Unexpected spikes to demand for products during pandemics or natural disasters often create shortages. A salient example is at the beginning of the Covid-19 pandemic, when there was a shortage of masks, toilet paper, and other goods. Consumers suddenly wanted these things immediately at much higher quantities than suppliers were expecting, and production capacity needed time to adjust to demand. When such shortages happen there is often policy debate about whether firms should be allowed to raise prices until the market clears or if they should instead face price caps. The advantage of allowing prices to rise is that it creates profit incentives for firms to increase their productive capacity in order to sell to consumers at the prevailing high prices. In contrast, price caps can diminish the payoff for incumbent firms from increasing their capacity and deter entry from new firms. The two policies also allocate the existing stock of goods differently. High prices allocate scarce goods to people with the highest willingness to pay for them, while under price caps the number of people wishing to buy the good exceeds the available supply, resulting in some sort of rationing. Allocating goods to the people with the highest willingness to pay would be efficient if we believed the marginal dollar has the same value to rich and poor people, but obviously if we think it is unfair or morally inefficient to allocate scarce vital goods predominantly to rich people then we might not be happy with allowing prices to rise without restriction during shortages.
While price restrictions are the predominant policy proposal argued about during shortages, they are not the only option for governments, and alternative mechanisms may do a better job of balancing investment incentives and inequality concerns. Suppose for simplicity that there are a number of firms producing homogeneous masks in a Cournot game, with no possibility of entry by other firms into the market.1 Suddenly there is a large and unexpected spike in demand for masks, and firms cannot adequately adjust mask supply in the short run because of capacity constraints in their factories. Each firm can produce at most Y masks. In order for firms to increase their capacity for producing masks beyond Y, they must first pay some fixed cost X.
Consider the following policies mulled by the government:
Policy A: Price cap
Imposing a price cap can result in a more equitable allocation of goods. However, it also runs the risk of making it unprofitable for firms to pay the fixed cost X to increase capacity since the return on investment is low. If firms decide it is not worth it to increase capacity then there will be rationing and underprovision of masks.
Policy B: Unrestricted pricing
High prices result in larger incentives for firms to pay the fixed cost X in order to increase their capacity and sell masks to marginal consumers, who are willing to pay a lot to receive the good. However, it also results in masks getting allocated initially only towards people with the highest willingness to pay, who may be predominantly high income. As a result there could be equity concerns with this policy.
Policy C: Partial price cap
Consider instead imposing a price cap on the first p fraction of goods sold, while the remaining 1-p fraction of goods can be priced at the firm’s discretion. That is, for each firm, pY goods get sold under a price cap, while (1-p)Y goods do not face a price cap. Reserving p fraction of units to be sold at low prices results in rationing of those goods, resulting in potentially greater allocation towards low income consumers compared to Policy B. The remaining 1-p fraction of goods get allocated towards the leftover consumers who have the highest willingness to pay. Notice that the share of high willingness-to-pay consumers who get masks under this policy is lower than under Policy B because of the partial price cap and rationing. That means the marginal consumer under this policy has an even higher willingness to pay than under unrestricted pricing in Policy B, since only the most valuable 1-p share of consumers who got allocated the good under unrestricted pricing get the good under this scheme. As a result, incentives to pay the fixed cost X are higher under this policy than under Policy B. The additional consumers who would be captured by expanding capacity are more valuable than they would be under unrestricted pricing.
The above discussion shows that Policy C results in an allocation that is both more equitable and provides better investment incentives than Policy B. The reason this works is because it recognizes that firms price and make investment decisions on the margin. Reallocating a set fraction of goods towards low income consumers makes the marginal residual consumer even more valuable than under unrestricted pricing.
Policy C is clunky to implement in practice, but a similar policy could work nearly as well. In the United States, the government could for example use the Defense Production Act to procure some number of masks from companies at the pre-shortage price level and ration them to citizens for free. It could commit to otherwise not interfering with prices. This would create essentially identical allocations and investment incentives as Policy C.
I do not claim that Policy C or its variants are the optimal policy. In particular, it could discourage firms from investing in capacity even before a shortage occurs because they anticipate partial price caps will prevent them from receiving the windfall from meeting the sudden spike in demand. Whether or not these dynamic concerns are actually relevant at all in practice, it would be worthwhile for economists and policymakers to consider more creative policies than the binary choice between price caps and unrestricted pricing.