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  • Price Gouging and Speculative Costs

    March 25th, 2020
    covid-19, econ, money  [html]
    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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