which in turn would have disrupted the economy and added costs both immediately and in the long term.