The law of supply and demand determines prices for goods and services in the market. As demand increases for a good or service, its price increases to insure demand does not exceed supply. Conversely, if demand decreases, prices go down so the good or service is more affordable thus increasing demand (Sowell, 2007). External forces of externalities can distort the law of supply and demand resulting in shortages or surpluses (Hackett, 2006). This week we will look at how government intervention through price controls affects the natural actions of supply and demand.
Politicians need to get votes in order to gain election to office. During campaigns, the public is exposed to a litany of promises designed only to get votes. Once a politician gains election to office, the promises are quickly forgotten. However, politicians often develop programs to either keep prices high in order to gain favor with suppliers or keep prices low in order to gain favor with the public.
Rent control is one such idea. Rent controls began during World War II as part of temporary wartime price controls (Tucker, 1997). The intention was to insure affordable housing. Rent controls continued after the war in order to provide affordable housing for returning GI’s. However, even programs started with the best of intentions have unforeseen circumstances that cause them not to achieve the desired results.
A scan through the classifieds of many rent-controlled cities reveals that there are very few moderately priced rental units available. In fact, most advertised units are priced well above the actual median rent (Tucker, 1997). The logical question to ask here is how can rents exceed the median price when prices are held below market value through price controls.
One explanation is found by looking at how the law of supply and demand works. With prices kept below the median price governed by the law of supply and demand the demand for rentals is held high. However, with prices held low there is little incentive for individuals to go into the rental business or to build rental properties. This results in a shortage of available rental units (Sowell, 2007).
To compensate for this shortage, policymakers exempt significant properties from rent control. To compensate for properties under rent control, these properties usually rent at above the median rent (Tucker, 1997). Most likely, these properties remain available and listed in the classifieds. For these reasons, rent control has been repealed in many communities.
Another form of price control that distorts the normal operation of the law of supply and demand is price subsidies that keep prices above the median price governed by the law of supply and demand. An example of such a subsidy is farm subsidies in the United States.
The first attempt by government to control prices came in 1920 when congress passed the McNary-Haugen bill. This bill fixed prices for some commodities in order to preserve the high prices that occurred during World War 1. However, President Coolidge vetoed the bill. In President Coolidge’s veto message he stated “I do not believe that upon serious consideration the farmers of America would tolerate the precedent of a body of men chosen solely by one industry who, acting in the name of the Government, shall arrange for contracts which determine prices, secure the buying and selling of commodities, the levying of taxes on that industry, and pay losses on foreign dumping of any surplus” (Folsom Jr., 2006).
President Coolidge understood the economic repercussions of price subsidies. He understood that other industries would have to be taxed to pay for the subsidies. He knew that keeping prices high would result in surpluses that the government would have to buy back and give away to foreign countries. Unfortunately, the next two presidents did not share the opinions of President Coolidge and farm subsidies exist today (Folsom Jr., 2006).
With price subsidies we also pay farmers not to grow crops in order to prevent surpluses that price subsidies create. The talents of these idle farmers could be put to use on other industries but as long as they can earn income for not working, they have no incentive to learn new skills that could be useful in other parts of the economic system. The economic system as a whole pays a high opportunity cost because of this wasted talent.
In both of these examples, we have seen that the operation of the law of supply and demand is distorted when government sets prices either at a level above or below the median price. Rent control show us that fixing prices below the median results in shortages and causes the prices of goods and service that are not fixed to be above the median to compensate for the lower fixed prices. When prices are kept high through subsidies, surpluses are created which have to either be bought back by the Government, at taxpayer’s expense, or given away. Governments also begin paying producers not to produce, again at taxpayer’s expense, in an effort to reduce surpluses. This paying of individuals to remain idle results in a high opportunity cost to the economic system.
Next week we will look at the affect of government intervention on the supply of goods and services produced.
References
Folsom Jr., B. (2006). The origin of american farm subsidies. The Freeman: Ideas on Liberty, , pp. 34-35. Retrieved January 19, 2010, http://www.fee.org/pdf/the-freeman/0604Folsom.pdf
Hackett, S. C. (2006). Environmental and natural resources economics (3rd ed.). London: M.E. Sharpe.
Sowell, T. (2007). Basic economics (3rd ed.). New York: Basic Books.
Tucker, W. (1997). How rent control drives out affordable housing. Retrieved January 19, 2010, http://www.cato.org/pubs/pas/pa-274.html
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