Teaching Price Control (Wrong) – An Economist Writes Daily

Economics textbooks differ in their treatment of price controls. None of them do a great job, in my opinion. The reason is mainly due to the purpose of the textbooks. Despite what you might suspect, most undergraduate textbooks aren’t used primarily to give students an understanding of the world. They are often used as a linked list of things to know and to create easy test questions. If a textbook is to change the assumptions of a model too much from what the rest of the chapter assumes, then the book does not specify what students are expected to know for the test.

I think this is the most charitable reason for books’ poor treatment of price controls – even college-level books. Less charitable reasons include botched exposition due to the author’s ignorance or overreliance on mathematics. Honestly, I would find it hard to believe these less charitable reasons.

I picked up 5 microeconomics textbooks and the graph below is typical of how they deal with a ceiling price.

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

Problem #1

The first problem is that any request for Qd is ready to pay more than Pc. This means that the distribution of assets to claimants will be determined by an unknown process. That is, there is no reason to assert that the people who value the goods the most will also be the ones who get the goods. The charts below illustrate several possible CS distributions of assets among claimants of different values.

As long as the horizontal sum of the shaded areas equals Qs, all are possible distributions of the CS. Note that CS could be zones A and B. But, CS could also be zones D and E. Or, CS could be any size zone between them. CS neither descends nor ascends clearly. The change is ambiguous. It is important to note that this conclusion requires that there is no resale by low value buyers. If there was a resale, this would imply that the ceiling price is not perfectly applied. The above model also assumes that there is no non-monetary or non-price competition.

Problem #2

I will pay less attention to the 2n/a problem because it is absurd on the face of it. The only way to achieve the CS of Areas A and B is to allow low value seekers to buy the good at Pc and then give the goods to high value seekers. But how could low-value applicants identify these people? Their only way to find out, given price competition alone, is to allow high-value applicants to bid for goods from low-value applicants. In other words, we must violate the perfect application of the price cap. It seems a bit silly to assume a perfect, cost-free app and then turn around and say “except for resellers”. The graph below illustrates.

I can’t stress enough that auctions or transactions are the only way to fully identify these high value seekers and steer assets away from low value seekers. The transaction process itself is what effectively allocates goods. CS will be areas A & B, but there is a refinement. Rather than the entire CS benefiting only high-value seekers, CS is split between high-value seekers who end up with goods and low-value seekers who are able to arbitrate sellers to seekers at high value. Note that the graphic above includes visible “splits” of CS indicating that it has been awarded to multiple people and not just those who value the good the most. The particular dealer welfare distribution is again determined by an unknown process.

Problem #3

The 3rd problem is that price is only one of the many ways in which people compete. Forcing price competition to be the only way is intellectual laziness when prices are controlled. In reality, the quantity supplied will equal the quantity demanded because non-price competition will be used to equate Qs & Qd. With a price cap, people may line up and compete for time (as they did with gas price controls in the 1970s). They may be competing through barter services (as when Hurricane Sandy caused blackouts in New York and rising gas prices were banned and controlled). It can also be by discriminating between heterogeneous applicants (as the owners of apartments with controlled rents do).

Restricted price control legislation the price competetion. It does not restrict all competetion.

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

However, transfers, like barter, can be difficult. Instead, many people will opt for no-transfer competition. Examples include lineups, grant writing trainings and, even worse, violence. These non-transfer means of competition result in high-value seekers using more resources (they are willing to spend the most). But, rather than moving resources between market players, resources are converted into a pure cost to society.

What happened to the well-being represented by zone B? It was about waiting time, resources spent on grant writing, and other costly activities that try to give people an edge over others in the competition for scarce resources.

And so…

And so I’m frustrated with the flat thinking exhibited by most textbooks. In their welfare calculations, they assume that higher value claimants obtain the goods without identifying the process by which this may occur.

I want to be fair to the authors. I won’t name those who don’t provide in-depth explanations of price controls. As I mentioned, their goals are not to improve understanding of economics. They are encouraged to sell textbooks to teachers and their students. I want to mention Jeffrey Perloff, who makes the reader aware of the shortcomings of the typical price control model in his book. He spends a paragraph in his Intermediate Microeconomics book discussing on tiptoe that the model has many assumptions that the reader is supposed to understand as unreasonable. So good for him to be frank.

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

Finally, the clearest and most thorough pedagogical treatment of non-monetary competition in the context of price controls is written by Russell Roberts in an essay entitled Supply and demand applications. Reading this essay will give you and your students a better understanding of economics. As the discussion above shows, however, the assumptions one makes cause wild swings in welfare implications. Therefore, be sure to explain to your students that the first case at the top of this essay is for standardized exams and the case at the bottom is for understanding reality. I hate that the two aren’t similar enough in this case.

Scott R. Banks