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Why price controls should stay in the history books

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The surge in inflation following the COVID-19 crisis and the expansionary policies of international central banks, including the Federal Reserve, have brought the subject of price controls back into the news. For example, recent articles have advocated forms of price controls to reduce US inflation and achieve other goals.

This article revisits price controls, discussing their history, how they work, and their drawbacks, as well as economists’ views on the policy. This explains why most economists believe that extensive price controls are costly and ineffective in most situations.

PCE inflation in the United States is at its highest since 1982

SOURCE: FRED (Federal Reserve Economic Data).

Price controls are government regulations on wages or prices or their rates of change. Governments can impose such regulations on a wide range of goods and services or, more commonly, on a market for a single good. Governments can either control rising prices with price caps, such as rent controls, or set a floor under prices with policies such as minimum wages. The following table shows some examples of common price controls.

Types of price control
Ceilings Rent control
Price control on basic necessities: food/gasoline
Controlling the prices of food, water or building materials after a disaster
Drug price control
Soils Minimum wage

The history of price controls

Price controls have a long history: the Code of Hammurabi prescribed commodity prices 4,000 years ago, and the colonies of Massachusetts and Virginia did the same 400 years ago. Governments generally restricted prices during wartime, with all major belligerents instituting broad limits on prices during World War II. Western countries commonly used broad price controls in the 1970s. The US government last used broad controls in a series of plans from 1971 to 1974 after the dollar was removed from the gold standard. Many developing countries control commodity prices, sometimes combining price controls with subsidies.

The impact of price controls

Consider the impact of price caps. High prices have two economic functions:

  • They allocate rare goods and services to buyers who are most willing and able to pay for them.
  • They signal that a good is valued and producers can profit by increasing the quantity supplied.

In other words, prices allocate scarce resources both on the consumption side and on the production side. Price controls distort these signals.

The following figure shows a stylized supply-demand graph for a competitive market in which the equilibrium price-quantity pair would be defined by the point at which the supply and demand curves intersect, at {PEQE}. In the presence of the price cap, however, consumers want QD units, while suppliers are willing to offer only QS units. QD is much greater than QS and the difference is a shortage of the product (Q) at the ceiling price.

Supply and demand with a ceiling price

Supply and demand with a ceiling price

PROVENANCE: The author.

The following figure similarly shows how a price floor, such as a minimum wage, changes the equilibrium {price, quantity} combination in a competitive market. In this figure, the floor price produces an overabundant supply, for example unemployment in the case of a minimum wage.

Supply and demand with a floor price

Supply and demand with a floor price

PROVENANCE: The author.

Price control costs

Price controls have costs, the severity of which depends on the extent of the control and the extent to which it alters the price relative to the free market price. Costs include the following:

  • A government bureaucracy and law enforcement must be funded to enforce the controls.
  • Goods and services are allocated inefficiently, both in consumption and in production.
  • Competition moves from production to political markets as companies attempt to influence pricing decisions.
  • The widespread circumvention of price controls encourages non-compliance with the law.
  • Suppressed inflation appears when temporary controls are released.

Most of these costs are simple, but the allocative inefficiency requires an explanation: because QD is greater than QS in the second digit, there is a shortage of the product and sellers have to figure out how to allocate a limited supply. Maybe they only sell to long-time customers or customers who also buy other products, or they just limit the amount each customer can buy. Rent control forces landlords to continue renting to existing tenants at artificially low prices. Such “non-price rationing” is inefficient because some buyers who do not get the good would be willing to pay more. Producers would be willing to increase production and sell to consumers who wish to buy at a higher price, but price controls make this illegal.

How do individuals and firms evade wage and price controls?

When a price cap prohibits a desired transaction, both buyer and seller often evade the price cap by trading in a closely related but unregulated product or by trading illegally on black markets. Similarly, sellers can modify a good slightly to prevent it from being subject to the same price limit. Economist Hugh Rockoff notes that the price of clothing has been particularly difficult to control because a garment can be easily reclassified into a more expensive category by adding inexpensive decoration or reduced in quality by replacing cheaper materials.

Historian Jennifer Klein has documented that the current reliance of the American health care system on employer-provided insurance is a relic of the evasion of wage controls during World War II. During this conflict, defense industries wanted to hire more workers but could not legally raise wages. To make their job more attractive, some employers have started to offer health insurance as a legal social benefit.

Price controls lead to larger behavioral changes in the long run. Consider how companies might react to a higher minimum wage that increases the cost of entry-level labor. In the short term, employers could raise prices and save on labour. Companies will tend to raise prices, even in a competitive market, because producers must pay higher wages to their employees. People will consume less of higher-priced products that are entry-level labor intensive. In the longer term, employers will install more efficient machinery, such as dishwashers or automated cooking machines, to reduce the amount of entry-level labor they use.

What do economists think of price controls?

Economists generally oppose most price controls, believing that they produce costly shortages and gluts. The Chicago Booth School regularly interviews leading economists on issues of interest, including price controls. Most economists do not believe that 1970s-style price controls could successfully limit US inflation over a 12-month horizon, and many of these economists cite the high costs of the controls.

Economists know, however, that price controls can be theoretically beneficial when imposed appropriately on a monopolist or monopsonist, and they tend to work best in imperfectly competitive markets. Economist Hugh Rockoff cautiously suggests a limited role for price controls during certain episodes of inflation in his book Drastic Measures: A History of Wage and Price Controls in the United States. Rockhoff reported that even the late Milton Friedman, a prominent free market advocate, accepted a limited role for temporary price controls in breaking inflation expectations during a disinflation.

Conclusion

Price controls have had a very long but not very successful history. Although economists recognize that there are some limited circumstances in which price controls can improve outcomes, economic theory and analysis of history show that general price controls would be costly and of limited effectiveness. . Appropriate fiscal and monetary policies can reduce inflation without the costs imposed by price controls.

References

  • Klein, Jennifer. For All These Rights: Business, Labor, and Training America’s Public-Private Welfare State. Princeton University Press, 2010.
  • Rockoff, Hugh. “The Response of Giant Corporations to Wage and Price Controls in World War II.” The Journal of Economic History, March 1981, vol. 41, pp.123-128.
  • Rockoff, Hugh. Drastic Measures: A History of Wage and Price Controls in the United States. Cambridge University Press, 2004.
  • Schuettinger, Robert; and Butler, Eamonn. Forty centuries of wage and price controls: how not to fight inflation. The Heritage Foundation, 1979.

Endnotes

  1. See Isabella Weber’s December 29 Guardian op-ed and Eric Levitz’s January 2 New York Magazine article.
  2. The book Forty centuries of wage and price control: how not to fight inflation, written by economists Robert Schuettinger and Eamonn Butler, examines historical examples in this article and is highly critical of price controls.
  3. In command economies, such as the former Soviet Union, consumers typically have to spend hours queuing to buy scarce goods and services.
  4. A monopolist is the sole seller of a product while a monopsonist is the sole buyer of a product. Monopolists will generally sell less output than many competing firms would and at a higher price. If the government caps the price at which a monopolist can sell, it will sell a greater quantity at the lower price. Similarly, if a monopsonist is forced to buy at a higher price, he will do so and buy a larger quantity. Some economists argue for a minimum wage on the grounds that the labor market is imperfectly competitive, so the minimum wage can potentially increase both wages and employment. Other policies, such as subsidies and taxes, can also be used to make imperfectly competitive markets behave more like competitive markets.