The FTC's recent report on price activity in the petroleum industry The "FTC Investigation of Gasoline Price Manipulation and Post-Katrina Gasoline Price Increases: A Commission Report to Congress" (Spring 2006) provides some useful material for other industries in which accusations of "price gouging" follow price fluctuations. The full study is 222 pages, but the May 23, 2006 "Commission Testimony Concerning Gasoline Prices" provides an executive level summary of its analysis.
This note will provide some reflections upon the investigatory report based upon examination of the testimony and attempt to relate its approach to regulatory responses to price increases in other market-sensitive industries, particularly the business of insurance, which is regularly subjected to accusations of "excess profits" during "hard market" periods of improving underwriting results. See, for example, "Commissioner John Garamendi Discloses Apparent Excess Profits' by Homeowner and Auto Insurers" (Dept. of Ins. Press Release May 25, 2006).
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The FTC was charged under two separate statutes to make a study of gasoline prices. Due to the size and complexity of the market, it focused on areas it regarded as most likely to have led to problems for consumers. The Commission was charged to look for "market manipulation or price gouging" particularly in the aftermath of Hurricane Katrina.
One of the Commission's first challenges was to address the meaning of "market manipulation" and "price gouging," which have no particular legal or economic definition. Within the meaning of "price manipulation" the Commission's Report included "(1) all transactions and practices that are prohibited by the antitrust laws, including the Federal Trade Commission Act, and (2) all other transactions and practices, irrespective of their legality under the antitrust laws, that tend to increase prices relative to costs and to reduce output." Testimony p. 3. As to "price gouging, the Commission "analyzed whether specific post-Katrina price increases were attributable either to increased costs or to national or international trends." Testimony p. 4.
The Commission applied decades of experience investigating and analyzing potentially anti-competitive behavior in the petroleum and other industries, and a four-year program of monitoring wholesale and retail prices of gasoline. The FTC began work in August of 2005, including the issuance of 139 Civil Investigative Demands (CIDs), the taking of sworn testimony from petroleum executives and examination of data from the Oil Price Information Service (OPIS).
Up until Hurricane Katrina, the price of crude oil was the principal determinant of the price of gasoline, according to the FTC's findings. They also found that refiners were operating and pricing their products competitively, with no evidence of price manipulation. They also found no indication that refining capacity was limited other than by "competitive market forces that made further investment in refining capacity unprofitable." Testimony p. 10.
The FTC found that like many other industries, petroleum companies have steadily reduced their inventory levels over recent years in order to be more economically efficient. These inventories of gasoline played an important role in enabling recovery from the supply shocks of Hurricanes Katrina and Rita.
The study found that Hurricane Katrina caused the immediate loss of 27% of the nation's crude oil production and 13% of its national refining capacity. Rita took out another 8% of production and 14% of refining capacity. While these led to retail gasoline price rises of 50 cents and 25 cents respectively, the prices had returned to pre-Katrina levels by December 2005. Testimony p. 13.
Although some companies and retailers raised prices more than most did, the Commission found that "ln light of the amount of crude oil production and refining capacity knocked out by Katrina and Rita, the sizes of the post-hurricane price increases were approximately what would be predicted by the standard supply-and-demand paradigm that presumes a market is performing competitively." Testimony p. 14.
The study did find that some individual retailer's prices rose more than the average and produced increased profit margins, a circumstance the FTC regarded as falling in the meaning of "price gouging" used in the statute. Testimony p. 15. It looked closely at 24 retailers that were the targets of state price gouging legal action, but found that their operating margins did not increase significantly, and their average price increases were in line with competitors. The commission did find 5 individual exceptions that indicate that some instances of price gouging did occur. Testimony p. 17.
As to recommendations for legislation, the FTC led with a caution against enacting laws without realization that there are economic downsides to restrictions on price rises in response to supply/demand changes. Their comment is worth noting in full:
The challenge in crafting a price gouging statute is to be able to distinguish gougers from those who are reacting in an economically rational manner to the temporary shortages resulting from the emergency. This is more than just a problem for legislators and prosecutors. Gasoline suppliers may react to this difficulty in distinguishing gougers by keeping their prices lower than they rationally would. Consumers, in turn, may have no incentive to curb their demand as they would in response to a higher price. Other suppliers may have no incentive to send new supplies to the affected area, as they would if the price increased. The possible result may be long gasoline lines and shortages. In short, any decision to enact federal price gouging legislation should be made with full awareness of both sides of the possible tradeoff."
1. The Critical Role of Prices
Consumers might be better off in the short run if they did not have to pay higher prices for the same quantity of goods; in the long run, however, distortions caused by controls on prices would be harmful to consumers’ economic well-being. Prices serve a crucial function in market-based economies. They are signals to producers and consumers that tell how to value one commodity against another, and where to put scarce resources in order to produce or purchase more or fewer goods. If these price signals are distorted by price controls, consumers ultimately might be worse off because producers may manufacture and distribute an inefficient amount of goods and services, and consumers may lack the information necessary to properly value one product against another. Moreover, even in periods of severe supply shock, such as a major reduction in production or distribution caused by a natural disaster like the 2005 hurricanes, higher prices signal consumers to conserve and producers to reconfigure operations to better prepare for the next supply shock. Thus, if there is a “right” price for a commodity, it is not necessarily the low price; rather, it is the competitively determined market price. Relative to past prices, a competitive market price may sometimes be low, and it may sometimes be high; but it will send an accurate signal to producers to manufacture a sufficient amount of goods and services that consumers want to buy at that price, and an accurate signal to consumers to reallocate purchase decisions.
If prices are constrained at an artificial level for any reason, then the economy will work inefficiently and consumers will suffer. Economists have known for years that price controls are bad for consumers, and the deleterious effect extends far beyond strictly fixed prices. (See WILLIAM J. BAUMOL & ALAN S. BLINDER, ECONOMICS: PRINCIPLES AND POLICY 53 (2d ed. 1982). The constraint need not be total or permanent to have adverse effects. “Soft” price caps that allow for some recovery of price increases, or a price gouging statute that temporarily constrains prices during periods of emergency, still may have the effect of misallocating resources by reducing the incentives to produce more and consume less.15 Thus, any type of price cap, including a constraint on raising prices in any emergency, risks discouraging the kind of behavior necessary to alleviate the imbalance of supply and demand in the marketplace that led to the higher prices in the first place. A temporary price cap may have an especially adverse effect on incentives as producers withhold supply in order to wait out the capped period.
An artificially low price may cause producers to shift their fungible resources (of which capital is the most fungible) to other markets. Sooner or later, the result may be shortages, and the relatively scarce goods may be allocated by some method other than a market-clearing price. Experience with past markets in which prices have been held artificially low through price controls has included such results as consumers waiting in lines (and often burning scarce fuel while waiting), a politically designed allocation system, or an illegal “black market” in which the market price is charged."
Testimony, pp. 18-20.
The Commission pointed out that there is no federal law barring price gouging, though many states have laws attempting to address the practice. Beyond the above short lecture on the economics of price controls, the FTC recommended that any federal price gouging law have the following characteristics:
These same economic considerations recognized by the FTC will apply in other industries. Shock losses and distortions caused by natural or man-made disasters have historically resulted in price changes in insurance, building supplies, labor and other components of economic activity. The FTC's report provides a valuable warning against policy makers succumbing to the temptation to use the force of government to keep consumer prices below a market clearing price. While this may have short-term benefits, the long-term damage may far outweigh the immediate advantages. These insights from experts in the field should be valuable references for policy makers in those other industries and in the area of environmental protection as global warming and population pressures trigger more and bigger crises in climate, weather and availability of natural resources.
Posted by dougsimpson at May 26, 2006 02:01 PM