Roger Ream Is Director of Seminars of The Foundation for Economic Education.
Casual observation of events can lead to faulty conclusions. Outward appearances can be quite misleading for things are not always as they seem. Failure to look beyond the obvious has led to many blunders on the part of both scientists and casual observers.
For instance, over the centuries it was obvious that we lived in a geocentric universe. Even the casual observer could watch the sun rise in the east, travel across the sky, and set in the west. However, Copernicus, among others, discovered that what appeared obvious was misleading. The solar system was in reality heliocentric, but the rotation of the earth on its axis made it ap pear that the sun revolved around the earth, rather than vice versa.
Likewise in the science of economics, one must be cautious when observing the effects of economic interventions. What seems obvious can be misleading. Take for example price controls. The politically determined ceiling price transmits faulty signals not only to consumers, producers and entrepreneurs, and resource owners, but also to pseudo-economists and most casual observers. As a result, the latter group reaches inaccurate conclusions concerning the effect of the price control. It appears that a control which dictates a ceiling price for a product keeps the price down (below what it would be in an unhampered market). However, this is an incomplete observation.
A recent illustration of the actual effect of price ceilings is the control of oil. To most observers, it was obvious that if the ceiling were removed on the price of oil, the price would rise. It was indisputable, they claimed, that if the price were no longer kept artificially low, it would increase. A so-called windfall profits tax was passed to remedy the injustices that would occur when the price rose. To question the assumption that removal of the ceiling on the price of oil would cause it to rise was to invite ridicule. It was so obvious that prices would rise and oil companies would reap windfall profits. To suggest otherwise would put one in the position of Copernicus or Galileo, who likewise questioned the unquestionable and faced banishment for doing so.
Price Ceilings Constrain Supply
However, as experience has shown, the primary effect of the controls was to diminish the amount supplied. They caused shortages and discouraged competition. Exploration and production were curtailed, so that eventually the effect of the price ceiling was actually to hold the price of oil above its unhampered market level. Soon after President Reagan decontrolled the price of oil (removed the ceiling), the price began to come down. When the control was removed, production increased, additional supplies were brought to the market, and competitive forces led to lower prices. Things did not happen as it seemed obvious they would. The so-called experts were wrong. This was because the controlled price was not, in effect, just a ceiling on the price, but a ceiling on the quantity supplied. It was a disincentive to producers. The control held down the supply, not just the price. Remarkably, the ceiling was removed and the price fell.
The Unseen Consequences
Despite overwhelming economic knowledge that price controls (in this discussion, ceilings on prices) discourage suppliers, thus causing shortages and therefore eventually pushing prices above their free market levels, the clamor for controls never subsides. A plea on behalf of the poor is perhaps the loudest excuse for ignoring economic wisdom and imposing controls. This emotional appeal to the plight of the poor often blinds individuals from seeing things as they really are, rather than as they seem. Controls lead to a less efficient employment of scarce resources, and this hurts the poor the most. It is those on the bottom of the economic ladder who have the greatest stake in efforts to create the most opportunities, goods, and services from limited resources. The effect of price controls will be shortages and eventually prices higher than they would be in an unhampered market; effects precisely contrary to the stated objectives of their supporters.
An area where well-intentioned but misguided individuals have done great harm to the very groups they claim to represent is the housing sector. In this instance, a type of price control particularly harmful to the poor has reared its destructive head. It is euphemistically called rent control, but in plain language it is control of people. Local governments intrude into the voluntary negotiations between two consenting adults, a tenant and a landlord, and dictate the terms of their contractual agreement. It is a denial of freedom of choice to both tenants and landlords. It is an attempt to transfer wealth from landlords to tenants, but it is doomed to failure as landlords eventually allow their buildings to deteriorate or abandon them completely.
The actual effects of rent control are generally unseen. The pseudo-economists and many casual observers fail to comprehend the long term effects of rent control. Similar to the case of price controls on oil, a ceiling on rents discourages present and potential suppliers of rental units; consequently fewer units are made available. In an unhampered market, when the quantity supplied is diminished (possibly due to a natural disaster, for instance), other things being equal, price will tend to rise. This rise in price tends to discourage the least urgent demands, thus moving the market toward market-clearing levels.
However, controls cause the quantity supplied to decrease, but prevent price from alleviating the situation. The market is grossly distorted. The artificial drop in supply is not offset by a corresponding fall in the quantity demanded—a shortage exists. Furthermore, other things are not equal, increasing birth rates, rising divorce rates, and a vast number of governmentally-induced factors cause demand to increase. This exacerbates the disequilibrium in the marketplace, causing the housing shortage to be considerably worse.
Controls Cause Shortages
The neglected, or unseen, aspect of the situation is the realization that the removal of ceilings on rent leads, in short order, to lower, not higher rents. Rent controls have the same effect as controls on oil—they stimulate demand and discourage supply, thus causing shortages (remember the gas lines) and eventually prices higher than would prevail in an unhampered market. If rent controls were repealed the supply of rental units would increase almost immediately. Soon, the forces of competition would cause rents to move toward market-clearing levels where supply and demand are in close approximation.
At first glance, it is difficult to accept the fact that in an otherwise unhampered market, the removal of price ceilings tends to cause prices to fall. Where there are no barriers to entry, entrepreneurs seek to satisfy consumer demand. Unfortunately, many barriers to entry exist in the energy sector, the housing sector, and throughout the U.S. economy. These barriers decrease supplies. The oil and gas industry is replete with regulations and taxes which hamper the exploration, production, and distribution of energy products. Zoning regulations and restrictive building codes artificially limit the supply of housing and therefore cause higher rents and housing prices. Throughout the economy governments at all levels have erected barriers that inhibit productive activity, add to costs, and therefore reduce the supply of economic goods.
Furthermore, government policies artificially increase demand for some items. Of course, controlling the price at less than a free market level causes an increase in demand. Transfer payments enhance the purchasing power of some at the expense of others. When welfare pro grams are financed by inflation of the currency, an increase in demand is created virtually out of thin air. Those who get the new money first are able to purchase the limited supply of the controlled product. Since the price is controlled and therefore cannot be bid up, those first in line are able to buy out the product before others.
Government artificially increases the demand for goods and services both intentionally and indirectly through its tax structure and regulatory policies. For example, the demand for oil and gas is increased with emission controls on automobiles and by the regulation of trucking which causes less efficient transportation of goods. Government programs which offer guaranteed or low interest housing loans increase the demand for housing.
Because of the tremendous governmentally-induced influences on supply and demand, as well as the constantly changing values of consumers, it is essential that prices remain free to accomplish smoothly their functions of transmitting knowledge of changes and coordinating economic activity.
This is not a geocentric universe, even though it appears to be. Likewise, ceilings on prices do not help the poor. It is simplistic and wishful thinking to believe they are a solution to the problems of poverty. That is, it confuses what appears to be true or what one wishes to be true, with what actually is true. Price controls cause shortages and when there is less to go around it isn’t the powerful or the well-to-do who will suffer most. With unfettered prices and an open market, economic efficiency will be maximized and consumers, the poor included, will be well served.