Why price controls should stay in the history books

The burst of inflation that followed the COVID-19 crisis and the expansive policy of international central banks, including the Federal Reserve, has put price controls back in the news. For example, recent articles have advocated forms of price controls to reduce US inflation and achieve other objectives.

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

Price controls are government regulations on wages or prices or their exchange rates. 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 control price increases with price ceilings, such as rent control, or put a floor on prices with policies such as minimum wages. The following table shows some examples of common price controls.

The history of price controls

Price controls have a long history: Hammurabi’s Code prescribed the prices of goods 4,000 years ago, and the colonies of Massachusetts and Virginia did the same 400 years ago. Governments have commonly restricted prices during war, and all major belligerents instituted sweeping price limits during World War II. Western countries commonly used extensive price controls in the 1970s. The US government last used extensive controls in a series of schemes between 1971 and 1974, after the exit of the dollar from the gold standard. Many developing countries control the prices of staple foods, 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 scarce goods and services to buyers who are most willing and able to pay for them.
• They point out that a good is valued and that producers can benefit by increasing the quantity supplied.

That is, prices allocate scarce resources on both the consumption and production sides. Price controls distort those signals.

The following figure shows a stylized supply and demand graph for a competitive market in which the equilibrium price-quantity pair would be defined by the point where the supply and demand curves intersect, at {P_mewhat_me}. However, in the presence of the maximum price, consumers want Q_D. units, while vendors are willing to offer only Q_S units. what_D. is much greater than Q_S and the difference is a shortage of product (Q) at the ceiling price.

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

Costs of price controls

Price controls have costs whose severity depends on the extent of the control and the degree to which the price changes from 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 production.
• Competition shifts from production to political markets as companies try to influence pricing decisions.
• Widespread evasion of price controls promotes disrespect for the law.
• Suppressed inflation appears when temporary controls are relaxed.

Most of these costs are straightforward, but the allocation inefficiency requires some explanation: because Q_D. is greater than Q_S In the second figure, there is a shortage of the product and sellers must figure out how to allocate a limited supply. Maybe they only sell to old 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 rates. Such “priceless rationing” is inefficient because some buyers who do not get the good are willing to pay more for it. Producers would be willing to increase production and sell to consumers who want to buy at a higher price, but price controls make it illegal.

How do people and companies evade wage and price controls?

When a price cap prohibits a desired transaction, the buyer and seller often evade the price cap by transacting in a closely related but unregulated product or by trading illegally in black markets. Similarly, sellers may change a good slightly to avoid being subject to the same price limit. Economist Hugh Rockoff points out that the price of clothing has been particularly difficult to control because an article of clothing can easily be upgraded to a higher price category by adding inexpensive decoration or reduced in quality by substituting cheaper materials.

Historian Jennifer Klein has documented that the US health system’s current reliance on employer-provided insurance is a relic of the evasion of wage controls during World War II. During that conflict, the defense industries wanted to hire more workers, but were legally unable to raise wages. To make your works more attractive, some employers began offering health insurance as a legal fringe benefit.

Price controls cause major behavioral changes in the long run. Consider how businesses might respond to a higher minimum wage that increases the cost of entry-level labor. In the short term, entrepreneurs could increase prices and save labor. 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 the higher-priced products that are intensive in basic labor. In the long term, employers will install more capable machines, such as dishwashers or automatic kitchen machines, to reduce the amount of entry-level labor they use.

What do economists think about price controls?

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

Economists know, however, that price controls can be theoretically beneficial when properly imposed 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 some bouts of inflation in his book. Clamping Down: A History of Wage and Price Controls in the United States. Rockhoff reported that even the late Milton Friedman, a leading proponent of free markets, accepted a limited role for temporary price controls to break inflation expectations during a disinflation.

Conclution

Price controls have had a very long but not very successful history. Although economists accept that there are certain limited circumstances in which price controls can improve outcomes, economic theory and analysis of history show that comprehensive 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

• Little one, Jennifer. For All These Rights: Business, Work, and the Shaping of America’s Public-Private Welfare State. Princeton University Press, 2010.
• Rockoff, Hugh. “The response of giant corporations to price and wage controls in World War II.” The Journal of Economic History, March 1981, vol. 41, pp. 123-128.
• Rockoff, Hugh. Clamping Down: A History of Wage and Price Controls in the United States. Cambridge University Press, 2004.
• Schuettinger, Roberto; and Butler, Eamonn. Forty Centuries of Price and Wage Controls: How Not to Fight Inflation. The Heritage Foundation, 1979.

final notes

1. See by Isabella Weber opinion article of December 29 in The Guardian and Eric Levitz’s January 2 article in New York Magazine.
2. The book Forty Centuries of Price and Wage Controls: How Not to Fight Inflation, Written by economists Robert Schuettinger and Eamonn Butler, he discusses the historical examples in this article and is highly critical of price controls.
3. In command economies, such as the former Soviet Union, consumers often spend hours in line to buy scarce goods and services.
4. A monopolist is the only seller of some product, while a monopsonist is the only buyer of some product. Monopolists will generally sell less output than many competitive firms would and for a higher price. If the government limits the price at which a monopolist can sell, it will sell more 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 advocate 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.