Price Controls

The Vision of Interventionism

In Part II of this book, we explained the basic structure and functioning of a pure market economy. In Part III, we surveyed the theoretical problems with pure socialism, and documented some of the horrors of socialist systems in practice.

In this final portion of the book, we will examine some of the most popular components of interventionism, which is an approach to economic policy that seeks to avoid the alleged flaws of pure capitalism and pure socialism. An interventionist government will not tolerate the outcomes of a purely free market, but on the other hand it doesn’t completely abolish private property. The goal of interventionist policies is to retain the obvious advantages of a free enterprise system, while at the same time moderating the “excesses” of pure capitalism through various corrective measures.

The following lessons will demonstrate that government intervention into the market economy leads to unintended consequences, which very often make the “cure” worse than the disease, even according to the official goals of the interventions. You may be surprised to learn that many of the problems with modern society are either exacerbated or even caused by government intervention. The example of this lesson is price controls, in which the government enforces a different price from the market-clearing equilibrium price. We break the discussion up into the treatment of price ceilings and price floors.

Price Ceilings

A price ceiling is a legal maximum the government sets on prices in the marketplace for a particular good or service; the idea is that a rising price hits the “ceiling” and is not legally allowed to go any higher. Typically the official rationale for a general price ceiling is that it keeps important items affordable for the poor; a classic example would be rent control, in which the government imposes caps on rental rates for certain types of apartments. In specific situations, temporary price ceilings may be imposed to prevent “gouging” of the public in times of distress. For example, after a natural disaster strikes, the local or state government might impose price controls on items such as bottled water, electric generators, and gasoline, in an effort to prevent merchants from “taking advantage of” the situation.

Although the general public applaud such restrictions—if they weren’t popular, they wouldn’t be so prevalent—our knowledge of how markets work will show that price ceilings actually hurt the very people they are supposed to be helping. The following list isn’t exhaustive, but it mentions some of the most damaging consequences of price ceilings:

Immediate Shortages

If it is to have any impact, a price ceiling must be set below the market price. But under normal circumstances, the actual market price will tend to be close to the market-clearing price, which (we recall from Lesson 11) is the price at which the quantity supplied equals the quantity demanded. Now if the government forces the price lower by imposing a price ceiling, it will cause a shortage of the good or service in question. The following diagram illustrates:

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Market for Apartment Units

In the diagram above, the original price of $800 is the equilibrium price to rent an apartment in an urban neighborhood. At that price, consumers want to rent a total of 10,000 apartment units, and owners want to rent out 10,000 apartment units. The market clears and everyone engages in as many transactions as he wants, subject to the high price.

But then the government imposes a price ceiling at $650, claiming that “regular people can’t afford” to pay higher rents, and threatening to heavily fine any landlord caught charging more than this amount. At the lower price, the quantity of apartment units demanded rises to 12,000, while the quantity supplied drops to 9,000.[8] There is now a shortage of 3,000 units, meaning that 3,000 people in the neighborhood want to rent an apartment at the going price, but can’t find any available units.

Shortages are quite serious because they make the good or service unavailable for the very people supposedly helped by the price control. It’s true, the 9,000 people who still have an apartment might be thankful that they are saving $150 per month on their rent (though perhaps not if they understand all of the additional points below). However, there are now 1,000 people in the community who would have had an apartment with market pricing but now have no apartment at all because of the price ceiling. We know that they would prefer to pay $800 for an apartment rather than having none at all (since the quantity demanded would be 10,000 total at a price of $800), and so they are clearly worse off because of the rent control.[9]

At this first step in the analysis, therefore, we must balance the gains to the 9,000 renters (who save $150 a month) against the presumably much more traumatic loss to the 1,000 renters who have an extra $800 a month, but not an apartment of their own. Even if we completely ignore the fate of the landlords—who are clearly worse off because of the rent control—and focus exclusively on helping tenants, it is not clear that the price ceiling has actually made the group as a whole better off.

The tradeoff is even more striking in other situations of price ceilings. For example, suppose a hurricane strikes a city, knocking out the power and causing flooding that contaminates the drinking water. Left to their own devices, the market prices of bottled water and canned goods would have a tendency to skyrocket because of the sharp increase in demand versus the fixed supply. If the local government passes an ordinance fining merchants who raise their prices on “necessities” in response to the emergency, that won’t result in everyone (including the poor) getting access to the items. On the contrary, what will happen is that the first few people to get to the store will clear out the shelves, loading up on bottled water and canned food at the pre-crisis prices. People who get to the store a few hours later will walk away with no water or food at all. For such poor souls, the officially reasonable prices are small consolation. They would much rather have paid $5 each for 10 bottles of water, than to have their family drink Coke for a week.

Another illustration is gasoline. People who live on the coast in the path of an oncoming hurricane will try to load the kids up and head inland. Consequently the demand for gasoline in the coastal city will temporarily spike, which normally would cause a sharp rise in prices, say to $7 per gallon. This unusually high price would cause the fleeing residents to only buy enough gasoline to get them onto the interstate where they would search for gas stations charging lower prices. The high market price would have effectively rationed the city’s supplies of gasoline on hand (when the news of the impending hurricane hit) among everyone trying to leave town.

However, if the city government threatens the gas station owners with fines or even jail for “price gouging,” then the first wave of motorists will fill up their tanks and empty out the gas stations. Subsequent motorists will drive around town but see “No Gas” signs posted at all the stations. They will have to get on the interstate, perhaps with very little gas in their tanks, and possibly break down along the way. If the goal is to get as many people out of the path of the incoming hurricane as smoothly as possible, imposing price ceilings on gasoline is a horrible idea.

Lower Supply in the Long Run

In addition to the immediate drop in the short-run quantity supplied, a price ceiling will also suppress the long-run supply, as entrepreneurs and investors respond to the new realities and shift their efforts and resources to other lines that do not suffer from price controls. For example, if rent control laws are applied in a major urban area, there will be an immediate shortage. However, the problem may become worse over time, as the population grows but investors do not view cheap apartment units as a very lucrative project.

For a different example, merchants who live in a town subject to flooding will not carry as large an inventory of bottled water and other goods, if they know the government will impose price ceilings in situations where they otherwise could have tripled their prices. Thus the expectation of price controls cripples one of the primary features of a market economy— entrepreneurs can foresee potential crises (water shortages) and know how to ameliorate them (stockpiling more bottles of water in normal times), but they won’t act on their foresight because the government takes away the market’s usual rewards for such behavior.

Non-price Rationing

One of the functions of the (undisturbed) market price is that it rations the available supply of a good among the competing demands for it. In essence, if someone wants more units of the good, he has to bid more dollars for it. This of course strikes many observers as unfair, since it gives an obvious advantage to the wealthy.

However, by placing a cap on the price, the government doesn’t eliminate the fact of scarcity; there are still more people who want to use the good, than there are units of the good to go around. All that happens is that the rationing must occur through non-price mechanisms. This actually might end up being more distasteful to the proponents of the price control, than the original price rationing.

For example, under rent control landlords can be much pickier in which tenants they select for their available apartments. They might insist on seeing several months’ worth of paycheck stubs, run a background check on the applicant, and require letters of reference from previous landlords. They might also prefer tenants who travel in the same social circles, or come from the same ethnic group, whether from outright bias or because they subconsciously feel more comfortable letting someone move into the building when (say) he goes to the same church. In such an environment, ethnic minorities and recent immigrants—especially if they don’t speak the native tongue—will be at a huge disadvantage, and may find it very difficult to find a place to live. This outcome is the exact opposite of what most proponents of rent control desire.

Drop in Quality

Another insidious effect of price ceilings is that they reduce the quality of the good or service being regulated. When a price ceiling forces sellers to receive a lower dollar amount per unit sold, they have less incentive to make the good or service desirable.

For example, rent control laws give rise to slumlords, the term denoting shady and cruel landlords of low-income apartment units. In a normal market, a merchant who habitually treated his customers with rudeness, and refused to live up to his contractual obligations, would soon go out of business. But under rent control, landlords are under far less competitive pressure to please their customers. Even if the tenant in unit 3-A has had enough and leaves, the landlord knows there is a long line of potential tenants eager to move in.

In essence, price ceilings provide a margin in which the sellers can reduce the quality of the good or service, without hurting their total sales revenues. In the numerical example of rent control diagrammed above, the landlords are in a position to reduce the quality of their units so long as the tenants would still be willing to spend $650 in rent. The landlords might be slow to replace a burnt-out hallway light, they might let the paint crack and peel on the building rather than apply a new coat regularly, and they certainly are not going to get up in the middle of the night to deal with a tenant’s broken water heater. Therefore, it wasn’t completely accurate to say (in our discussion following the supply and demand graph on page 257) that the 9,000 tenants were better off because they had to pay $650 for an apartment unit that previously was $800. This is because they are not getting the “same” apartment unit in both situations.

Price Floors

A price floor is a legal minimum, in which the government does not allow the price of a good or service to fall below the “floor.” Buyers caught paying less than the floor price face fines or other forms of punishment. The public justification for price floors is that certain sellers deserve a higher price for their goods or services than what they would receive in a pure market economy.

In modern Western countries labor is the primary recipient of price floors.[10] In particular the government imposes a minimum wage making it illegal for an employer to pay a worker less than a certain amount per hour. Because this is the most popular and recognizable example of a price floor, we will concentrate on it for the rest of this lesson.[11] The analysis generally applies to other goods or services.

As with price ceilings, price floors have many unintended consequences, which should make the proponents of the minimum wage reconsider whether they are really helping unskilled workers. The consequences include:

Immediate Surplus (or Glut)

The market-clearing price (wage) for unskilled labor equates the quantity demanded by employers, with the quantity supplied by unskilled workers. If the government sets a floor above the market-clearing level, then it will induce a surplus of unskilled labor. There will be a supply glut, meaning more workers are trying to find jobs at the going wage than employers want to hire. This situation is more popularly known as unemployment. The following diagram illustrates the effects of a minimum wage law.

Market for low-skill labor services

Market for Low-Skill Labor Services

In the diagram, the equilibrium wage is $5 per hour. At this wage, employers want to hire 100,000 workers, and 100,000 people apply for these types of low-skill jobs. When the government comes in and artificially raises the wage rate to $8 an hour, the quantity of workers seeking jobs rises to 120,000, while the quantity demanded falls to 80,000. Thus there is a shortage of 40,000 workers. These 40,000 unskilled people are willing to work at the going wage of $8 an hour, but no matter how many applications they fill out, they simply cannot get a job.

Even at this stage, it is not obvious that the minimum wage law is helping unskilled workers. It’s true, the 80,000 who retain their jobs now make $3 more per hour, but there are 20,000 people who would have been happy to work at $5 an hour and yet now can’t get a job at all. In addition, there are 20,000 other workers who are frustrated by the inability to find a job at $8 an hour, but they wouldn’t be working in any case since $5 an hour would be unacceptable to them.

It is crucial to realize that the minimum wage law does not compel an employer to hire a low-skilled applicant. It simply makes it illegal to hire the applicant for less than the minimum wage. Far from penalizing the rejection of a job application, the minimum wage law actually makes it more burdensome for an employer to give someone a job.

Ruling out cases of philanthropy or other non-commercial contexts, an employer hires a worker because he expects the worker to bring in enough extra revenues to justify the paycheck. (If the employer didn’t think the employee would do so, he’d be losing money on the deal and would have no incentive to hire.) By artificially raising the bar of the minimum paycheck, the government effectively makes it impossible for people with productivities below a certain level to get a job.

Keep in mind that some unskilled workers simply do not produce $8 worth of extra output for every hour they are on the job. If someone’s labor only produces, say, $7 of output per hour, then an $8 minimum wage would force an employer to lose $1 for every hour this person works. If the employer wants to maximize his profits, it would be smarter not to hire this person at all.

Lower Demand in the Long Run

If the government enacts a minimum wage law that takes employers by surprise, they will respond immediately by cutting back on the number of employees.[12] In the longer run (so long as they expect the minimum wage to remain in force) the employers will alter their businesses in ways that will reduce their demand for labor.[13] For example, the employers can install more equipment and better tools to allow each (retained) worker to perform more duties. This raises his or her productivity on the margin; a given worker can produce more output per hour if his workplace has more machinery.

For example, a modern fast food restaurant can be staffed by a handful of people and still serve hundreds of meals in a single shift, whereas the same feat would have required many more workers at a fast food restaurant in the 1950s. Part of the difference is the tremendous advances in automation in the last 60 years. A well-trained worker can load the soda dispenser with an empty cup and press a button, while using a specialized scoop to dump fries into a carton resting in a specially designed holder, as she listens to a drive-through order on her headset and then punches it onto a keyboard with buttons denoting each value meal. If the customer needs change, the worker might not even have to count it out, as the register automatically shoots out the appropriate combination of quarters, dimes, nickels, and pennies.

Thus rather than having to retain (say) 8 workers at $8 an hour with the old setup, the restaurant owner can spend many thousands of dollars installing the latest equipment and floor design. This investment allows him to achieve the same output but with only 5 workers, thus saving $24 an hour. Over the course of hundreds of shifts, the investment in redesigning the restaurant pays for itself.[14] But after the renovations the restaurant is permanently less dependent on human beings to get the job done.

Non-wage Competition

The “problem” that minimum wage laws seek to fix is that the demand for labor is not high enough so that every willing worker can find a job paying a generous wage. By enacting a minimum wage, the government doesn’t alter this underlying reality. Workers still need to compete with each other for every job opening, it’s just that the minimum wage takes away one method of bargaining. Ironically this feature of minimum wage laws hurts precisely those groups that are the most vulnerable and in need of employment.

For example, a 20-year-old immigrant who doesn’t speak the native tongue and has no work experience could not possibly compete for a job opening in a factory against middle class suburban college students (home for the summer) who belong to the same gym as the factory owner’s family if the two applicants had to receive the same wage. But if the immigrant is allowed to underbid the wage demands of the native college students, he can get the job. The employer might take a chance and hire the immigrant with broken English at, say, $4 an hour, to see if he’s a hard worker and can be quickly trained. But if the government requires that all new hires receive $8 an hour from Day One, the immigrant can never get off the ground and establish a (legal) job history, which could allow him to move up the rungs of the wage ladder.

Minimum wage laws take away the ability of low-skilled workers to compete for jobs by lowering their wage demands. Employers will therefore fill the (smaller) pool of job openings according to other criteria. To get a job you “need to know someone,” be related to someone already in the company, and so forth. The workers who will fail on these criteria are largely the ones that the proponents of the minimum wage think they are helping.

Drop in Workplace Quality

By forcing employers to pay more per hour, and by ensuring a long line of willing workers ready to replace anyone who quits, minimum wage laws reduce the incentive for employers to make jobs attractive in other dimensions. For example, the employer might reduce break times, stop providing free food in the lunch room, and set the thermostat higher in the summer and lower in the winter. The employer might be slower to replace overhead fluorescent bulbs, and (in an office environment) might spend less money on office furniture. Perhaps the bathrooms will be stocked with very cheap toilet paper and clinical-smelling hand soap.

Perversely, the minimum wage law takes away potential arrangements that would make employers and workers happier. Suppose 3,000 people make $8 an hour working at a very hot factory that is cooled only by fans. The owner of the factory surveys the workers and they unanimously agree that they would much rather earn $7.50 an hour, if the employer would install central air conditioning. For her part, the owner of the factory reckons that with 1,000 people working on any given shift, the proposed pay cut would save her $500 per hour in labor costs. She does some research and believes she can install central air and pay the higher utility bills for about $450 an hour, all things considered.

Clearly this sounds like a win-win proposal. The workers take a slight pay cut, it’s true, but they would rather have a smaller paycheck without dripping in sweat 8 hours a day. The owner on the other hand would have to shell out thousands of dollars upfront to install the new unit, but over time the lower wage payments would more than compensate for this initial outlay (and the higher utility bills). But if the minimum wage is set at $8 per hour, this sensible proposal will not occur, because it is illegal. Thus the workers toil miserably away in their sweat-soaked clothes, and the factory owner earns $50 less per hour of operations. Although this final example is a bit contrived, it illustrates a major flaw with minimum wage laws: A job is attractive for many reasons, the paycheck being just one. By arbitrarily setting a floor below the wage, the government might perversely cause the other job attributes to decline so that even those workers who keep their jobs end up being hurt—let alone those workers who can’t get a job at all.


  1. Even "though (in the short run) the physical number of apartment units doesn't shrink, the number that owners put on the market for rent can definitely drop because of the new rent control law. Most obvious, homeowners who were willing to rent out a spare bedroom to a stranger at $800 per month, might keep it vacant (and available for their kids coming back on college breaks or for other out-of-town guests) if they can only charge $650. Even the owners of dedicated apartment buildings might prefer to rent out only some of the units at the lower price, to a group of tenants who have passed more rigorous background credit checks and so forth."
  2. There "are also an additional 2,000 people who are frustrated because of the shortage, but in a sense they are not really losing out (except for their headaches and time spent searching fruitlessly for an apartment). If the price were allowed to rise to its market-clearing level, they would have fallen out of the market and not gotten an apartment in that scenario, either."
  3. Farmers "are also beneficiaries of price supports, in which the government assures a guaranteed minimum price for certain agricultural products. However, typically the government establishes this floor by using tax dollars to artificially boost the demand for the privileged items. Rather than punishing people who pay less than $10 per bushel of wheat, the government steps in and buys up wheat (and stores it in silos) whenever the market price would otherwise fall below $10. The analysis of this type of \"price floor\" is much different from the situation we are analyzing in the text."
  4. Our "analysis of a wage floor explicitly enforced by the government largely applies to the case where a union threatens violence or property destruction in order to raise the wages of its members above the market-clearing level. Many economists view this as a form of government intervention, because governments typically do not punish unions for criminal intimidation the way they would punish other attempts (by employers during labor negotiations for example) to disturb voluntary transactions. However in the text we will restrict the discussion to the purer intervention that comes directly from the government."
  5. Or "at least, they will desire to do so, just as soon as contractual obligations allow. In practice there might be other constraints, such as the loss of employee morale if the boss lets 10% of the staff go in response to a minimum wage hike. Nonetheless, other things equal a minimum wage increase will reduce the profit-maximizing number of (low-skilled) employees for a given business."
  6. To "say that the demand (not just the quantity demanded) falls in the long run means two things: First, at the constant minimum wage, the number of workers who can find jobs will fall. Second, even if the government eventually removed the minimum wage, the equilibrium number of workers hired (at that point) would initially be lower than the original number of workers before the imposition of the minimum wage."
  7. Note "that at the original wage of $5 per hour, the renovation would only save the owner $15 an hour in reduced labor costs. Depending on the expense of renovation (properly accounting for interest and the depreciation of the new equipment), the minimum wage law could be the difference between designing a restaurant to be run by 8 employees versus 5."
  8. Even "though (in the short run) the physical number of apartment units doesn’t shrink, the number that owners put on the market for rent can definitely drop because of the new rent control law. Most obvious, homeowners who were willing to rent out a spare bedroom to a stranger at $800 per month, might keep it vacant (and available for their kids coming back on college breaks or for other out-of-town guests) if they can only charge $650. Even the owners of dedicated apartment buildings might prefer to rent out only some of the units at the lower price, to a group of tenants who have passed more rigorous background credit checks and so forth."
  9. There "are also an additional 2,000 people who are frustrated because of the shortage, but in a sense they are not really losing out (except for their headaches and time spent searching fruitlessly for an apartment). If the price were allowed to rise to its market-clearing level, they would have fallen out of the market and not gotten an apartment in that scenario, either."
  10. Farmers "are also beneficiaries of price supports, in which the government assures a guaranteed minimum price for certain agricultural products. However, typically the government establishes this floor by using tax dollars to artificially boost the demand for the privileged items. Rather than punishing people who pay less than $10 per bushel of wheat, the government steps in and buys up wheat (and stores it in silos) whenever the market price would otherwise fall below $10. The analysis of this type of \"price floor\" is much different from the situation we are analyzing in the text."
  11. Our "analysis of a wage floor explicitly enforced by the government largely applies to the case where a union threatens violence or property destruction in order to raise the wages of its members above the market-clearing level. Many economists view this as a form of government intervention, because governments typically do not punish unions for criminal intimidation the way they would punish other attempts (by employers during labor negotiations for example) to disturb voluntary transactions. However in the text we will restrict the discussion to the purer intervention that comes directly from the government."
  12. Or "at least, they will desire to do so, just as soon as contractual obligations allow. In practice there might be other constraints, such as the loss of employee morale if the boss lets 10% of the staff go in response to a minimum wage hike. Nonetheless, other things equal a minimum wage increase will reduce the profit-maximizing number of (low-skilled) employees for a given business."
  13. To "say that the demand (not just the quantity demanded) falls in the long run means two things: First, at the constant minimum wage, the number of workers who can find jobs will fall. Second, even if the government eventually removed the minimum wage, the equilibrium number of workers hired (at that point) would initially be lower than the original number of workers before the imposition of the minimum wage."
  14. Note "that at the original wage of $5 per hour, the renovation would only save the owner $15 an hour in reduced labor costs. Depending on the expense of renovation (properly accounting for interest and the depreciation of the new equipment), the minimum wage law could be the difference between designing a restaurant to be run by 8 employees versus 5."

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