"Price gouging" lawsuit distorts the market

Attorney General Phill Kline filed suit today against a Florida company for alleged violations of the Kansas Consumer Protection Act. The suit is the result of an undercover investigation conducted by Attorney General Kline?s Consumer Protection and Antitrust Division.

The suit alleges that on October 8th, Meds-Stat proposed to deliver and sell a vial of five doses of flu vaccine to a Kansas City, Kansas pharmacy for $900 with the knowledge that the vaccine was to be used in a ?nursing home.? On October 1st, the price for the same vial was listed as $85.

The only thing a politician does when he files a lawsuit against "price gouging" is prove that he doesn't understand the basic operation of free market economics. Read the extended entry if you have the same problem, and then you will understand why price gouging is what makes capitalism possible.

A market exists when there are both buyers and sellers interested in buying or selling a particular good. You have to have all three (buyer, seller, and good); ideally, in fact, you have more than one of each. If you have only one buyer or only one seller, you have a monopoly; with only one good, you have an auction. The desirable characteristics of a free market occur only in the presence of competition for each component.

People participate in a market because they want to profit. Not simply by "making money" (that is the role of a capitalist), but by making a profitable exchange of value. Profit is the difference in value between what you started off with, and what you ended up with (assuming that difference is positive). And the beauty of the free market is that if you aren't going to make a profit on a particular trade, you don't have to. In the absence of overriding necessities or coercion, people won't make trades that don't benefit them.

The usual objection is that the people in the market are trading the same good, with the same value, at a price they negotiated. How can profit exist if they are both paying the "market value" of the good? The answer lies in the difference between the market price of a good and it's perceived value. The buyer perceives that he is paying less than the value of the good to him; the seller perceives that he is receiving more than the value of the good. They both profit because of the difference in perception. Absent that perception, there can be no valuation; the "market price" is merely the expression of the aggregate perceptions.

Markets that are functioning properly are dynamic. They change in response to conditions, because the perceptions driving the participants change. There are many different factors that can affect those perceptions, but the one that is relevant for this scenario is scarcity.

Scarcity is one of the basic drivers of trade. The famous caravan trails of the medieval and renaissance period were driven by the scarcity of spice and silk in Europe. Caravans were able to charge high prices in the European marketplace because their goods were scarce; few caravans could make the trip. The demand of the buyers exceeded the available supply of the sellers, resulting in buyers paying higher prices because of the limitted quantity of available goods. In addition to simple scarcity, the caravans would typically not arrive all at once; each one would enjoy a brief monopoly on goods from the East.

That's the same basic issue with claims of price "gouging" with reference to the flu vaccine; scarcity drives an increase in market price, while a temporary condition prevents effective competition, resulting in a single seller.

But the buyers of silk and spices still felt the trade was profitable. So do the buyers of the higher-priced flu vaccine. The free market is still operating, it's just adjusting to the new condition of scarcity for a particular good by adjusting the price. The fact is, at the lower prices, supply is insufficient to meet demand. Price is therefore increased, and that increase seeks to differentiate between buyers -- those who are willing to pay the most (ie, have the highest perceived value for the good) are those who gain access to the limited supply of the good.

The free market, in this case, operates to ensure that the greatest increase in perceived value is realized. The seller makes a large profit on his good, which increases the quality of his life; the buyer whose perceived value is the highest has also profitted in terms of his own quality of life. Those buyers whose perceived value for the good is lower do not trade, or make different trades which they consider more profitable.

Obviously, there are people who weren't able to afford the prices of spices and silk from the East off of the caravans, or who were able to afford the prices but would prefer them lower (who wouldn't?). Noting the continued high prices, they decided that they saw an opportunity in the marketplace for cheaper goods -- and so they funded the naval explorations that eventually led to the discovery of America.

And that's part of the reason that objecting to price gouging is detrimental to society. Without the high prices resulting from a scarce good, there is less incentive to invest in attempts to increase the supply. In other words, price gouging on the flu vaccine provides an incentive for researching ways to make the vaccine more cheaply, or with less chance of a mistake ruining the batch. Reduce that incentive, and you increase the chances of having more problems.

There is one additional component to most claims of price gouging. The good involved is usually not a luxury good, but something considered a necessity, or (as in this case) a medical treatment that a large number of people can benefit from. In other words, there is a perceived "need" for the good that renders the buyers unable to discriminate on price or to choose not to buy.

This gets back to the basic concept of fairness and equality under the law. If lives or legal rights are at stake, money should not be an issue; the poor have the same legal rights as the rich, and being unable to pay a lawyer to enforce them should not represent a barrier to exercise of those rights. Similarly, few would argue that a baker should deny his bread to a poor man who would otherwise starve.

This works because legal rights and the basic necessities of life are not a scarce good; bread is a commodity and legal rights (as opposed to entitlements) are intangibles that cost nothing to extend. The value of the baker's bread is deemed less than the value of the beggar's life to society; society is not forced to choose who receives the bread, but can afford to provide bread to all (at least for the present). If forced to make a decision about who receives bread and who does not, under conditions of scarcity, the equation changes.

And that's exactly what's happening with the flu vaccine. We have a medical good, which registers as a necessity of life to many people because they conflate truly lifesaving treatments with treatments that merely improve quality of life. And that good is perceived as a commodity; over many years the production system has functioned reliably, and everyone who wanted a flu vaccine could get one at a reasonable market price.

But under the new condition of scarcity, the supply is dramatically reduced. Where we once had, say, 10 caravans of spices in the market selling goods from the East, we suddenly awaken one morning to realize that 9 of those caravans have been burned to the ground. The remaining caravan doesn't have enough goods to replace those lost by the other 9. In the short term, he can't get more (caravan trips take a long time). Scarcity exists, and the market adjusts. The price of the good increases to serve as a differentiator between buyers, ensuring that those who obtain the goods are those who value them the most.

Some will say this is not fair. This is true. markets are not about fairness. Markets are about profits, not only to individuals but also to society. Remember that the profit is a function of the difference in perceived value; society is better off when the high prices are paid on a scarce good because both individuals are better off than they would be under a different trade.

Fairness is a fine principle when speaking of commodity goods with an ample supply, and the free market produces fair results in that case. But fairness does not work under conditions of scarcity, because not everyone will be able to make the trade they want. Buyers must distinguish themselves somehow, and price is the discriminating factor (in the abstract). This results in the maximum benefit to society.

The other key point to understand here is that flu vaccines are not necessities; they are luxuries. There are no dire consequences to not receiving a flu vaccine. (At worst, you get the flu, and there are good chances you won't even without a vaccine).

Markets are simply mechanisms for determining the allocation of resources. Price fluctuations in response to changing conditions simply ensure that the trades most beneficial to society are made when conditions of scarcity exist. As an example, let us consider the hypothetical case of a man who is severely allergic to the flu. If he gets the flu, unlike 99% of the people who get it, he will die. He has a strong case for getting a dose of the vaccine -- a very high perceived value. And he's willing to pay a very high price.

But if the price of the vaccine remains at the pre-scarcity levels, and the vaccine doses are distributed to anyone who pays the (low) price, he may not get a dose of the vaccine at all, because he has no way to express his perceived value -- and the doses may well run out while he is waiting in line. The flu vaccine that could have saved his life will instead keep someone else from getting sick for a few days.

And that's why we need to let the market work. Those who need the vaccine will pay the higher prices. Those who don't will hold off until the supply is available once more. In the short term the increased prices will help allocate the vaccine properly, and in the long term, those increased prices will motivate improvements in the suppliers.