Why is price controls important

We'll start by talking about price ceilings, which are sometimes called price caps. Price caps are one way to address issues of market power. In situations where it is felt that the price is artificially high because of a lack of competition, one of the actions a government can take is to set a maximum price a monopolist can charge.

Let's look at a couple of examples. One of the most frequently cited example is that of price caps on rental accommodations, the most famous case in the US being that of New York City. As the United States entered World War II in , a crash program of ship-building was started in addition to other munitions and arms manufacturing. One of the places where many ships were built was the Brooklyn Navy Yard. The rapid increase in the demand for labor caused a lot of people to move to New York. These migrants needed places to live and soon filled up all of the available apartments in New York.

Given that apartment buildings are capital, and cannot be built overnight in response to increased demand, when they filled up, landlords would be in a position of market power and would be able to charge higher and higher prices when every apartment came on the market or when a lease ended.

In order to stop this from happening, as a wartime emergency measure, the City of New York instituted rent controls, setting maximum amounts on what a landlord could charge. It should be noted that World War II ended in This was 75 years ago, but rent control persists in New York to this day. As an aside, the Federal Income Tax was originally intended to be an "emergency measure" to help pay for the costs of World War I.

That war ended a little over a century ago, but the income tax is still with us. Perhaps this is a hint that we should be careful about granting politicians the power to adopt "emergency measures," as they have a habit of sticking around long after the emergency has ended. You can imagine what these rent caps did. In a market, high prices serve as a signal to producers that demand has increased, and every businessman lives to find an unsatisfied demand.

This is where the lure of positive economic profits lies. High prices act as a magnet to bring more supply to a market, and that extra supply competes with the existing supply to help drive prices down to an equilibrium. High rent prices are a signal, telling prospective builders where their product is most needed.

This is what Adam Smith was talking about when he coined the metaphor "the invisible hand," guiding the behavior of consumers and producers. Rent control removes the economic signal that buildings are in demand in New York. For this reason, providers of apartment houses have no incentive to build new apartments. So, we still have lots of workers flocking to the city, all the apartments are full, and nobody has an incentive to build new ones because the prices are controlled.

This does nothing to alleviate the shortage of apartments. Price controls aren't a new concept. In fact, they go back thousands of years. According to historians, the production and distribution of grain were regulated by Egyptian authorities in the third century B.

Other civilizations implemented price controls, including the Babylonians, the ancient Greeks, and the Roman empire. We can find instances of price control in more modern times, including during times of war and revolution.

In the United States, colonial governments controlled the prices of commodities required by George Washington's army, which resulted in severe shortages. Governments continue to intervene and set limits to how producers can price their products and services.

For instance, municipal governments often limit how much rent a landlord can collect from their tenants and the amount by which they can increase these rents in order to make housing more affordable.

The U. Price controls come in two forms: Price floors and price ceilings. Price floors are the minimum prices set for goods and services. They may be set by the government or, in some cases, by producers themselves. Minimum prices are imposed to help producers when authorities believe that prices are too low, leading to an unfair market. Once set, prices can't fall below the minimum. Price ceilings or caps are the highest points at which goods and services can be sold.

This occurs when authorities want to help consumers if they feel that prices are far too high. This is especially true in the case of rent control when government agencies want to protect tenants from slumlords and overzealous landlords. Just like price floors, prices can't go above ceilings once they're set.

Rent control is one of the most common forms of price control. Government programs establish limits on the maximum amount of rent a property owner can collect from their tenants. These limits are also imposed on annual rent increases. The rationale behind rent control is that it helps keep housing affordable , especially for more vulnerable people like those with lower incomes and the elderly. Governments commonly impose controls on drug prices. This is especially true for life-saving and specialty medications like insulin.

Drug companies often come under pressure for setting prices too high. Consumers and governments say this puts certain medications out of reach for the average citizen. Minimum wages are considered a form of price control as well. In this case, it is a price floor or the lowest possible salary an employer can pay to their employees. Minimum wages ensure that individuals can maintain a specific standard of living.

Sports franchises often put price controls on tickets to make attendance more affordable for all fans. Price controls are often imposed when governments feel that consumers can't afford goods and services. For instance, price ceilings are established to prevent producers from price gouging. Governments may also set price limits on goods and services if they feel that producers aren't benefiting from how goods and services are priced in the free market.

This allows companies to remain competitive and ensure that they are profitable. Controlling how prices are set keeps companies from developing monopolies. Companies are at an advantage and can dictate prices when demand is high and supply is short. As such, they may be able to inflate prices to boost their profits. Typically the official rationale for a general price ceiling is that it keeps important items affordable for the poor; a classic example would be rent control, in which the government imposes caps on rental rates for certain types of apartments.

If it is to have any impact, a price ceiling must be set below the market price. But under normal circumstances, the actual market price will tend to be close to the market-clearing price, which we recall from Lesson 11 is the price at which the quantity supplied equals the quantity demanded.

Now if the government forces the price lower by imposing a price ceiling, it will cause a shortage of the good or service in question. The following diagram illustrates:. At that price, consumers want to rent a total of 10, apartment units, and owners want to rent out 10, apartment units. The market clears and everyone engages in as many transactions as he wants, subject to the high price. At the lower price, the quantity of apartment units demanded rises to 12,, while the quantity supplied drops to 9, Shortages are quite serious because they make the good or service unavailable for the very people supposedly helped by the price control.

However, there are now 1, people in the community who would have had an apartment with market pricing but now have no apartment at all because of the price ceiling.

Even if we completely ignore the fate of the landlords—who are clearly worse off because of the rent control—and focus exclusively on helping tenants, it is not clear that the price ceiling has actually made the group as a whole better off. The tradeoff is even more striking in other situations of price ceilings. For example, suppose a hurricane strikes a city, knocking out the power and causing flooding that contaminates the drinking water.

Left to their own devices, the market prices of bottled water and canned goods would have a tendency to skyrocket because of the sharp increase in demand versus the fixed supply. On the contrary, what will happen is that the first few people to get to the store will clear out the shelves, loading up on bottled water and canned food at the pre-crisis prices.

People who get to the store a few hours later will walk away with no water or food at all. For such poor souls, the officially reasonable prices are small consolation. Another illustration is gasoline. People who live on the coast in the path of an oncoming hurricane will try to load the kids up and head inland. This unusually high price would cause the fleeing residents to only buy enough gasoline to get them onto the interstate where they would search for gas stations charging lower prices.

They will have to get on the interstate, perhaps with very little gas in their tanks, and possibly break down along the way. If the goal is to get as many people out of the path of the incoming hurricane as smoothly as possible, imposing price ceilings on gasoline is a horrible idea.

In addition to the immediate drop in the short-run quantity supplied, a price ceiling will also suppress the long-run supply, as entrepreneurs and investors respond to the new realities and shift their efforts and resources to other lines that do not suffer from price controls. For example, if rent control laws are applied in a major urban area, there will be an immediate shortage.

Rising wages and prices may keep output and employment below their potential. Price and wage controls may limit these temporary costs of disinflation by prohibiting wage increases that are out of line with the new trends in demand and prices. From this viewpoint, restrictive monetary policy is the operation that cures inflation, and price and wage controls are the anesthesia that suppresses the pain.

But this best case for price controls is weak. The danger is that the painkiller may be mistaken for the cure. In the eyes of the public, price controls free the monetary authority from responsibility for inflation.

As a result, the pressures on the monetary authority to avoid recession may lead to a continuation or even acceleration of excessive growth in the money supply.

Something very like this happened in the United States under the controls imposed by President Richard M. Nixon in The study of price controls teaches important lessons about free competitive markets. By examining cases in which controls have prevented the price mechanism from working, we gain a better appreciation of its usual elegance and efficiency.

This does not mean that there are no circumstances in which temporary controls may be effective. But a fair reading of economic history shows just how rare those circumstances are. Price Controls By Hugh Rockoff. Further Reading Alston, Richard M. Kearl, and Michael B. Capie, Forrest, and Geoffrey Wood. Clinard, Marshall Barron. New York: Rinehart, Galbraith, John Kenneth. A Theory of Price Control. Cambridge: Harvard University Press, Grayson, C. Confessions of a Price Controller. Homewood, Ill.

Jonung, Lars. Brookfield, Mass. Rockoff, Hugh. New York: Cambridge University Press, Schultz, George P.