Fiddling with the free market:
Is the (market) price always right?

By William Sundstrom

In the wake of Hurricane Katrina a year ago, we heard many complaints of “price gouging”--by oil companies in their gasoline pricing, by greedy innkeepers in cities like Memphis--all taking advantage of temporary shortages and human desperation to make a quick buck.

Price gouging by big oil was very much on the mind of the U.S. House of Representatives this May when it passed by an overwhelming margin H.R. 5253: The Federal Energy Price Protection Act of 2006. This law “declares that it shall be an unfair or deceptive act or practice in violation of the Federal Trade Commission Act for any person to sell crude oil, gasoline, diesel fuel, home heating oil, or any biofuel at a price that constitutes price gouging.”

HR 5253 leaves it to the FTC to define price gouging--one suspects this is a case resembling Justice Potter Stewart’s famous definition of hard-core pornography: “I know it when I see it.” At any rate, progress through the Senate appears to have slowed, as prices at the pump have drifted back down since May.

These events are a reminder of the public’s unease with the unfettered operation of the “law of supply and demand”; there appear to be times when capitalist self-interest ought to be reined in, in the interest of fairness, and many harbor nagging suspicions that the marketplace is not always a level playing field but may be stacked against the powerless or unfortunate.

The moral condemnation of price gouging is probably as old as market exchange itself. Certainly by the 13th Century we have a rather influential Catholic author offering a pretty good definition of price gouging in his discussion of what has come to be known as the doctrine of the “just price”: “If someone would be greatly helped by something belonging to someone else, and the seller not similarly harmed by losing it, the seller must not sell for a higher price: because the usefulness that goes to the buyer comes not from the seller, but from the buyer's needy condition: no one ought to sell something that doesn't belong to him.” (Thomas Aquinas, Summa Theologica)

What Aquinas argues is that pricing should not take unfair advantage of the unfortunate circumstances of one of the trading partners. Modern research on fairness norms in markets--for example by Nobel laureate Daniel Kahneman--confirms that this is a widely held view to this day. Although Karl Marx, as an admirer of hard-nosed British political economy, would have cringed to hear this, his theory of exploitation of labor has a quite similar flavor to Aquinas: Capitalists take advantage of the desperate circumstances of their propertyless workers to earn their profits.

Since Marx, modern economics has become known for defending the efficiency of the free market, even seemingly exorbitant prices. But efficiency seems like such a heartless abstraction when placed up against the just price theory of Aquinas or Marx’s exploitation. Could price gouging actually be not just efficient, but moral?

About 500 years after Thomas Aquinas we have a Scottish defender of the free market discussing how famines arise precisely when the government attempts to enforce a just price during a period of scarcity or dearth:

“When the government, in order to remedy the inconveniences of a dearth, orders all the dealers to sell their corn at what it supposes a reasonable price, it either hinders them from bringing it to market, which may sometimes produce a famine even in the beginning of the season; or if they bring it thither, it enables the people, and thereby encourages them to consume it so fast as must necessarily produce a famine before the end of the season.” (Adam Smith, Wealth of Nations)

What Smith argues is that the market price provides both an incentive to increase supply, and an incentive to conserve (ration corn to its most important uses). The price-gouging grain traders are for Smith the most active and effective force working against mass starvation: “No trade deserves more the full protection of the law, and no trade requires it so much, because no trade is so much exposed to popular odium.” Might the same principle apply in many similarly desperate situations, such as in the aftermath of a natural disaster?

But an obvious potential flaw in Smith’s argument was stressed by Nobel prize winner Amartya Sen in his own study of famines: The same high price that encourages increased supply as well as conservation may also price some of the very poor right out of the food market. The desirable incentive properties of the market identified by Smith run up against its adverse effects on income distribution. This lack of entitlements is the major proximate cause of many historical famines, in Sen’s view.

Fortunately, famine does not stalk modern American society, but conflict over the competing roles of prices persists. A particularly important example is the price of labor (that is, the wage). Efficient allocation of labor requires a free market, but the resulting wage may be below what is required for subsistence, or at least for basic human dignity. In these cases we have the question of the proper role of policy (minimum wage or living wage laws), as well as business ethics (is there a moral obligation to pay a living wage?)

I think Sen’s writing here provides some useful guidance. He does not propose the price controls that Smith criticized so effectively. Rather, he suggests addressing the distributional issues directly: how to enhance incomes, and provide insurance against disaster risk? If society were to arrive at effective means of reducing the occurrence of situations in which buyers or sellers are desperate and thus vulnerable to price gouging, we would feel more comfortable with the functioning of Smith’s invisible hand.

William Sundstrom is a professor of economics at Santa Clara University.
Oct. 24, 2006