Alex Tabarrok (reference below, video on right), describes the five major unintended consequences of government-regulated price ceilings (a maximum price allowed by law).
Five effects of price ceilings
Tabarrok sets out the five major unintended consequences of price ceilings, each of which is addressed in more detail below:
Reductions in product quality
Wasteful lines and other search costs
A loss in gains from trade (deadweight loss)
A misallocation of resources
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Example of 1971 price controls in the U.S.
Tabarrok writes that:
“In 1971, President Nixon, in an effort to control inflation, declared price increases illegal. Because prices couldn’t increase, they began hitting a ceiling. With a price ceiling, buyers are unable to signal their increased demand by bidding prices up, and suppliers have no incentive to increase quantity supplied because they can’t raise the price. What results when the quantity demanded exceeds the quantity supplied? A shortage! In the 1970s, for example, buyers began to signal their demand for gasoline by waiting in long lines, if they even had access to gasoline at all. As you’ll recall from the previous section on the price system, prices help coordinate global economic activity. And with price controls in place, the economy became far less coordinated.”
Price ceilings create shortages
A shortage is the amount by which the quantity demanded exceeds the quantity supplied at the controlled price.
Tabarrok illustrates the shortage produced by a price ceiling.
Price ceilings lead to reductions in quality
Tabarrok uses examples from the Nixon controls to explain why price ceilings allow producers to reduce quality and still be able to sell all their product at the controlled price.
Price ceilings lead to wasteful lines and other search costs
Tabarrok emphasizes that price regulation does not eliminate competition because competition for scarce resources is an unalterable aspect of human social organization. What happens under price regulation, instead of competing on price, competition appears in other forms.
The most common other form is bidding up waiting time. One can estimate the extent to which waiting time will be bid up:
Tabarrok underlines the societal loss from this method of competition: when one competes on price, the seller receives the full value of what the buyer pays; when one competes through lineups the value paid by the buyer is not received by the buyer, it is simply wasted.
Price ceilings reduce gains from trade
Tabarrok’s demonstration that price ceilings produce a deadweight loss compared to the free market outcome as follows:
Price ceilings lead to misallocation of resources
Tabarrok explains how price ceilings prevent the highest value uses from outbidding lower valued uses, for example oil in the 1970s going to heating California swimming pools rather than getting to higher value use of keeping New England houses above freezing. He compares the consumer plus producer surplus when a free market allocates gasoline to its highest value to the consumer plus producer surplus if it is allocated randomly in the following diagram.
Suppose that the quantity demanded and quantity supplied in the market for milk is as follows: What is the equilibrium price and quantity of milk?
When a price ceiling is in place keeping the price below the market price, what’s larger: quantity demanded or quantity supplied?
The Canadian government has wage controls for medical doctors. To keep things simple, let’s assume that they set one wage for all doctors: $100,000 per year. It takes about 6 years to become a general practitioner or a pediatrician, but it takes about 8 or 9 years to become a specialist like a gynecologist, surgeon, or ophthalmologist. What kind of doctor would you want to become under this system? (Note: The actual Canadian system does allow a specialist to earn a bit more than general practitioners, but the difference isn’t big enough to matter.)