Price-Gouging as a Remedy for Shortages

Yesterday, the Boston area suffered a catastrophic failure of its water supply system. A 10-foot diameter pipe carrying water from the Carroll Water Treatment Plant to Boston and neighboring communities ruptured and is not currently usable. Although fresh water is widely available from local reservoirs, treated water is not. It will be a few days in the most optimistic scenario before potable water is available at taps for over 2.5MM people. Reading between the lines of press reports, it was (and maybe still is) a distinct possibility that potable water could be unavailable for weeks, as the pipe is custom-designed, and replacement parts would have to be machined from scratch.

Of course, all of the supermarkets were stripped bare of bottled water and other beverages within hours of the news. There were even reports of fights and near riots over a product which costs approximately $0.25 per bottle.

Local governments announced plans to distribute bottled water (such as they have in storage) free of charge to needy residents.

This situation is instructive from the perspective of economics, and a simple analysis leads us to a solution which is both optimal and politically impossible at the same time.

If owners of bottled water (e.g. supermarkets, convenience stores, normal citizens, and free lancers) were able to sell at any price without fear of being accused of price-gouging, then there would be two beneficial effects:

1) water would be allocated in a more rational way, rather than by luck or by who gets to the supermarket first; and

2) supplies would increase as enterprising people truck bottled water in from other areas.

To offset the problem that poor people will be priced out of the market, the state government could hand out checks to every affected household -- perhaps $10 per person per day (a $30MM per day hit to the annual state budget of almost $30B). It is up to each person to decide how much of that distribution should be spent on bottled water.

It's important to remember that there are other options to drinking bottled water or using it to wash your hands or brush your teeth. It's possible to create your own potable water by boiling tap water for at least 1 minute and then cooling it back down. A pain in the neck to be sure, but boiled water is a cheap substitute.

This is pure speculation, but if implicit price controls were removed, I suspect that the price of bottled water would triple or quadruple initially. And then you would see a mad rush of supply as people from as far away as New York rent trucks to ship bottled water to Boston. The opportunity for a quick profit is very attractive. You could probably fit 2,000 half-liter bottles in the bed of a one-ton pickup truck alone. Attach a trailer, and you could probably pull another 5,000 bottles easily. If there was a gross profit of $0.50 per bottle to be had driving 7,000 bottles up from NY in a pickup truck, I think a lot of New Yorkers would jump at the opportunity. And that's for a random guy with a pickup truck.

The bottom line is that if price-gouging were allowed, the market would clear at an acceptable level, and there would be enough bottled water to satisfy everybody. Those who are willing to make do with a little less, can save the cash distributed by the state. Those who need more water will have to make do with a little less cash.

We see these local shortages from time to time (e.g. gasoline shortages in Florida after hurricanes), and always there is a crackdown on price-gouging. Too bad more people don't recognize that the solution to local shortages is to allow price-gouging. Indeed we should encourage it.