The Problems with Price Controls

Howard Baetjer: All right. In this presentation, we’ll continue making this point about the importance of market prices. One of the fundamental reasons why free markets are so important for humanity is that free markets generate market prices and market prices are essential to keep us well coordinated. In this presentation, let’s think about the consequences of price controls. [00:00:30] That is, not allowing prices to go to their market level, but by some sort of legislation, preventing them from going to the market level. The ostensible purpose of such price controls often is to protect people from bad things. For example, rent controls, which limit the legal amount a landlord can charge and the tenant may pay in the rent controlled areas, they are meant to protect the tenants from charging what people consider [00:01:00] unfair rents or rents that are too high for them to afford. It’s got a kindly origin, perhaps, in many cases, but bad, unintended consequences can result from that.

We’ll talk about price gouging. After a natural disaster, when it’s hard to get goods into an area, typically, the market prices, the short term market prices rise very high. That’s a hardship for people who have a hard time paying [00:01:30] them.

There are laws against price gouging, which hold prices down below the market level after a hurricane, or an earthquake, or something. We’ll consider the benefit and the … We’ll consider the consequences of those, the benefits and some harms from those.

Very much in the news these days is the minimum wage laws, which are a minimum, so that’s a price floor. Sorry. Minimum is [00:02:00] a floor.

Students: Yes.

Howard Baetjer: The people are not allowed to pay low skilled workers below a certain level. The goal in the hearts and minds of many who support minimum wages is to have people without the advantages, they do make more money. The goals can be good, but the consequences are often negative. We’ll pay attention to those and then we’ll ask whether price controls are ever justified.

[00:02:30] Let’s consider rent controls to begin with and take a look, please, at the graph that you see. The difficulty with a rent control that doesn’t allow prices to come up to the market level, which is $500 in our example, is that at the legal rent level of $400 per month, the quantity of apartments demanded is greater than the quantity supplied. [00:03:00] The difference is going to be a shortage. There won’t be enough apartments for people. It’s good for those who already have the apartments that they’re paying less than they otherwise would. Maybe some people don’t get put out on the street when their lease expires and if they can’t pay higher rents in a time of rising rents. People who are in the apartments [00:03:30] are protected.

What about those who are looking for an apartment in the city? They may simply not be able to find the apartment that they want because landlords don’t have the incentive to offer all the apartments people need, because the price isn’t allowed to rise to the market clearing level. The insight from this, and this is standard economics, is that price ceilings like a [00:04:00] rent control virtually always cause shortages. There’s simply not enough to satisfy the desires of all those who are willing and eager to pay that price. Let’s think about the incentives there. In a situation with the rent control, such as is pictured there, what’s the incentive, problematic incentive for people who are in the apartments?

[00:04:30] What I have in mind here is that, if you’re in a bigger apartment than you need, but you don’t have to pay the market rate for it, you’re getting a controlled, agreeable, low, low rate for it, you have a much weaker incentive to move out and allow that space to be taken up by someone else. How about the incentives on the supply side? When rents are controlled, what can you tell me about the incentive of people who [00:05:00] might supply new apartments?
Student: They won’t build them and they won’t maintain the ones that are built at decent level.

Howard Baetjer: Sure. There are two things there. They won’t … They have much less incentive to build new apartments if they can’t charge high rents for them. In many cases around the world where there have been rent controls, there have been these terrible, long lasting shortages, even where governments [00:05:30] have had crash programs to build new apartments. There are still too few, as long as the rents are below that market clearing level. Thomas Sowell has a wonderful description of this in his great book, Basic Economics. Then, there’s also that point about not maintaining them. Why would the landlord not maintain the apartments.

Student: In a lot of cases, the rent controls only apply to people who are already there. If you can get them to leave, [00:06:00] it’s even better, because you can convert it to condominiums or something.

Howard Baetjer: Yeah. That’s right. If the apartment gets grungy enough, the people leave. Once they leave, you can raise the rents or convert them to condominiums. Also, does a landlord need to keep the apartment in tip top shape in order to rent it?

Students: No.

Howard Baetjer: No. People are desperate for apartments, so they’ll come in even to the grungy areas. Also, in many times, there have been the problem that [00:06:30] as costs of paint and plumbing and electrical work rise, but the rents don’t rise, the landlords don’t take in enough income to pay for the improvements in the apartments. There was a wonderful quip by someone to the effect that rent control for reducing the value of real estate, rent controls are second only to aerial bombardment, [00:07:00] for reasons we’ve talked about.

Let’s go, then, onto minimum wages. With a minimum wage, which is a species of prices floor that does not allow the price to come down to the market clearing wage. In the picture, the market clearing wage would be seven dollars an hour, but we imagine a minimum wage law saying the price may not go down below $8.25 an hour. Then, we have the problem [00:07:30] that the quantity of labor service is supplied by the low skilled workers is greater than the quantity demanded by the firms, the Wendy’s, the Safeway’s, the McDonald’s, the grocery stores that might hire them. That leaves us with a surplus. What do we call the surplus of labor services?

Students: Unemployment.

Howard Baetjer: It’s unemployment. There’s very little question that higher minimum wages, minimum wages about the market clearing level [00:08:00] are a main cause of unemployment. Not for people with our kind of education, but for people with very poor education who don’t have the skills to produce for their employers, goods and services value worth more than the minimum wage. What are some of the incentives for employers who are faced with higher minimum wages? If they have to pay their workers [00:08:30] more, what might they do instead?

Student: They will either turn to automation or, if they’re just talking about human labor, they’re going to pick more generally reliable employees, but that will often cut out folks who can’t have a car and have reliable transport to work, who are young in favor of older workers. You’ll cut the bottom rungs off the ladder, as it were. It generally tends to affect [00:09:00] the worst off of these minimum wage workers.

Howard Baetjer: Good. That’s exactly right. I like that image of cutting off the bottom rungs of the job ladder. Most people need to get a job to learn about being responsible, learn work skills. If they can’t get onto the job ladder, it’s hard to climb it. We see today that issue you mentioned about automation. If it’s very expensive for the operator of a Starbucks or a McDonalds to hire new [00:09:30] workers, they have an incentive to look for machines, like kiosks, where people can order using your cell phone to put in an order, rather than giving it to a human being.

All those problems are unintended bad effects of price controls. We could say more about that, but I’d like to go on to the question now, of whether or not price controls are ever justified. I don’t believe they are ever justified, because the argument for [00:10:00] the coordinating effect of market prices is so strong. It’s worth considering what seems to me the strongest case for price controls, that is price controls after a natural disaster. Because there, people through no fault of their own are in a situation of hardship. It just doesn’t seem right, somehow, for them to have to pay outrageous prices for the goods [00:10:30] and services they need.

Let’s take a particular case, which I know about from my colleague, Russ Sobel, and I’ll have a story that he tells that I’ll read at the end of this little discussion, about the consequences of price controls after Hurricane Hugo that hit Charleston, South Carolina many years ago. It was a category five hurricane, I think, with a huge storm surge. Charleston is low lying and so the storm surge [00:11:00] pushed the sea water up into the fresh water system and into the sewer water system. Sea water and sewer water and fresh water all were being mixed around. People couldn’t trust the water in their pipes.
At the same time, lots of trees came down and so people were without electricity. In that circumstance, what would happen to the price of bottled water in the stores?

Student: [00:11:30] Increase a lot.

Howard Baetjer: It increased dramatically, from say a dollar a gallon to $10 a gallon. What happened to the prices of hand pull, electric, gasoline powered generators.

Student: Also, go up.

Howard Baetjer: Also, skyrocketed, because people wanted those for generators. Apparently, the prices of the generators went up from, let’s say $750 to $10,000 for a generator. The prices of bottled water went up, [00:12:00] just temporarily, went up from, say, a dollar a gallon to $10 a gallon. In those situations, are price controls justified? In order to answer that question, we need to think about the consequences of those price controls. What I want to do now is contrast who would get the water and who would get the generators, and the two alternatives. When water is at the market prices of $10 [00:12:30] a gallon, who would get the water? Another question I want you to consider is: What story is that price telling?

It’s useful to think about prices as having a story to tell.

When they go to the market level, let’s start with water. When prices go to the market level of $10 a gallon, what story are they telling? Who is going to get the water? Then, we’ll turn it around … I didn’t finish the story for you. People did not like this price gouging and very quickly, [00:13:00] somehow, the city council of Charleston passed an emergency statute saying that until further notice, no one is allowed to charge higher prices after the storm than they were charging before the storm.

There was a hard rent control in the city limits of Charleston, capping prices at what they were before the storm. Those generators still had to be sold at $750. The water had to be sold at one dollar [00:13:30] a gallon.

Take a moment, please, and think. Who would get the water at $10 a gallon? What would that price of $10 a gallon be saying? First of all, at $10 a gallon, who would get the water? First of all, how do you suppose my students answer this, my micro students, answer this? What’s the first thing that they say? If the price goes up to $10 a gallons of water, who is going to get it?

Student: The wealthy?

Howard Baetjer: The wealthy. [00:14:00] That’s what they say right away. Plausible, and probably it’s true to some extent, but let’s think about it a little bit more. Who would get the water at $10 a gallon?

Student: The people who have a really exceptional use for it.

Howard Baetjer: People who are willing to pay $10 a gallon for it, who have an exceptional use for it. Hold that thought for a second, to contrast it with the other way around. At the controlled price of one dollar a gallon, who is going to get the water?

Student: Whoever shows up first.

Student: The fastest runner!

Howard Baetjer: The fastest runner, the people who [00:14:30] get there first, because they’ll strip the shelves. Those, perhaps, from the harder hit areas who get to the stores later, how much water will there be for them?

Student: None.

Student: None.

Howard Baetjer: There won’t be any. The shelves will be stripped. Let’s think about water on the supply side. If prices go up to $10 a gallon after the storm, what would you expect to happen as a consequence tomorrow and the next day?

Student: Expecting Joe Smith to go and buy a whole bunch of [00:15:00] gallons of water, drive into the city, and sell them to people at a big mark up.

Howard Baetjer: That’s exactly right. You’d expect people who hear about this, $10 a gallon for water. Might expect college students such as yourselves to say, “Look. Let’s rent a U-​Haul truck. We’ll go over to the local Wal-​Mart and fill it up with all the water we can. We’ll drive to Charleston and we’ll make some money,” and water flows into Charleston. What is that $10 per gallon price saying, so to speak?

Student: We really need it.

Howard Baetjer: We really need it. Fresh water is urgently needed [00:15:30] in Charleston. Bring water to Charleston. What does the one dollar per gallon price say to the rest of the world?

Student: We’ve got plenty.

Howard Baetjer: Business as usual. Everything is the way it has been. No exceptional circumstances. Both on the supply side and the demand side, that $10 price is very useful. It gives those who get to the store first an incentive to leave more for others who can’t get there until later. It gives an incentive for more to be brought [00:16:00] to Charleston.

Let’s go to the generators. At a price of $10,000 for what was a $750 generator, who is going to get the generators? Again, what do my students, my introductory students say?

Student: The wealthy.

Howard Baetjer: The rich, the wealthy people, they’re going to be the ones who get them. Let’s think about it a little further. Who do you suppose actually … I can’t say it [00:16:30] that way. We’ll get to who actually got the generators because the price control was in effect. If the price control were not in effect and the generators went way up to thousands of dollars, who would get the generators and who would benefit from them? Take a moment and think.

Student: It would most likely be …

Howard Baetjer: Hold on. Take a moment. Who would be willing to buy a generator at that? Who would buy the generators? Who would get them and who would benefit? Go ahead.

Student: If I’m a mother and my daughter has diabetes and I need to keep her insulin [00:17:00] cold, I would probably be willing to pay that much. If I just want to watch TV, I probably won’t.

Howard Baetjer: You might [press 00:17:06]. Yes. That’s good. If you have to keep the insulin cold. That’s good. Who else might be willing to pay that for a generator?

Student: The people who operate grocery stores would probably be willing to pay.

Howard Baetjer: Why? Why grocery store owners?

Student: You have to keep the food cold or it all goes bad and you have to throw it out.

Howard Baetjer: Sure. Suppose you have $9,000 worth of frozen food in the freezers. You’re going to be willing to pay … The [00:17:30] other way around. If you’ve got $15,000 worth of frozen food in the freezers, you’re certainly going to be willing to pay $10,000 for the generator. When the grocery store owner does that, who benefits?

Student: Everybody.

Howard Baetjer: Everybody who buys that food. Also, generators were needed in Charleston because, with the phone lines brought down by the falling trees, people couldn’t use their credit cards and they needed cash. Automated teller machines [00:18:00] need electricity. Banks might have been willing to pay a lot for a generator to keep their ATMs going. Gasoline was needed for people’s vehicles and for the chainsaws needed to clear away the limbs of the trees. To get gasoline out of the ground requires pumps, electrical pumps, at the gas stations. Gas stations might have been willing to pay that. Probably, the machines would not be [produced 00:18:29] by the rich just to keep [00:18:30] their air conditioning running. It would have been purchased by businesses who had services to provide for the rest of the community.

With the price control in effect, who do you suppose got the generator? I have a story that I’ll read you about it here in a moment. What do you think? Who would get the generators with the price controls in effect?

Student: People that get there first. People who have connections.

Howard Baetjer: That’s the way it worked. My colleague, Russ Sobel, [00:19:00] told me this story. When I was working on my book, I wrote him for it. Here’s the story of actual two generators in Hugo after that awful storm. My neighbor was high school best friends years ago with the now owner of a local hardware store. His neighbor had a friend who owned a hardware store. The store had two generators. He didn’t get the store open before the price controls took effect, so he was faced with them. He kept one for his family, makes [00:19:30] sense, and sold the other at the controlled price to my neighbor, like 1/​10th of the free market price. Listen. My neighbor’s daughter (who was my age, the girl next door cutie) was blow drying her hair on it. My dad was going over to use his electric shaver. In the meantime, the gas station, the grocery store, the bank with an ATM, and the K-​Mart were all without power.

That story [00:20:00] of the generator, that precious electricity, being used for a young woman to blow dry her hair and Russ’s father to use his electric shaver, that’s when I urge my students to remember when they think about price controls, because it’s a desperate, tragic example of the misallocation of resources that occurs when prices aren’t allowed to tell their story and keep us coordinated and [00:20:30] allocate resources to where they’re most, believed, at least, to be most valuable.

In conclusion, then, on this section of the course on prices, in closing, I would say market prices are precious. They have an important story to tell and they should be allowed to tell them. The conclusion, then, is for no … I don’t think there’s ever good reason, justification, for controlling prices. [00:21:00] The function they play of communicating information, serving as knowledge surrogates, and letting us know the real condition of the availability of resources and desire for it, is so important that they should always be allowed to do that. There’s a very libertarian conclusion. Never, under any circumstances, should prices be controlled by legislation.