Do Price Controls work?

 

Evaluating the likely micro- and macro-economic effects of price controls.

Price controls are legal restrictions on the maximum or minimum prices that can be charged for a good. They are imposed by governments either in for the long-term  because of structural problems in a market or political choices, or as short-term provisions in an emergency. They work by making it illegal for traders and consumers to buy or sell goods outside of the set price.

If a government imposes a maximum price above the market equilibrium, or a minimum price below the market equilibrium, this should not have any effect on the market equilibrium. Instead, a maximum price for rent, for instance, set above the equilibrium, would in theory restrain bad landlords from exploiting renters.

Those economists who believe in free markets would say that landlords should be allowed to practise first degree price discrimination and to charge whatever the market will bear (whatever someone is prepared to pay) for property. Others would suggest that allowing prices above a certain point would encourage all landlords to raise their prices and so a maximum above the equilibrium would have value in setting a well-known limit which would have a psychological impact in restraining the incentive to raise prices.

Similarly, setting a minimum price below equilibrium could stabilise a market without affecting the equilibrium price. This could occur in situations of monopsony. For instance, supermarkets have an incentive, as oligopsonies, to push down the money offered to small farmers and producers for their goods. Small farmers and producers have few alternative outlets. This might mean that they are prevented from making a profit, and that they leave the market.

Such a situation would either remove supply which could not be rebuilt easily, or result in the negative social and environmental externalities associated with the development of big single producers buying up the previously existing property (as in the Highland clearances of Scotland of the nineteenth century.) This would be bad for consumers and food standards. The small reduction in the profits of large supermarkets could also force the supermarkets to be more efficient and to lower costs in other ways, encouraging dynamic efficiency and lowering x-inefficiency.

In labour markets, price controls are often seen as useful in the form of a minimum wage. The minimum wage sets a ‘floor’ below which employers cannot lower wages. This ensures against ‘sweat shop’ bad employers, who exploit workers in conditions of near-slavery. It also ensures that such bad employers do not gain an advantage over better employers whose practises do not cause social problems, and that such bad employers do not drag the better ones down to their level or push them out of business. It also means that, because employees can make enough money to live, that social externalities associated with poverty and exploitation are reduced.

Price controls could be difficult to administer. Firstly, they would require either that buyers and sellers are regulated and monitored, or that they self-report their prices, or have to be accompanied by large fines or costs for those who break them.

The evidence of rationing (which was a form or resource allocation control that depended on set amounts rather than prices) in the twentieth century, which existed from 1939-1954 in the UK, and again briefly in 1974 is that even physically controlling goods is not completely possible. There were always people who were prepared to buy and sell on black markets. Technology, however, and the existence of self-monitoring and self-reporting departments in businesses based around VAT reporting and HR practices may have minimised this risk, as might the greater and more traceable use of electronic transactions compared to paper money. Minimum wage systems have also been operated in the UK with a high degree of efficiency for nearly three decades.

Secondly, and more seriously, price maxima and minima could be set at the ‘wrong’ levels. For example, a minimum price for a good or service set above the market equilibrium will mean that there is an oversupply of that good or service. This is a serious form of resource misallocation which in turn creates the problem of what to do with the waste or surplus. If the minimum which is set too high is a minimum wage, it will create unemployment immediately and dynamically.

The immediate problem will be that there will be too many workers seeking too few jobs, because the demand from employers above the equilibrium will be above the supply of labour. The dynamic problem will be that employers will find the opportunity cost of machinery which replaces workers to have declined, and will start investing in it, if workers become too expensive. If governments also respond to the complexity of workers’ choices by making the system porous—for instance by having different minimum wages for different industries or classes of employee, such as the old, the young, or those with savings in part-time jobs, employers could be incentivised to turn against those of full working age willing and able to supply high quality services and labour full-time.

Such developments in theory raise structural and classical unemployment. They also increase government costs, and run risks of government failure. Government failure could occur because the government creates a bureaucracy to maintain or calibrate price controls which can never know as much as the market and which will have a tendency to act politically and in terms of self-preservation rather than solely with the ‘right’ price in mind. If the price controls were established in an emergency, public choice theory would also suggest that the bureaucracy would have a tendency to keep itself in business and income when the emergency passed by finding excuses to promote the price controls.

Governments might impose price controls for macroeconomic reasons rather than because of the situation in particular markets. Firstly, imposing controls on businesses when inflation is rising might seem attractive as a way of slowing the inflation. Such behaviour might, however, simply suppress or displace the inflation. It could suppress it by creating a situation in which prices of goods and services increasingly failed to match their real value in terms of the work, energy, or resources which it took to produce the items. In those circumstances, black markets, excess demand, distorted supply chains, shortages, and rationing, will become more common until the system implodes, as at the end of the USSR.

Secondly, the price mechanism is a way in which the market system allocates, indicates, and incentivises. Intervening to prevent the price mechanism from working via price controls could prevent the innovation and discovery of alternatives, or individual rationing of choices, which the market offers and which in the long run could benefit society. If the government aims to prevent high prices which exist in the market because of oligopsony supermarkets exploiting insecure small farmers in unstable markets, subsidising the farmers, operating buffer stock schemes, or breaking up the monopoly power of supermarkets might be better long-run alternatives than price controls.

The time and purpose for which a government creates price controls might matter. For instance, in the UK gas industry, a price cap was set in the mid-2010s which was high at the time and above the equilibrium wholesale price. This encouraged small companies with no storage and low costs to enter the market and to offer what appeared to be good deals to consumers, whilst discouraging bigger companies from investing in storage because they had to protect their short-term profits.

When the wholesale market changed in the early 2020s, and prices in international wholesale markets rose, the smaller firms could not cope and went out of business because they could not raise their prices. The larger companies had no storage capacity. The government had been encouraged to frame problems in terms of the price cap and not storage, and was then forced to raise the cap, creating a shock for consumers and businesses at a time when there were other causes of cost-push inflation. This was a policy failure which left the UK at risk of power cuts, business closures, and bankruptcies.

A second example would be the capacity of the NHS to set prices for drugs. This is achieved through the exploitation of the size of the National Health Service, which consumes the vast majority of drugs produced by national and international companies in the UK. This means that ‘price-gouging’ by large pharmaceutical companies, as in the United States, is not possible. It also means, however, that the most expensive new drugs are often simply not offered to patients or even available because global companies do not sell them at reduced prices to the NHS or private British hospitals, preferring to charge more to maximise profits elsewhere.

In an emergency, such as a war, pandemic, or natural disaster, control of resources and sales is probably a better alternative to price controls. For instance, controlling the number of items a family or individual could purchase would work better when people are in conditions of panic than attempting to control prices, for the same reason that shutting banks ends bank runs more easily than raising interest rates does. If the emergency is caused by a balance of payments crisis, in which a country experiences a collapse of currency and capital flight, then rationing might again be a better solution.

Price controls create bureaucracies, and costs, and only work in limited circumstances. They depend upon social choices and trade price ‘discovery’ and free markets for security and stability, but sometimes result in government failure. There is substantial evidence that, even where they seem to work, they could, as in the gas industry, affect policy choices and investment adversely. They might be a social and individual benefit to farmers and marginal workers, and could therefore form part of an anti-poverty or emergency recovery strategy. Price controls must always, however, be treated as a last resort.