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Oct 2, 2019

In Emergencies, Price Controls Are (Still) Harmful

When dire emergencies loom, like catastrophic hurricanes, price controls do everything but help alleviate the situation. 

There are not many issues that economists are nearly unanimous about, but one of them is the analysis of price controls. The basic economics of price ceilings and price floors are part of every introductory textbook and are normally presented without indicating that there is much internal criticism of the analytical framework by other economists. Price ceilings and price floors are government policies that turn out to produce exactly the opposite of what they intend, and thereby create problems that are often responded to with even more poor policies. What starts as a seemingly simple and well-intentioned attempt to help consumers or particular producers can quickly become a disaster.

In this essay I will walk through that basic economic analysis and then turn to talk about the way price controls, specifically price ceilings, are applied in emergency situations through laws against so-called “price gouging.” Those particular situations spotlight some of the aspects of price ceilings that aren’t always emphasized in the textbook treatment and thereby enable us to get a greater appreciation of how market processes work when we do not try to put such controls on prices.

A Quick Overview of Price Controls

In the typical textbook treatment, one chapter walks students through the way in which markets tend toward the market-clearing (or equilibrium) price and quantity. At that price, the quantity demanded equals the quantity supplied and, given the price, no one walks away frustrated or disappointed. The plans of demanders are coordinated with those of suppliers. In that chapter, we normally motivate this by supposing that the price of a good is temporarily above or below that market-clearing price. We then walk through the ways this creates a knowledge signal and incentive for buyers and sellers to respond in such ways as to move that price toward market-clearing. On the assumption that all else remains constant, economic theory shows why the price will reach that market-clearing point.

We motivate this by pointing out that prices below or above market-clearing will cause shortages and surpluses, respectively. So if the price is below market-clearing, the quantity demanded (QD) of the product will be relatively high as the lower price attracts more buyers. The quantity supplied (QS) will be relatively low, as suppliers will be unwilling to part with their stock of the good at that low price. The result will be a shortage, which we define as QD > QS. How does this resolve itself? Some demanders who really want the good will be frustrated in not being able to get it at the current low price and will be willing to pay something more than that price for the good. As they offer more for it, some suppliers will now be willing to offer more for sale at that higher price. Other demanders will now make higher offers and this process will continue until the market-clearing price is reached. Note the competition here: demanders are competing with other demanders so that they can better cooperate with suppliers.

The process for prices temporarily above market-clearing is a mirror image. This time the QS of the good will be relatively high, as suppliers are willing to offer a large supply at the high price. The QD, by contrast, will be relatively low as the high price causes some potential demanders to walk away. When QS > QD we have a surplus, and suppliers find themselves with stocks of unsold goods. They soon realize that they can get rid of some of them by offering them at a somewhat lower price. As they do, some demanders are now willing to purchase, even as some suppliers back out of the market being unwilling to sell for the lower price. As QD rises and QS falls, we work our way back down to market clearing. Notice here that the competition is among suppliers: they are competing with each other to find demanders they can cooperate with. In both the shortage and surplus case, it is the entrepreneurial insight of the “long side” of the market (i.e.: the demanders who can’t find suppliers in a shortage, and then the suppliers who can’t find demanders in a surplus) that drives us toward the market clearing by changing their behavior in response to the market signal and the incentives it creates.

For markets to work as they should, market participants require the freedom to exercise the entrepreneurship involved in changing bids and asks. If demanders can’t offer a higher price or suppliers can’t offer a lower price, this process is short-circuited and we get permanent shortages and surpluses and the problems they cause. This is what happens when politicians pass laws that mandate a maximum price, what we call a “price ceiling,” or a minimum price, what we call a “price floor.” In the typical textbook presentation, an analysis of these price controls comes in the chapter after the one on market adjustment and market clearing.

If governments pass price ceilings that mandate the highest price a good or service can sell for, we will get those shortages. Think about rent control, perhaps one of the best examples of a price ceiling. If we force the rental price of apartments below market-clearing, a larger number of people will want to rent at that price, but a smaller number of owners of (potential) apartments will put them on the market. The result will be a shortage of apartments. But this time, because the disequilibrium price is legal maximum, there’s no way for potential renters to legally bid up the price to signal the higher value they place on renting and thereby encourage an increase in the QS. The result is that the shortage will persist as long as the price ceiling is below the market clearing rent.

Shortages create a number of problems. The main one is finding some way of allocating the limited supply among the much larger number of demanders. In general, shortages lead to queues, whether in the form of physical lines at a store, as in the former Soviet Union, or things like waitlists for apartments. The large pool of demanders gives the suppliers the power in this situation, as they can pick and choose among the demanders without worrying they are giving up a sale. This allows suppliers to discriminate by whatever criteria they think are important (and presumably legal). Suppliers will also find ways around the rent maximum by tacking all other kinds of charges on to the rental agreement such as key charges or rental charges for a mailbox. The limits on rents also discourage landlords from doing maintenance, either short run or long run. They can afford to not fix current problems quickly because there’s always someone else to rent to if the current tenant is unhappy. One result of this is the increase in complex bureaucratic rules about settling complaints, either privately or publicly. This is a consequence of rent control. The artificially low rent also means that owners are unlikely to update in more major ways, or bring other buildings onto the rental market, as they cannot recoup the costs at the legally permitted rent. Rent control and similar laws are one element of why there are housing shortages in so many US cities.

With laws that mandate a minimum price, what we call “price floors,” all of this analysis applies in reverse. Suppliers are prevented from lowering their price to draw in potential demanders for their good or service, which prevents prices from moving to market-clearing levels and makes the resulting surpluses permanent. One of the best examples of a price floor is minimum wage laws. The suppliers in this case are workers who are selling their labor to employers who demand it. At a minimum wage above market-clearing, people who are willing to work at a wage below the minimum are legally prevented from making an offer to do so, which means they cannot compete the wage down to market-clearing as they would without a law. With a large number of people wanting to work and employers only being willing to hire relatively few at the higher minimum wage, we get a surplus of labor, better known as unemployment. The law denies the potential workers the ability to send the signal that they are willing to work for less and thereby create the incentive for firms to hire them. The unemployment that results becomes persistent.

Much like price ceilings, price floors like minimum wage laws cause a number of problems. In parallel fashion to rent control, the party on the “short side” of the market has the power here. Firms can choose from among a very large pool of potential workers and know that if they don’t wish to hire someone for whatever reason, there’s always someone else who’ll take the job. Minimum wage laws create an incentive for employers to discriminate along any number of (legal) margins. Firms also respond to the higher wage by reducing other forms of compensation for those who do get the work. This might include reducing hours, but can also include eliminating free meals or free uniforms, increasing the workload expectation, or having supervisors become more micro-managing. All of these adjustments are not negotiated and likely make employees worse off. Most important, wages are linked to productivity, so a minimum wage law is also a minimum productivity law. The result is that minimum wage laws cut off the bottom rungs of the economic ladder to lower skilled workers, who are far more statistically likely to be young and non-white. Changes in minimum wage levels are closely correlated with changes in the black/white youth unemployment ratio. It is often the most vulnerable, those who advocates of such laws claim to wish to help, who are harmed the most. The inability to signal through the price system creates any number of problems, whether in the form of price ceilings or price floors.

Emergencies Don’t Change the Analysis

Unfortunately, even among non-economists who would agree with the analysis of price ceilings above, many of these lessons are disregarded when it comes to suppliers raising prices in emergency situations like natural disasters. Unlike something like rent control, which tries to force the price down below the current market-clearing level, laws against so-called “price gouging” (a term that has no objective definition in economics) outlaw or dramatically limit price increases from the current market-clearing levels. They are a response to the combination of sharply increased demand and possibly reduced supply pushing prices up significantly for items like gas, ice, water, and flashlights. Anti-gouging laws are extremely popular, and probably reflect our deep-seated moral instincts that find such behavior repugnant, rather than any attempt at economic analysis. Be that as it may, it does not change the validity of the economics.

Anti-gouging laws cause all of the same problems that every other price ceiling does: shortages, queues, excessive search costs, power in the hands of sellers, and numerous other forms of inefficient non-price allocation, including favoring relatives and accepting bribes. Even as people might recognize this, they still frequently believe it is “unfair” to “take advantage” of people’s “need” for goods and services during an emergency. It’s interesting, however, that anti-gouging laws are never applied to the suppliers of labor services. Carpenters, plumbers, and electricians often see their wages double or triple in the aftermath of a natural disaster, but I have never seen anyone accuse them of “wage gouging” nor any of them prosecuted for it. The moral outrage seems interestingly selective here.

Whatever the role of the felt repugnance, selective though it may be, from the economist’s perspective, the issue looks a little different. What is the case for allowing prices to rise dramatically when goods are scarce during an emergency? In general terms, we want prices to serve as a signal and incentive in all the ways we’ve discussed before. The much higher prices for goods during an emergency reflect the reality of their increased scarcity caused by the emergency, and that is important information and provides an important incentive. Another way to think about this is that we have a problem to solve: how do we increase the supply of the now much scarcer resources and thereby bring the price back down so we can get those resources in more people’s hands?  Counter-intuitively, allowing prices to rise without limit in the throes of the crisis is the way to do so. There are two effects in play.

In the immediate run, allowing prices to rise this way forces potential buyers of the goods to make very careful decisions about how they will use those goods. If bottled water is extremely expensive, people are unlikely to use it to, for example, give their dogs a bath. High-priced ice is far more likely to be purchased by those who need to keep medicine cold than those who want to keep beer cold. High prices help to ensure that the very limited supply of the good get used in its most valuable way. Those who have a very urgent need for the good will be more likely to be willing to pay the high price. And that’s the way it should be. When water is in short supply, giving the dog a bath seems a less valuable use of it than does human consumption. Letting prices rise enables us to husband scarce resources in economically efficient and socially valuable ways.

But it’s the second effect that’s perhaps the more important and more overlooked one. The much higher price for the goods in short supply serves as a signal flare providing both knowledge and incentives for people to bring in new supplies of the good. Seeing that water is selling for $30 a case after a hurricane in Florida both informs and incentivizes people across the Southeast US and beyond to buy up water near them and undertake the expense of bringing it to the affected area, and then selling it for something less than $30 a case. They profit from this activity, but they also shift the supply curve to the right, increasing the supply of water and bringing its price down in the process. This is entrepreneurship pure and simple, with benefits to all parties. Others will see the profits being made and imitate the first few who truck in water. Their entry into the market will further increase supply and drive down price. Notice that we have begun to solve the fundamental problem:  how do we get an increased supply into the affected area at a lower price? The answer is to let prices rise as much as needed in the immediate aftermath of the hurricane.

None of this analysis is anything different than the standard approach to price ceilings. But something about emergencies and very high prices seems to activate a disgust with charging higher prices that overrides our ability to think through the effects, This reaction is also connected to the belief that it’s better to help people through charity and altruism than self-interest. In general, humans tend to be suspicious when self-interest is activated, and it’s often hard for us to see how self-interested behavior can lead to socially beneficial unintended consequences. This reaction is a moral instinct most likely developed in our long evolutionary past, most of which was spent in small, kin-based groups. In that context, self-interested behavior threatened the survival of the group, and anyone who behaved that way would be seen as taking advantage of other group members. This moral instinct is frequently in play in market interactions in general, as we see in the moral disdain for profit-making. Emergencies will activate this reaction even more strongly, as it seems more obvious that the profit-seekers must be taking advantage of others by charging higher prices. What economics can help us understand, contrary to our untrained moral intuitions, is that, under the right institutions, self-interested behavior can lead to socially beneficial consequences, even in emergencies.

One of the problems is that people seem to think that the choice is between low prices and sufficiently abundant supplies versus high prices and abundant supplies. In fact, that’s not the choice. At low prices, supplies will be very low, while at higher prices supplies will, at least in short order, be far greater. If the problem is making sure that there are greater supplies of the good, you are not going to get that by legally mandating a low price. The “fault” here lies not with sellers charging high prices, but with the destruction caused by the natural disaster or other emergency that has led to a reduction in supply and an increase in demand. What sellers are doing is trying to solve the problem the crisis has created. The path to greater supplies at lower prices is to allow prices to rise initially to send the signal to bring forth new supplies.

Emergencies do not change the laws of economics, even if the way they play out offends our moral sensibilities. If the problem during an emergency is that goods have become more scarce and more expensive, the solution is not to try to force the price down, but rather to let it rise to signal the scarcity and provide the knowledge and incentives to entrepreneurs who can bring in new supplies and drive the price back down. No one likes paying higher prices in an emergency, but there is no option of paying a lower price and having supplies magically appear. The higher price in the immediate aftermath is a necessary step to responding in socially beneficial ways to the effects of the crisis. If we want to avoid the problems caused by price ceilings, we need to find a way to get beyond our instinctive repugnance and think about what sorts of policies will actually solve the problem we want to solve. Letting market prices do their job is the right choice.