Markets Pay Dearly For Government Price Controls

The subject of price controls is attracting attention in the wake of recent hikes in the cost of food. US Vice President Kamala Harris is arguing for a federal ban on “price gouging” while the food industry pushed back on accusations it is charging excessive prices in a recent Wall Street Journal article.

The US presidential election is raising the temperature of the debate. The likelihood of the US government intervening when it deems prices to be “unfairly high” is increasing as costs rise and companies react with price hikes. For example, there is mounting evidence that climate change is making food production more expensive, and geopolitical conflicts such as the Houthi attacks on ships and the war in Ukraine are inflating supply chain costs.

Government-imposed price controls impact supply chains in many ways, but for the most part, they cause shortages and reduced service to consumers.

Sudden increases in demand like fads for toys or fashion garments seldom cause official price hikes. In the vast majority of cases, retailers and dealers increase their prices to consumers to pass on rising costs or in response to supply shortages. Price rises resulting from obvious cost increases are easier to justify and understand. An example is when the price of a barrel of oil goes up, triggering increased gas prices at the pump. However, the focus of this article—and, I believe, of the current price gouging controversy—is not on price increases resulting from demand spikes or cost increases, but on those related to supply shortages.

Price gouging refers to taking advantage of a scarcity of products (e.g., when toilet paper was in short supply during the Covid-19 pandemic) by charging exorbitant prices for the scarce items. A government might decide that the market price is “too high” and require the companies involved to restore consumer prices to pre-crisis levels. However, this action will also restore the pre-crisis supply constraints that originally pushed up prices.

To understand this argument, consider how Uber sets prices. When there are not enough drivers to fulfill customers’ orders for rides, Uber raises prices. This creates an incentive for more drivers to get on the road and serve customers.[1] As a result, customers can still find a ride when it is raining or during rush hour when drivers are less inclined to work. In this example, disallowing price increases would deprive some customers of rides and cause others to wait an excessively long time for an Uber vehicle.

Similarly, when the supply of consumer goods plunges for various reasons, such as a poor crop yield or hurricane-related devastation, and many customers are chasing too few goods, retailers must incentivize suppliers to boost production. In other words, they must pay suppliers more, thereby increasing their own costs which consumers have to pay for. When retailers are prevented from using this strategy, some products become unavailable, resulting in empty shelves, and the retailers bring down costs by reducing customer service levels. They might cut worker numbers and opening hours.

Also, supply/demand imbalances often cause black markets to develop. Examples include black markets for Taylor Swift concert tickets and Super Bowl tickets or fixed exchange rates.[2] In these unregulated markets, prices can be an order of magnitude higher than the official price. Furthermore, such markets increase inequality by opening opportunities only for those who can pay black market prices.

Combinations of product shortages, reduced quality, inferior services, and black markets are the hallmarks of supply chains inhibited by price controls. Many industries and services exhibit these problems.

The solution for “gouging” may be the opposite of price controls. Governments could decide to incentivize suppliers to increase their output (and encourage new suppliers to join the industry) by allowing even higher prices and supporting higher output levels with direct payments.

Naturally, governments should also ensure that industries are competitive and companies do not create monopolies. But this is a topic for another blog post.

[1] To a small extent these price increases may lower the demand for trips but this is a minor effect in comparison to the increased supply.

[2] For example, when the government of Argentina fixed the Peso/Dollar during a period of rampant inflation, street vendors throughout Buenos Aires were offering a much higher price for dollars than the official rate.