Price gouging

As a student of economics it is interesting to hear about price gouging. Price gouging is loosely defined as firms asking for a price far higher than the perceived ‘fair price’. A recent example of this is here. Basically the consumer thinks that the prevailing price is too high.

Two points of this idea strikes me as odd. Firstly the actual fair price is some what arbitrary. It seems to me that logically, a fair price will always be below the prevailing price. For example, say an apple costs £1. Surely a consumer can say that this price is too high. A price of 50 pence is fairer. Then at that price of 50 pence, a price of 20 pence seems fairer. If one follows this trail one ends up at the conclusion that the fairest price of them all is exactly £0.

Even if the consumer thinks about the cost of growing apples, than he will come to the conclusion that the fairest price is that which exactly matches the cost of the apple. Thus the grower gets no profit and only just covers his cost.

This brings me on to the second issue. Under a normal market competition, where producers are allowed to enter the market freely, the above outcome (of the actual price becoming equal to cost) can actually happen. If the above apple producer is selling at £1 but the cost per apple is only 50 pence than I can guarantee that an intrepid farmer will enter the market, under cut the original grower in terms of price and take most of the profit for himself as people will now buy his, slightly cheaper apples. If there is no collusion, the prices will fall to match the cost and then the producers will get their costs down to get some profit. All this is just basic competition. What prompted this race to the bottom in terms of prices was that the original grower was making large profits and the fact that collusion was not possible. It was a signal for others to see if they can try and earn some of that profit for themselves.

However, if that original farmer’s profit is taken away with a tax, or as some have suggested, the price simply be set by law to be lower, that signal for other producers to enter the market will disappear. The market is distorted. Competition no longer exists and prices do not race to the bottom and there is no competitive pressure to cut costs to make a bit more profit.

When oil firms are making massive profits, they ought not to be taxed or price of petrol fixed at a lower level. What should happen is there should be encouragement for firms with alternative sources of cheaper energy to enter the market for fuel.

Price gouging is nothing more than the market working. When one starts to distort the market, inefficiency results which will lead to generally higher prices and less competition which will inevitable lead to the consumer being worse off. What people should be asking is not how can we stop firms from making profit, but how can we make entry into the market easier and how can we create more competition.