Hurricane Sandy’s Lesson on Preserving Capitalism
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The Fiscal Times
November 6, 2012

With long gas lines and other shortages putting people on edge in the wake of Hurricane Sandy, the usual post-disaster debate over the economics and ethics of price-gouging is underway. However, while the question of whether it is okay, even desirable, for businesses to raise prices after natural disasters is certainly important, there are larger lessons that can be drawn from this debate.

Economists do not like the term “price-gouging.” They believe that price increases are the best way to allocate scarce goods and services after a natural disaster and, importantly, to encourage additional supply. When people can make a large profit by supplying goods and services to a market, they will work extraordinarily hard to meet the demand.

But if there is such an advantage to allowing the price system to work after an event like Hurricane Sandy, why did producers often choose to stick with pre-disaster prices? Why would they leave profits on the table by maintaining pre-disaster prices and allocating goods through other mechanisms such as first-come, first-serve until supplies run out? One answer is that price-gouging after a natural disaster is illegal in many places. But this just begs the question. Why do so many places choose to prohibit large price increases in response to disaster induced shortages?

Most of the explanations economists have come up with rely upon the idea of fairness. After a natural disaster, people consider food, water, even goods like gasoline a necessity, and despite attempts by economists to explain that allowing prices to rise is best, they are sensitive to two types of inequities.

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First, after a disaster supplies are short, shopping around may be next to impossible, and consumers do not appreciate producers exploiting short-term monopoly power. That’s especially true when they can’t see any obvious way for the higher prices to induce more supply in a reasonable timeframe due to the post-disaster conditions. If consumers feel they are being taken advantage of at a time when they already have enough problems due to the disaster, they might decide to shop elsewhere and this could hurt future sales to the extent that firms will forego price increases.

Second, people do not consider it fair when only the wealthy can get the things they need to ease their troubles. If people have to go without because of an act of god, then everyone should share in the pain. The wealthy should not be able to corner the available supplies of goods and services that are in high demand because of the disaster.

This relationship between the acceptance of the price allocation system in the wake of natural disasters and how fair the system is perceived to be has lessons that extend beyond times of crisis. If income inequality is very low and monopoly power is largely absent, then most people can consume most goods and services if they are willing to sacrifice enough. In this case, people are tolerant of allowing prices to dictate who gets what.

But as inequality grows and people are priced out of markets, when there are more and more things that a large fraction of society cannot obtain no matter how much they are willing to give up, and as more and more people feel they are being taken advantage of by a system beholden to economic or political power, the support for the price allocation mechanism – the heart of capitalism – begins to erode.

Why is this important? If inequality and the economic and political power that come with it continue to grow, the belief that capitalism is unfair could become widespread. This, in turn, could bring about the kinds of changes to the market system that free-market advocates fear so much.

Is the capitalist system the problem? As we saw in the post-WWII period, capitalism can produce rapid economic growth without the kinds of changes in inequality and political power we have seen in recent decades. But capitalism can only exist within a structure of formal and informal institutions, and these institutions are critical factors in how well capitalism performs. When institutions fail to provide the correct guidance, the system drifts off course.

Market fundamentalists are often the first to point to the price mechanism as a means of dealing with natural disasters, and they are often the most ardent defenders of inequality and the economic and political power that come with it. They fear that any attempt to blunt growing inequality will put us on the path to socialism and ruin. But free-market advocates need to recognize that support for market allocation mechanisms during both disasters and normal times depends upon the belief that the system is fair.

Free-market advocates fear creeping socialism, but too much inequality is presently a much bigger threat to the capitalist system. To protect capitalism, advocates of the market system should support the institutional changes that are needed to put us back on course to broadly shared prosperity.

University of Oregon macroeconomist Mark Thoma writes primarily about monetary policy its effect on the economy. He has also worked on political business cycle models. Thoma blogs daily at Economist’s View.