Economist Writing Every Day

Economics textbooks differ in their treatment of price controls. None of them does a great job, in my opinion. The reason is mostly due to the purpose of textbooks. Despite what you might suspect, most undergraduate textbooks are not used primarily to give students an understanding of the world. They are often used as a bound list of things to know and to create easy test questions. If a textbook has to change the assumptions of a model too much from what the balance of the chapter assumes, then the book fails to make clear what students are supposed to know for the test.

I think that this is the most charitable reason for books’ poor treatment of price controls – even graduate level books. The less charitable reasons include sloppy exposition due to author ignorance or an over-reliance on math. I honestly would have trouble believing these less charitable reasons.

I picked up 5 microeconomics text books and the below graph is typical of how they treat a price ceiling.

The books say that the price ceiling is perfectly enforced. They identify producer surplus (PS) as area C and consumer surplus (CS) as areas A & B. There are very good reasons to differ with these welfare conclusions.

Problem #1

The first problem is that all demand for the Qd is willing to pay more than Pc. This means that the distribution of the goods to demanders will be determined by some unknown process. That is, there is no reason to assert that the people who value the goods most highly will also be the ones who obtain the goods. The below graphs illustrate several possible CS distribution of the goods across demanders of differing values.

So long as the horizontal sum of the shaded areas is equal to Qs, all of them are possible distributions of the CS. Note that CS could be areas A & B. But, CS could also be areas D & E. Or, CS could be any sized area between them. CS neither clearly falls nor rises. The change is ambiguous. Importantly, this conclusion requires that there is no resale by low-value buyers. If there were resale, then that would imply that the price ceiling is not perfectly enforced. The above model also assumes that there is no non-pecuniary or non-price competition.

Problem #2

I will give less attention to the 2^nd problem because it is preposterous on its face. The only way to achieve CS of areas A & B is to allow low-value demanders to purchase the good at Pc, and then give the goods to the high-value demanders. But, how would low-value demanders be able to identify those people? They only way to know, given only price competition, is to allow the high-value demanders to bid for the goods from the low-value demanders. In other words, we must violate the perfect enforcement of the price ceiling. It seems a little silly to assume perfect costless enforcement and then to turn around and say ‘except for resalers’. The below graph illustrates.

I really can’t emphasize enough that bidding or transacting is the only way to perfectly identify those high-value demanders and to entice goods away from low-value demanders. The transacting process itself is what allocates goods efficiently. CS will be the areas A & B, but there is a refinement. Rather than the entire CS being enjoyed only by the high-value demanders, the CS gets split among the high-value demanders who end with the goods and the low-value demanders who are able to arbitrage from sellers to the high-value demanders. Note that the above graph includes visible ‘splits’ of CS representing that it was allocated to multiple people and not only to those who value the good most highly. The particular distribution of resaler welfare is again determined by an unknown process.

Problem #3

The 3^rd problem is that price is only one of many means by which people compete. Forcing price competition to be the only means is intellectual laziness when prices are controlled. In reality, the quantity supplied will be equal to the quantity demanded because non-price competition will be used to equate Qs & Qd. With a price ceiling, it may be that people wait in line and compete by spending time (such as they did with gasoline price controls in the 1970s). It may be that they compete by bartering services (such as when hurricane Sandy caused power outages in New York and gasoline price gouging was prohibited and policed). It might also be by discriminating amongst heterogeneous demanders (such as practiced by the owners of rent-controlled apartments).

Price control legislation restricts price competition. It doesn’t restrict all competition.

There are plenty of creative non-price means of competition. But, they have substantial welfare implications. If the competition includes a transfer to the seller, then the welfare losses are mitigated. It’s just that the pecuniary price plus the non-pecuniary price is equal to the marginal value. Area B ceases to be CS and is instead transferred to the sellers as PS.

However, transfers, like barter, can be hard. Instead, many people will opt for non-transfer competition. Examples include waiting in lines, grant writing trainings, and worse: violence. These non-transfer means of competition result in high-value demanders using more resources (they’re willing to expend the most). But, rather than the resources being moved among market participants, the resources are converted to a pure cost to society.

What happened to the welfare represented by area B? It was expended on time waiting in line, resources directed toward grant writing, and other costly activities that attempt to give people an edge over others in the competition for scarce resources.

And so…

And so I am frustrated by the flat thinking exhibited by most textbooks. In their welfare calculations, they assume that the highest-value demanders obtain the goods without identifying the process by which it can occur.

I want to be fair to authors. I won’t name the ones who fail to provide a thorough explanation of price controls. As I mentioned, their goals are not to improve understanding of the economy. They have an incentive to sell textbooks to faculty and their students. I do want to mention Jeffrey Perloff, who makes the reader aware of the typical price control model’s shortcomings in his book. He spends a paragraph in his Intermediate Microeconomics book discussing by way of tip-toe that the model has a lot of assumptions that the reader is meant to understand as unreasonable. So good for him being forthright.

But I want to throw lavish praise on a particular book and a particular essay. Armen Alchian and William Allen in Exchange & Production spend several dense paragraphs explaining that the typical model conclusions are most likely wrong because they rest on assumptions that should be too unrealistic even for economists.

Finally, the clearest and most thorough pedagogical treatment of non-pecuniary competition in the context of price controls is written by Russell Roberts in an essay called Applications of Supply and Demand. Reading this essay will give you and your students a better understanding of economics. As the above exposition demonstrates, however, the assumptions that one makes cause wild swings in the welfare implications. Therefore, be careful to explain to your students that the first case at the top of this essay is meant for standardized exams and that the bottom case is meant for understanding reality. I hate that the two are not similar enough in this case.