Price Controls with Fixed Supply

Most economists oppose price controls, especially those following a disaster or some other unexpected event (commonly called “anti price-gouging legislation”).  However, UMASS–Amherst economist Isabella Weber objects.  She tweets: “One of the problems with [the supply and demand diagram] is that it is missing a crucial dimension: time. When it comes to price gouging in emergencies, that’s a pretty big problem.”  This tweet has spawned numerous responses from various economists, most pointing out to her that the supply and demand model does take into account time: the x-axis is properly labeled “quantity per unit of time.” (My late, great PhD professor, Walter Williams, would deduct points from anyone who wrote the x-axis as just quantity).  Furthermore, both supply and demand become more elastic over time.

These objections are correct, but I think they miss the claim that Weber is making as well as the larger, economic mistake she is making.  Weber is arguing that price controls do not have the negative effects of deadweight loss when the supply of a good is fixed and the timeline for it to become unfixed is long.  Let’s analyze her claim first on its own merits and then from a richer economic lens.

Weber is approaching this problem from the perspective of Marshallian welfare economics where the performance of a market is judged by whether or not total surplus (the gains from trade to the producer plus the gains from trade to the consumer) is maximized.  Calculating these gains from trade is fairly easy: for the consumer, it is simply the difference between what a consumer is willing to pay for each unit consumed and what they have to pay for each unit consumed.  For the producer, the gains from trade are the difference between the price the seller receives for each good sold and what they are willing to sell for each good sold.  The total surplus (total gains from trade) are thus consumer surplus (consumer gains from trade) plus producer surplus (producer gains from trade).  

Two very important things to note: 1) how much surplus is generated in the market depends on the quantity exchanged in the market.  If the quantity exchanged falls, total surplus will fall (and vice versa)  2) how surplus is distributed between consumers and producers depends on the price.  Generally speaking, a higher price implies lower consumer surplus and more producer surplus (all else held equal).

From a strict, Marshallian welfare-economic perspective, Weber’s claim is correct.  When supply is fixed (i.e., perfectly inelastic) and there is no time to either increase supply or get the curve more elastic, then price gouging legislation will not result in deadweight loss.  Since the quantity does not change, putting a price ceiling simply shifts gains from trade from the producer to the consumer.  Total surplus in the market does not change; there is no deadweight loss since the quantity in the market does not change.

However, from a broader, richer economic perspective, where we think about how people actually behave when faced with different choices, her point is incorrect.  Price controls will still lead to shortages as the quantity demanded exceeds the quantity supplied.  While there is no deadweight loss, the costs of those shortages still arise: queuing, hoarding, etc.  Furthermore, since the price being kept artificially low disincentivizes the supply curve from becoming elastic and/or growing, the costs of price ceilings persist longer than they would otherwise.  These are very real costs and, taking them into account, shows that even given fixed supply, price controls make everyone worse off.

So, by comparison of these two states (price ceilings where producer surplus is transferred to the consumer but the consumer and producer bear much higher total costs over a longer period of time, or prices rise, consumer surplus is transferred to the producer, but these extra costs are not imposed), price ceilings still incur undesirable effects, especially so following a disaster.

And there are many other possible objections as well.  In a conversation with me on Facebook, retired Texas Tech economist Michael Giberson pointed out that there is no particular economic justification to prefer consumers over producers in this (or any other) exchange.  Another is that there is no reason to think that the distribution of goods to the consumer will be any more “just.”

Furthermore, as Kevin Corcoran recently reminded us, we want to avoid the one-stage thinking permeating Weber’s claim.  Price control legislation has long lasting effects by changing the incentives for suppliers against preparing for a disaster.  As economist Benjamin Zycher shows, price controls in wartime discourage producers from stockpiling war materiel in peacetime.  The same holds true for non-defense goods.  Stockpiling is costly; it takes away storage space from goods that can be more quickly sold.  For firms to stockpile, they need to have the expectation of higher prices in the future.  If they know they will not be able to charge higher prices in the future, then the cost of stockpiling will be higher than the benefits.  Firms will keep fewer goods on hand, so that when the disaster does strike, fewer goods will be available for the aftermath.  The best time to end price controls is before a disaster.  The second best time is now.

In sum, Isabella Weber’s tweet is mathematically correct but economically incorrect.  It is internally consistent and logical, but contains no economics.  We must always look beyond just the model to the reality the model is simulating.