By Hugh Rockoff
Governments have been trying to set maximum or minimum prices since ancient times. The Old Testament prohibited interest on loans to fellow Israelites; medieval governments fixed the maximum price of bread; and in recent years, governments in the United States have fixed the price of gasoline, the rent on apartments in New York City, and the wage of unskilled labor, to name a few. At times, governments go beyond fixing specific prices and try to control the general level of prices, as was done in the United States during both world wars and the Korean War, and by the Nixon administration from 1971 to 1973.
The appeal of price controls is understandable. Even though they fail to protect many consumers and hurt others, controls hold out the promise of protecting groups that are particularly hard-pressed to meet price increases. Thus, the prohibition against usury—charging high interest on loans—was intended to protect someone forced to borrow out of desperation; the maximum price for bread was supposed to protect the poor, who depended on bread to survive; and rent controls were supposed to protect those who were renting when the demand for apartments exceeded the supply, and landlords were preparing to “gouge” their tenants.
Despite the frequent use of price controls, however, and despite their appeal, economists are generally opposed to them, except perhaps for very brief periods during emergencies. In a survey published in 1992, 76.3 percent of the economists surveyed agreed with the statement: “A ceiling on rents reduces the quality and quantity of housing available.” A further 16.6 percent agreed with qualifications, and only 6.5 percent disagreed. The results were similar when the economists were asked about general controls: only 8.4 percent agreed with the statement: “Wage-price controls are a useful policy option in the control of inflation.” An additional 17.7 percent agreed with qualifications, but a sizable majority, 73.9 percent, disagreed (Alston et al. 1992, p. 204).
The reason most economists are skeptical about price controls is that they distort the allocation of resources. To paraphrase a remark by Milton Friedman, economists may not know much, but they do know how to produce a shortage or surplus. Price ceilings, which prevent prices from exceeding a certain maximum, cause shortages. Price floors, which prohibit prices below a certain minimum, cause surpluses, at least for a time. Suppose that the supply and demand for wheat flour are balanced at the current price, and that the government then fixes a lower maximum price. The supply of flour will decrease, but the demand for it will increase. The result will be excess demand and empty shelves. Although some consumers will be lucky enough to purchase flour at the lower price, others will be forced to do without.
Because controls prevent the price system from rationing the available supply, some other mechanism must take its place. A queue, once a familiar sight in the controlled economies of Eastern Europe, is one possibility. When the United States set maximum prices for gasoline in 1973 and 1979, dealers sold gas on a first-come-first-served basis, and drivers had to wait in long lines to buy gasoline, receiving in the process a taste of life in the Soviet Union. The true price of gasoline, which included both the cash paid and the time spent waiting in line, was often higher than it would have been if the price had not been controlled. In 1979, for example, the United States fixed the price of gasoline at about $1.00 per gallon. If the market price had been $1.20, a driver who bought ten gallons would apparently have saved $.20 per gallon, or $2.00. But if the driver had to wait in line for thirty minutes to buy gasoline, and if her time was worth $8.00 per hour, the real cost to her was $10.00 for the gas and $4.00 for the time, an overall cost of $1.40 per gallon. Some gasoline, of course, was held for friends, longtime customers, the politically well connected, and those who were willing to pay a little cash on the side.
The incentives to evade controls are ever present, and the forms that evasion can take are limitless. The precise form depends on the nature of the good or service, the organization of the industry, the degree of government enforcement, and so on. One of the simplest forms of evasion is quality deterioration. In the United States during World War II, fat was added to hamburger, candy bars were made smaller and of inferior ingredients, and landlords reduced their maintenance of rent-controlled apartments. The government can attack quality deterioration by issuing specific product standards (hamburger must contain so much lean meat, apartments must be painted once a year, and so on) and by government oversight and enforcement. But this means that the bureaucracy controlling prices tends to get bigger, more intrusive, and more expensive.
Sometimes more subtle forms of evasion arise. One is the tie-in sale. To buy wheat flour at the official price during World War I, consumers were often required to purchase unwanted quantities of rye or potato flour. “Forced up-trading” is another. Consider a manufacturer that produces a lower-quality, lower-priced line sold in large volumes at a small markup, and a higher-priced, higher-quality line sold in small quantities at a high markup. When the government introduces price ceilings and causes a shortage of both lines, the manufacturer may discontinue the lower-priced line, causing the consumer to “trade up” to the higher-priced line. During World War II, the U.S. government made numerous unsuccessful attempts to force clothing manufacturers to continue lower-priced lines.
Not only do producers have an incentive to raise prices, but some consumers also have an incentive to pay them. The result may be payments on the side to distributors (a bribe for the superintendent of a rent-controlled building, for example), or it may be a full-fledged black market in which goods are bought and sold clandestinely. Prices in black markets may be above not only the official price but even the price that would prevail in a free market, because the buyers are unusually desperate and because sellers face penalties if their transactions are detected, and this risk is reflected in the price.
The obvious costs of queuing, evasion, and black markets often lead governments to impose some form of rationing. The simplest is a coupon entitling a consumer to buy a fixed quantity of the controlled good. For example, each motorist might receive a coupon permitting the purchase of one set of new tires. Rationing solves some of the shortage problems created by controls. Producers no longer find it easy to divert supplies to the black market since they must have ration tickets to match their production; distributors no longer have as much incentive to accept bribes or demand tie-in purchases; and consumers have a smaller incentive to pay high prices because they are assured a minimum amount. Rationing, as Forrest Capie and Geoffrey Wood (2002) pointed out, increases the integrity and efficiency of a system of price controls.
Rationing, however, comes at a cost. The government must undertake the difficult job of adjusting rations to reflect fluctuating supplies and demands and the needs of individual consumers. While an equal ration for each consumer makes sense in a few cases—bread in a city under siege is the classic example—most rationing programs must face the problem that consumer needs vary widely. One solution is to tailor the ration to the needs of individuals: people with a long commute to work can be given a larger ration of gasoline. In World War II, community boards in the United States had the power to issue extra rations to particularly needy individuals. The danger of favoritism and corruption in such a scheme, particularly if continued after the spirit of patriotism has begun to erode, is obvious. One way of ameliorating some of the problems created by rationing is to permit a free market in ration tickets. The free exchange of ration tickets has the advantages of providing additional income for consumers who sell their extra tickets and improving the well-being of those who buy. A “white market” in ration tickets, however, does nothing to encourage additional production, an end that can be accomplished by removing price controls. Also, a white market in ration tickets will not necessarily cause the product sold to be moved to the same regions of the country where the tickets are sold. Thus, a white market will not necessarily eliminate regional shortages.
With all of the problems generated by controls, we can well ask why they are ever imposed and why they are sometimes maintained for so long. The answer, in part, is that the public does not always see the links between controls and the problems they create. The elimination of lower-priced lines of merchandise may be interpreted simply as callous disregard for the poor rather than a consequence of controls. But price controls almost always benefit a subset of consumers who may have a particular claim to public sympathy and who, in any case, have a strong interest in lobbying for controls. Minimum-wage laws may create unemployment among the unskilled or drive them into the black market, but minimum wages do raise the income of those poor workers who remain employed in regulated markets. Rent controls make it difficult for young people to find an apartment, but they do hold down the rent for those who already have an apartment when controls are instituted (see rent control).
General price controls—controls on prices of many goods—are often imposed when the public becomes alarmed that inflation is out of control. In the twentieth century, war has frequently been the occasion for general price controls. Here, the case can be made that controls have a positive psychological benefit that outweighs the costs, at least in the short run. Surging inflation may lead to panic buying, strikes, animosity toward racial or ethnic minorities who are perceived as benefiting from inflation, and so on. Price controls may make a positive contribution by calming these fears, particularly if patriotism can be counted on to limit evasion. This was the limited case for controls made by Frank W. Taussig, a member of the Price Fixing Committee in World War I, in his famous essay “Price-Fixing as seen by a Price-Fixer.” A somewhat similar case can be made for removing controls cautiously when suppressed inflation—that is, inflation that the government holds down forcibly by price controls—is significant. Toward the end of World War II, more than fifty leading economists, including friends of the free market such as Frank H. Knight and Henry Simons, wrote to the New York Times (April 9, 1946, p. 23) calling on Congress to continue controls for another year until supplies and demands were more nearly in equilibrium in order to prevent the inflationary spiral they feared would arise if controls were removed suddenly.
However, most inflation, even in wartime, is due to inflationary monetary and fiscal policies rather than to panic buying. To the extent that wartime controls suppress price increases produced by monetary and fiscal policies, controls only postpone the day of reckoning, converting what would have been a steady inflation into a period of slow inflation followed by more rapid inflation. Also, part of the apparent stability of the price indexes under wartime controls is an illusion. All of the problems with price controls—queuing, evasion, black markets, and rationing—raise the real price of goods to consumers, and these effects are only partly taken into account when the price indexes are computed. When controls are removed, the hidden inflation is unveiled.
Inflation is extremely difficult to contain through general controls, in part because the attempt to limit control to a manageable sector of the economy is usually hopeless. John Kenneth Galbraith, in A Theory of Price Control, which was based on his experience as deputy administrator of the Office of Price Administration in World War II, argued that the prices of goods produced by large industrial oligopolists were relatively easy to control. These firms had large numbers of administrators who could be pressed into service—administrators who were willing, moreover, to shift their allegiance from their employers to the government, at least during the war. Galbraith overstated the market power of large firms, most of which were in highly competitive industries. But even if he had been right about these firms’ market power, the problem with limiting controls to a particular sector of the economy is that when demand is surging, it tends to shift from the controlled to the uncontrolled sector, forcing prices in the uncontrolled sector to rise even faster than before. Resources follow prices, and supplies tend to rise in the uncontrolled sector at the expense of supplies in the controlled sector. Thus, a government that begins by controlling prices on selected goods tends to end with across-the-board controls. This is what happened in the United States during World War II. The attempt to confine controls to a limited sector of highly concentrated industrial firms simply did not work.
A second problem with general controls is the trade-off between the need to have a simple program generally perceived as fair and the need for sufficient flexibility to maintain efficiency. Creating an appearance of fairness requires holding most prices constant, but efficiency requires making frequent changes. Adjustments of relative prices, however, subject the bureaucracy administering controls to a barrage of lobbying and complaints of unfairness. This conflict was brought out sharply by the American experience in World War II. At first, relative prices were changed frequently on the advice of economists who maintained that this was necessary to eliminate problems in specific markets. However, mounting complaints that the program was unfair and was not stopping inflation led to President Franklin D. Roosevelt’s famous “hold-the-line” order, issued in April 1943, that froze most prices. Whatever its defects as economic policy, the hold-the-line order was easy to justify to the public.
The best case for imposing general controls in peacetime turns on the possibility that controls can ease the transition from high to low inflation. If a tight monetary policy is introduced after a long period of inflation, the long-run effect will be for prices and wages to rise more slowly. But in the short run, some prices may continue to rise at the older rate. Wages also may continue to rise because of long-term contracts or because workers fail to appreciate the extent of the change in policy and, therefore, hold out for higher wages than they otherwise would. Rising wages and prices may keep output and employment below their potential. Price and wage controls may limit these temporary costs of disinflation by prohibiting wage increases that are out of line with the new trends in demand and prices. From this viewpoint, restrictive monetary policy is the operation that cures inflation, and price and wage controls are the anesthesia that suppresses the pain.
But this best case for price controls is weak. The danger is that the painkiller may be mistaken for the cure. In the eyes of the public, price controls free the monetary authority from responsibility for inflation. As a result, the pressures on the monetary authority to avoid recession may lead to a continuation or even acceleration of excessive growth in the money supply. Something very like this happened in the United States under the controls imposed by President Richard M. Nixon in 1971. Although controls were justified on the grounds that they were being used to “buy time” while more fundamental cures for inflation were put in place, monetary policy continued to be expansionary, perhaps even more so than before.
The study of price controls teaches important lessons about free competitive markets. By examining cases in which controls have prevented the price mechanism from working, we gain a better appreciation of its usual elegance and efficiency. This does not mean that there are no circumstances in which temporary controls may be effective. But a fair reading of economic history shows just how rare those circumstances are.