Does Price Gouging Exist?

I first encountered the concept of price gouging while teaching economics during grad school. A quick Google search yields 1.8 million hits and a Wikipedia entry. I use it to illustrate the fundamentals of supply and demand. The story goes like this: A convenience store in Ft. Meyers Florida sells bottled water for $1.00. A hurricane hits, and the store raises the price to $3.00, effectively "gouging" customers. Politicians jump at this as unfair business tactics, and it is not, it is supply and demand. Demand for bottled water increases because clean water is more scarce. Supply of bottled water decreases because the costs of distributing/selling have increased. As such, the equilibrium price has increased due to market forces and not greedy businesses. (see illustration) No customer will pay more than they value the item, so no price gouging. In fact, there are consumers that still underpay.

This does not sit well with my students for long. They cannot reconcile the seeming "unfairness" of it all. Situations abound where prices increase (or decrease) after an event. Then, it got me thinking. The gouging comes from a change in bargaining power (i.e., holdup problem). Here are a few examples: 1) you have a heart attack, you don't take time to search and evaluate different hospitals and doctors. 2) Gas prices increase just as your car's fuel light shows empty. 3) Companies offer you a 15% pay cut, or laid off. Admittedly, this partially has to do with short-run versus long-run price elasticity, but the bargaining power also has a story. 

If these events are likely to occur, then both sides should protect themselves from it. For example, health insurance sets a fee limit (because you would almost anything for treatment), farmers sell futures of crops, airlines set contracts on jet fuel prices, and unions write up labor contracts. 

One final example. During my trip to Xi'an, China, I enjoyed haggling over different souvenirs. I bought a hat for 35 Yuan (about $6). Later, I bought the same hat, with the help of local friend, for 10 Yuan (about $1.5). Was the one store price gouging because they charged a higher price? No. Because I valued the item at $15, I instead feel I ripped off the store. In fact, my bargaining position increased with new information.