Price Controls and Shortages
FEBRUARY 01, 1980 by GEORGE REISMAN
Dr. Reisman is Associate Professor of Economics at Pepperdine University in Los Angeles.
This article is reprinted by permission from his new book, also reviewed in this issue, The Government Against the Economy.
Price controls are advocated as a method of controlling inflation. People assume that inflation means rising prices and that it exists only when and to the extent that businessmen raise their prices. It appears to follow, on this view, that inflation would not exist if price increases were simply prohibited by price controls.
Actually, this view of inflation is utterly naive. Rising prices are merely a leading symptom of inflation, not the phenomenon itself. Inflation can exist, and, indeed, accelerate, even though this particular symptom is prevented from appearing. Inflation itself is not rising prices, but an unduly large increase in the quantity of money, caused, almost invariably, by the government. In fact, a good definition of inflation would be, simply: an increase in the quantity of money caused by the government. Rising prices as a chronic social problem are a consequence of governments overthrowing the use of gold and silver as money and putting in their place unbacked paper currencies and checking deposits whose quantity can be increased without limit and virtually without cost.
The imposition of price controls to deal with inflation is as illogical as would be an attempt to deal with expanding pressure in a boiler by means of manipulating the needle in the boiler’s pressure gauge. It is no less self-destructive, as well. Prices are equivalent to an instrument panel on the basis of which everyone plans his economic activities and which enables the plans of each individual to be harmoniously adjusted to the plans of all other individuals participating in the economic system.
The free market is a truly awe-inspiring complex of relationships in which the rational self-interest of individuals unites all industries, all markets, all occupations, all production, and all consumption into a harmonious, progressing system serving the well-being of all who participate in it.
All of this is what price controls destroy.
Controls Cause Shortages
The one consequence of price controls that is the most central and the most fundamental and important from the point of view of explaining all of the others is the fact that price controls cause shortages.
A shortage is an excess of the quantity of a good buyers are seeking to buy over the quantity sellers are willing and able to sell. In a shortage, there are people willing and able to pay the controlled price of a good, but they cannot obtain it. The good is simply not available to them. Experience of the gasoline shortage of the winter of 1974 should make the concept real to everyone. The drivers of the long lines of cars all had the money that was being asked for gasoline and were willing, indeed, eager, to spend it for gasoline. Their problem was that they simply could not obtain the gasoline. They were trying to buy more gasoline than was available.
The concept of a shortage is not the same thing as the concept of a scarcity. An item can be extremely scarce, like diamonds, Rembrandt paintings, and so on, and yet no shortage exist. In a free market the effect of such a scarcity is a high price. At the high price, the quantity of the good demanded is levelled down to equality with the supply available, and no shortage exists. Anyone willing and able to pay the free-market price can buy whatever part of the supply he wishes; the height of the market price guarantees it, because it eliminates his competitors. It follows that however scarce a good may be, the only thing that can explain a shortage of it is a price control, not a scarcity. It is a price control that prevents the price of a scarce good from being raised by the self-interest of the buyers and sellers to its free-market level and thus reducing the quantity of the good demanded to equality with the supply of the good available.
Of course, if a price control on something exists, and a scarcity of it develops or grows worse, the effect will be a shortage, or a worsening of the shortage. Scarcities can cause shortages, or worsen them, but only in the context of price controls. If no price control existed, the development or worsening of a scarcity would not contribute to any shortage; it would simply send the price higher.
Shortage Amidst Abundance
It should be realized that a shortage can exist despite a great physical abundance of a good. For example, we could easily develop a severe shortage of wheat in the United States with our present, very abundant supplies, or even much larger supplies. This is because the quantity of wheat demanded depends on its price. If the government were to roll back the price of wheat sufficiently, it would create a major additional demand not only a larger export demand, but a larger demand for raising cattle and broilers, making whiskey, and perhaps for many other employments for which one does not presently think of using wheat, because of its price. In other words, no matter how much wheat we now produce or might produce in the future, we could have a shortage of wheat, because at an artificially low price we could create a demand for an even larger quantity.
To the degree that the controlled price is below the potential free-market price, buyers judge that they can afford more of the good with the same monetary wealth and income. They judge that they can carry its consumption to a point of lower marginal importance. In this way, the quantity of the good demanded comes to exceed the supply available, whether that supply is scarce or abundant.
Price controls also reduce supply, which intensifies the shortages they create.
In the case of anything that must be produced, the quantity supplied falls if a price control makes its production unprofitable or simply of less than average profitability.
Squeezing Marginal Producers
It is not necessary that a price control make production unprofitable or insufficiently profitable to all producers in a field. Production will tend to fall as soon as it becomes unprofitable or insufficiently profitable to the highest-cost or marginal producers in the field. These producers begin to go out of business or at least to operate on a smaller scale. Their place cannot be taken by the more efficient producers, because the same price control that drives them out of business restricts the profits of the more efficient produc ers and deprives them of the incentive and also the capital required for expansion. Indeed, the tendency is eventually for even the most efficient producers to be unable to maintain operations and to be driven out of business.
For example, the price controls on oil have held down the supply of oil. They have not yet totally destroyed the supply of oil, but they have discouraged the development of high-cost sources of supply, such as oil from shale rock and even from the continental shelf in some instances. They have also made the more intensive exploitation of existing oil fields unprofitable, which, it is estimated, could be made to yield from one-third to two-thirds more oil over their lives by the adoption of such methods as thermal or chemical flooding, sometimes known as “tertiary recovery.” At the same time, in restricting the profits from the lower-cost oil deposits, price controls have held down both the incentives to discover and develop new such deposits and the capital necessary to the oil companies for expanded oil operations of any type.
Rent controls on housing that has already been constructed provide a similar example of the destruction of supply. As inflation drives up the operating costs of housing—namely, such costs as fuel, maintenance, and minor repairs—more and more landlords of rent-controlled buildings are forced to abandon their buildings and leave them to crumble. The reason is that once the operating costs exceed the frozen rents, continued ownership and operation of a building become a source merely of fresh losses, over and above the loss of the capital previously invested in the building itself.
This destruction of the housing supply starts with the housing of the poor and then spreads up the social ladder. It starts with the housing of the poor because the operating costs of such housing are initially so low that they leave relatively little room for further economies. For example, there are no doormen to eliminate and therefore no doormen’s salaries to save. Also, the profit margins on such housing (i.e., profits as a percentage of rental revenues) are the lowest to begin with, because the land and the buildings are the least valuable and therefore the amount of profit earned is correspondingly low. As a result, the housing of the poor is abandoned first, because it provides the least buffer between rising operating costs and frozen rents.
A price control reduces supply whenever it is imposed in a local market and makes that market un-competitive with other markets. In such a case, the local market is prevented from drawing in supplies from other areas, as was the Northeast and the United States as a whole during the Arab oil embargo.
In exactly the same way, in the winter of 1977, price controls on natural gas prevented areas of the United States suffering freezing weather from bidding for additional supplies from the producing regions in the South and Southwest. Natural gas shipped across state lines was controlled by the Federal Power Commission at a maximum of $1.42 per thousand cubic feet. Natural gas sold within the states where it was produced, and thus outside the jurisdiction of the FPC and free of price controls, was selling at $2.00 per thousand cubic feet, with lower costs of transportation besides. It was therefore much more profitable to sell natural gas in the states where it was produced, such as Texas and Louisiana, than in such states as New Jersey or Pennsylvania.
Export Policies Affected
A price control not only prevents a local market from drawing in supplies from elsewhere, but it can also cause a local market that normally exports, to export excessively. In this case, as supplies are drawn out, the price control prevents the people in the local market from bidding up the price and checking the outflow.
This phenomenon occurred in this country in 1972 and 1973. Our price controls on wheat, soybeans, and other products made possible an unchecked exportation that jeopar dized domestic consumption and led to an explosion of prices each time the controls were taken off, in President Nixon’s succession of on-again, off-again “phases.”
In this instance, the fall in the value of the dollar in terms of foreign currencies played a critical role. When President Nixon imposed price controls in August of 1971, he also took steps to devalue the dollar by 10 percent. Over the following two years, the dollar continued to fall in terms of foreign currencies and in 1973 was formally devalued a second time. The fall in the dollar’s foreign exchange value meant a lower price of dollars in terms of marks, francs, and other currencies. Since the prices of our goods were frozen, a lower price of dollars meant that all of our goods suddenly became cheaper to foreigners. As a result, they began buying in much larger quantities—especially our agricultural commodities. As they began buying, domestic buyers were prevented by price controls from outbidding them for the dwindling supplies. As a result, vast accumulated agricultural surpluses were swept out of the country, and domestic food supplies were threatened, which is why prices skyrocketed each time the controls were taken off.
The fact that price controls jeopardize supplies in markets that export leads to embargoes against further experts, as occurred in this country in the summer of 1973, when we imposed an embargo on the export of various agricultural commodities. In addition, price controls in markets that must import make such markets helpless in the face of embargoes imposed by others, as we were made helpless in the face of the Arab oil embargo. It follows that in degree that countries impose price controls, they must fear and hate each other. Each such country must fear the loss of vital supplies to others, as the result of excessive exportation, and the deprivation of vital supplies from others, as the result of their embargoes and its helplessness to cope with them. Each such country makes itself hated by its own embargoes and hates the countries that impose embargoes against it. Our embargo on agricultural products in 1973 did not endear us to the Japanese. And there was actual talk of military intervention against the Arabs. Simply put, price controls breed war. A free market is a necessary condition of peace.
A price control reduces supply whenever it is imposed on a commodity of the kind that must be stored for future use. The effect of a price control in such a case is to encourage a too rapid rate of consumption of the commodity and thus to reduce supplies available for the future. As we have seen, buyers are led to buy too rapidly by the artificially low price, and sellers are led to sell too rapidly, since the fixity of the controlled price does not enable them to cover storage costs and earn the going rate of profit in holding supplies for future sale.
If the buying public is unaware of the impending exhaustion of supplies, the effect of sellers placing their supplies on the market right away is to depress the current market price below the controlled price. This process tends to go on until the current market price falls far enough below the controlled price, so that once again it has sufficient room to rise in the months ahead to be able to cover storage and interest costs. The resulting structure of prices guarantees the premature exhaustion of supplies.
Under conditions such as those described above, the buying public sooner or later becomes aware of the fact that supplies will run out. At that point, demand skyrockets, as the buyers scramble for supplies. As soon as this occurs, and it may be very early, the larger supplies that sellers are encouraged to place on the market under price controls are not sufficient to depress the market price below the controlled price, because they are snapped up by the speculative buying of the public, which is aware of the shortage to come. The consequence of the speculative buying of the public is that the item disappears from the market right away; it is hoarded.
The hoarding of the buying public is not responsible for the existence of shortages. The public hoards in anticipation of shortages caused by the price controls. The public’s speculative demand cannot even be blamed for hastening the appearance of a shortage. That too must be blamed on price controls, because in the absence of the controls the additional demand of the public would simply raise prices; at the higher prices, the rise in the quantity of goods demanded would be cut back; prices would rise to whatever extent necessary to level down the quantity demanded to equality with the supply available.
Speculation on the part of the suppliers of goods is likewise blameless for the existence of shortages. Contrary to popular belief, price controls do not give suppliers a motive to withhold supplies, but, as we have seen, an incentive to unload them too rapidly.
There is, of course, an important exception to the principle that price controls give sellers an incentive to sell their supplies too rapidly. This is the case in which the sellers are able to look forward to the repeal of the controls. In this case, a price control makes it relatively unprofitable to sell in the present, at the artificially low, controlled price, and more profitable to sell in the future, at the higher, free-market price. In this case, sellers do have a motive to withhold supplies for future sale.
Even in this case, however, it is still the price control that is responsible for the existence of any shortage that develops or intensifies. In this case, the price control discriminates against the market in the present in favor of the market in the future; it prevents the market in the present from competing for supplies with the market in the future. Furthermore, in the absence of a price control, any build-up of supplies for sale in the future would simply be accompanied by a rise in prices in the present, which would prevent the appearance of a shortage, as we have seen repeatedly in previous discussion.
Finally, it should be realized that the withholding of supplies in anticipation of the repeal of a price control does not imply any kind of antisocial or evil action on the part of the suppliers. Price controls, as we have seen, lead to inadequate stocks of goods; in many cases, it is probable that the build-up of stocks in anticipation of the repeal of controls merely serves to restore stocks to a more normal level. Even if the build-up of stocks does become excessive, its effect later on, when the stocks are sold, is merely to further reduce the free-market price in comparison with what that price would otherwise have been. In any event, any ill-effects that may result are entirely the consequence of price controls.
The Consumer’s Interest
Sometimes, the question is raised as to what argument one could give to a consumer to convince him to be against price controls; especially what argument one could give to a tenant to convince him to be against rent controls. Our discussion of how price controls reduce supply indicates a very simple argument to give to any consumer against any price control. That is that if he wants something, he must be willing to pay the necessary price. It is a natural law—a fact of human nature—that a good or service can only be supplied if supplying it is both worthwhile to the suppliers and as worthwhile as any of the alterna tives open to them. If the price is controlled below this point, then it is equivalent to a prohibition of supply. To command, for example, that apartments be supplied at rents that do not cover the costs of construction and maintenance, and the going rate of profit, is equivalent to commanding that buildings be built out of impossible materials like air and water rather than steel and concrete. It is to command construction in contradiction of the laws of nature. In the same way, to command that oil be sold less profitably in New York than in Hamburg, say, or that natural gas be sold less profitably in Philadelphia than in Houston, is equivalent to commanding that these materials become drinkable and that water become burnable, for it is no less an act in contradiction of the nature of things.
Now it is simply absurd for a consumer who wants a good, to support a measure which makes its supply impossible. And that is what one should tell him. That is what the consumers themselves should tell the legislators who are busy enacting price-control laws for their alleged benefit. These would-be benefactors of the consumers are prohibiting the consumers from making it worthwhile for businessmen to supply them. They are destroying the businessmen. In effect, they are destroying the consumers’ ability to find agents to act on their behalf. They are reducing the consumers to the point where if they want anything, they will have to produce it themselves, because price controls will make it unprofitable for anyone to supply it to them. Already, rent control has “benefitted” tenants to the point that it is becoming increasingly necessary if one wants an apartment to own it oneself: one must buy a “co-op” or a condominium. Price controls have made it increasingly difficult, and at times absolutely impossible, to buy oil or natural gas. If the legislators are to go on “benefitting” the consumers long enough with their price controls, they will benefit them all the way back to the economic self-sufficiency that was the leading characteristic of feudalism.
The ignorance that underlies the destruction of our economic system is made possible by a protective shell of envy and resentment. People take the attitude that somehow the utilities, the landlords, the oil industry, or whoever, are “already rich enough,” and that they’ll be damned if they’ll let them get any richer. So, on with the price controls. That is the beginning and the end of their thinking on the subject, and they just don’t care to think any further. They are eager to accept high nominal profits as a confirmation of their view that the industries concerned are “rich enough,” and to let it go at that.
However, the simple fact is that none of these industries is rich enough, and in preventing them from becoming richer, or even staying as rich as they are, people foolishly harm themselves. None of these industries is rich enough for the simple reason that we really do not have enough power plants, enough good apartment buildings, or enough oil wells and oil refineries. Speaking for myself, as a consumer, I must say that I would like Con Edison, the landlords of New York City, the oil industry, and so on, all to be worth many more billions than they are presently worth. I would benefit from that fact. If Con Ed had more power plants, my supply of electricity would be assured. If the landlords had more and better buildings, I would have a better apartment. If the oil industry had more wells and refineries, I would have a more abundant and secure supply of oil products.
If one thinks about it, I believe, nothing could be more absurd than consumers in a capitalist economy attacking the wealth of their suppliers. That wealth serves them—they are the physical beneficiaries of it. All of the wealth of the utilities, the landlords, the oil companies—where is it? It is in power plants and power lines, apartment buildings, oil wells and oil refineries. And whom does it actually, physically, serve? It serves the consumers. It serves us all of us. We have a selfish interest in the preservation and increase of that wealth. If we deprive Con Ed of a power plant, we deprive ourselves of power. If we deprive our landlords of more and better buildings, we deprive ourselves of apartments. If we deprive the oil industry of wells and refineries, we deprive ourselves of gasoline and heating oil.
Trust the Market
There is indeed a harmony of interests between the consumer and the producer under capitalism. Because of it, even if businessmen become cowardly and do not fight for their own interests, we, as consumers, must fight for them, and thereby for ourselves. For we have a selfish interest in being able to pay prices that make it profitable for businessmen to supply us. It is to our self-interest to pay utility rates, rents, oil prices, and so on, that enable the producers in these fields to keep their facilities intact and growing, and that make them want to supply us. And I must say that we do not have to worry about being charged unfairly in a free market, because any high profits that might be made from us are simply the incentive and the means to an expanded supply, and are generally made only because of special efficiency on the part of the producers who earn them.