Price Ceilings Cause Shortages and Higher Costs

The coordination of demand and supply, which we discussed last month, does not occur automatically. It is an example of Adam Smith’s invisible hand, which leads people interested only in pursuing their own interests to make choices that promote the interests of others as well. But the invisible hand, as amazing as it is, works only under certain conditions. Without property rights, a defense against the violation of those rights from both external and internal threats, a predictable judiciary, a stable monetary system, and a limited government, the voluntary exchange on which social coordination depends quickly breaks down.

Government has important roles in protecting private property, preventing capricious judicial decisions, and protecting the monetary unit against debasement. But these functions can be performed effectively only by a limited government. Once government goes beyond protecting voluntary exchange as an impartial referee and attempts to determine particular outcomes, it disrupts the social cooperation that is the surest means to generally desirable outcomes. Examples of disruptive government incursions into market activity are unfortunately frequent. A particularly harmful form of government meddling is the attempt to outlaw market prices.

When most people think of market prices they don’t think of the communication and cooperation those prices allow. Consumers typically see prices as too high and therefore an impediment to their desire for more things. Suppliers see the same prices as too low. What happens when the government responds to consumer pressures by imposing a maximum legal price on a product below the price the market would set? The unfortunate, and ironic, result of a price ceiling is to increase the cost of products to consumers.

In the accompanying figure the demand curve, D, and supply curve, S, determine a price P*, which the market tends toward. As I discussed in last month’s column, P* motivates suppliers to make available exactly that amount, Q*, that consumers want at that price. This ability of millions of people to coordinate their decisions with one another is the result of the information they communicate through market prices. Now consider what happens when the government imposes a price ceiling below P*, say at P_C.

At that price suppliers are willing to make available only Q_S units of the product, while consumers are anxious to buy Q_D units. The result is a shortage, as consumers cannot get as much of the product as they want. Shortage—the inability to buy a product although one has the money in hand—is different from scarcity, which we can define as the inability of people to have as much as they would like at a zero price. Scarcity is an unavoidable feature of the real world; shortages are not. Any shortage would be eliminated by the price generated by market communication, so shortages are always created by government restrictions on market prices.

Advocates of price ceilings claim that they lower the cost of the product for consumers. This claim seems plausible since the price consumers pay is P_C after the ceiling is imposed instead of P*. But you can’t lower the cost to consumers by restricting the price communication that allows them to secure the maximum cooperation from suppliers. Indeed, price ceilings increase the consumers’ cost. Since the height of the demand curve tells us how much consumers are willing to pay for another unit of the product, we can see from the figure that when only Q_S units of the product are available, consumers are willing to pay Pm rather than do without. And just because they can’t legally pay that amount in dollars doesn’t mean they won’t pay it in other ways.

For example, one way consumers compete during shortages is on the basis of first-come, first-served. According to Hedrick Smith’s book The Russians, the average housewife in the former Soviet Union spent 14 hours a week queuing up for products because of the shortages created by pervasive price ceilings. How long will people queue up for an additional unit of a price-controlled product? Until the cost of doing so is equal to the difference between what they are willing to pay, P_M, and the price ceiling, P_C. So the total monetary and time cost will tend toward Pm, which is more than consumers would pay without the price ceiling. The consumers pay more, but notice, the suppliers don’t receive more. The higher amount consumers pay does nothing to communicate to suppliers that more should be made available.

Another common cost-increasing response to price ceilings is reduced quality. While suppliers cannot legally benefit from the excess demand (Q_D – Q_S) by raising the price above P_C, they can reduce the quality of the product, which reduces their costs. The reduction in quality can take many forms, and is often tied in with the queuing just discussed.

Rent controls cause a deterioration in the quality of apartments. When landlords have more demand than they can satisfy, and are unable legally to charge higher rents, they reduce costs by doing less to maintain their apartments. New York City once tried to solve this problem with its rent-control law by exempting tenants from paying the rent if their apartments were damaged. Not surprisingly, tenants began breaking windows and ripping up carpets to avoid paying the rent.

Of course, some consumers come out ahead under price ceilings. With lots of people anxious to buy at the controlled price, it doesn’t cost suppliers much to discriminate against certain people. Those whom suppliers favor often get products at lower prices without long waits. For example, celebrities and the politically well-connected have no trouble obtaining rent-controlled apartments in New York City, while others end up doing without.

But most consumers are harmed by price ceilings. This is hardly surprising since price ceilings prevent consumers from communicating with suppliers in ways that motivate the best possible response to their demands.