Price Gouging and Speculative Costs

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Let’s say you see a po­ten­tial pan­demic com­ing, and you pro­duce a product that could be crit­i­cal. Maybe you make res­pi­ra­tor masks, maybe you make ven­tila­tors, maybe you make PCR test reagents. You can see that if you and your com­peti­tors don’t ramp up pro­duc­tion and the pan­demic hap­pens, there will be a short­age. What do you do?

One op­tion is to do noth­ing: keep pro­duc­ing at your reg­u­lar rate. If the pan­demic fears were overblown then you’re fine. If the pan­demic hap­pens you quickly sell out, and start scram­bling to ramp up pro­duc­tion.

Another op­tion is to ramp up pro­duc­tion now, spec­u­la­tively. Start pay­ing work­ers ex­tra to work longer shifts and run your as­sem­bly lines around the clock. Train ex­tra work­ers. Find what you’re bot­tle­necked on and figure out how to get that ramped up too. If the pan­demic fears were overblown you lose a lot of money, but if the pan­demic hap­pens peo­ple need what you have so much that you can charge high prices. How much to ramp up pro­duc­tion in ad­vance de­pends on how likely you think the pan­demic is, and how much you’d be able to in­crease prices if it does hap­pen.

Ex­cept we have laws and cus­toms against price goug­ing: if the pan­demic does hap­pen, you are go­ing to have a lot of trou­ble rais­ing your prices. The laws gen­er­ally do al­low pass­ing along in­creased costs, but the prob­lem here is that your costs were spec­u­la­tive. Let’s work an ex­am­ple.

Imag­ine your ven­tila­tors nor­mally cost $35k to make, and the mar­ket price is $40k each. If you push re­ally hard to ramp up pro­duc­tion you can make a lot more, but your cost goes up to $90k/​each. In New Jersey, the state I looked at last time, you’re al­lowed to pass along costs but can’t in­crease your profit on “mer­chan­dise which is con­sumed or used as a di­rect re­sult of an emer­gency or which is con­sumed or used to pre­serve, pro­tect, or sus­tain the life, health, safety or com­fort of per­sons or their prop­erty” by more than 10% (56:8-107, 108, 109). Your nor­mal profit is 14%, so you would be al­lowed to sell them for $104k. Your pos­si­bil­ities are:

  • No pan­demic: you spent $90k each, but the mar­ket price is $40k. You lose $50k each.

  • Yes pan­demic: you spent $90k each, and the mar­ket price is way above that, but you can legally only charge $104k. You make $14k each.

If you think the pan­demic is >78% likely to hap­pen then you’ll ex­pect to make money by ramp­ing up pro­duc­tion, oth­er­wise you’ll lose money. So even if a pan­demic looks, say, 75% likely, you don’t ramp up.

Similarly, imag­ine you make res­pi­ra­tor masks and you know that ev­ery so of­ten there’s an emer­gency where de­mand spikes. Could be a pan­demic, but could also be wide­spread fires, or many other things. Since melt-blown fabric is a ma­jor bot­tle­neck, you could de­cide to keep a large stock­pile of it so you can eas­ily ramp up pro­duc­tion in an emer­gency. The same un­fa­vor­able math ap­plies here: you’re heav­ily limited in how much you can in­crease prices in an emer­gency, so keep­ing a large stock­pile to be pre­pared for even a rea­son­ably likely event is a money-loos­ing propo­si­tion.

In the cur­rent crisis peo­ple are likely to die be­cause we don’t have enough ven­tila­tors, and the marginal per­son prob­a­bly needs one for about a week, and the peak lasts maybe two months, so the marginal ven­tila­tor saves about eight lives. At the US statis­ti­cal value of life of ~$9M, that’s $72M per ven­tila­tor. We’re head­ing into a dis­aster where we don’t have enough ma­chines that we would value at ~$72M/​each and nor­mally cost ~$35k/​each to make. This is re­ally bad.

It’s too late to fix this for the cur­rent situ­a­tion, but I see three main ways out of this for the fu­ture:

  • Allow price goug­ing: don’t re­strict what prices peo­ple can sell things at.

  • Allow spec­u­la­tive pro­duc­tion: re­quire com­pa­nies to dis­close and doc­u­ment pro­duc­tion plans, re­quire them to share their prob­a­bil­ity es­ti­mates of how likely they think things are to be needed, keep them hon­est by al­low­ing third par­ties to bet against them at their pub­lished prob­a­bil­ities.

  • Have a gov­ern­ment that will put in emer­gency ven­tila­tor or­ders at an early stage of the crisis even when they may not be needed, stock­pile masks for po­ten­tial pan­demics, and gen­er­ally stay on top of things.

Th­ese three ap­proaches re­quire in­creas­ing lev­els of gov­ern­ment com­pe­tence and fore­sight, and given re­cent perfor­mance I’m pretty skep­ti­cal. But the cur­rent ap­proach where the gov­ern­ment doesn’t han­dle the prob­lem and also does not al­low in­dus­try to make a profit han­dling the prob­lem is a dis­aster.

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