Why does the price of gas increase immediately when a hurricane threatens supplies, even though the gas at the pump has already been paid for? Why does the price of gas in Seattle increase immediately when a hurricane threatens New Orleans or Houston? A popular explanation for rising gas prices is that it happens because unscrupulous, hard-hearted merchants see disasters as opportunities to take advantage of people in their time of need. Its an emotionally attractive explanation that fuels popular outrage and inspires laws against price gouging. Its also an explanation that is completely wrong. We can save ourselves a lot of angst, many of the pains associated with disaster recovery, and a lot of money in law enforcement resources by understanding why gas prices rise in the midst of disaster and by repealing laws against price gouging.
Evil people dont cause high prices. Supply and demand cause high prices. In the face of an impending disaster, consumers want more gas at any given price, which means that the demand curve has shifted. At the same time, disasters like hurricanes usually mean that the amount of gas merchants are willing to sell at any given price will fall. This is due in part to the fact that they will have their own disaster-related problems to deal with. Also, if energy infrastructure is harmed it means that the cost of acquiring fuel will rise. An increase in demand coupled with a reduction in supply means an increase in price.
Increasing the price is an appropriate response to long gas lines rather than a cruel attempt to stick it to the helpless. When people begin lining up to get something at the going price, this tells merchants that the price is too low. Raising the price corrects the imbalance and sends consumers an important signal: specifically, it tells them to redouble their efforts to conserve the resources that have rising prices. One person quoted in the Memphis Commercial-Appeal mentioned that she would not be attending the Cooper-Young festival because of rising gas prices in the wake of Hurricane Ike. My wife and I have cut back on unnecessary driving in response to rising gas prices. It isnt pleasant, but its a pretty small sacrifice when one considers the role of rising prices in expediting recovery from disasters.
Pundits and politicians are quick to criticize oil companies and gas stations for earning windfall profits during times of disaster. And it is true that an oil company or a gas station will book a higher profit if prices increase during disasters. First, though, this profit is a reward to the merchant for correctly anticipating that the price would be higher. It also sends a signal into the marketplace that attracts other profit-seeking suppliers into the marketplace.
A lot of the confusion stems from a misunderstanding of cost. The cost of a gallon of gas is not what the merchant paid for it. The cost of a gallon of gas is the merchants next-best opportunity. If a gas station paid $3 for a gallon of gas yesterday and expects to be able to sell it for $5 tomorrow, the cost of that gallon is not $3. Its $5. By selling the gas today, the gas station owner gives up the opportunity to sell it tomorrow for $5. Therefore, we can expect the gas station owner to charge $5 for the gallon of gas today.
The same reasoning explains why the price of gas in Seattle would increase after a hurricane in Texas even if that hurricane did nothing to disrupt supply. The cost to the Seattle gas station owner is not what he paid for the gas, but what he could get for the gas if he decided to sell it in Texas instead.
This is one of my favorite topics to cover in economics 101 because it uses some very simple principles to show why prices rise after disasters and because it illustrates the disastrous unintended consequences of well-intentioned government interventions. It also has implications for appropriate policy responses to disasters: when we leave the market to its own devices, prices tend toward uniformity across space and time. The price rises, but at least everyone who wants gas can get it. When the government steps in, ostensibly to help people by outlawing price-gouging, they create shortages. With friends like these, disaster victims do not need enemies.