Introduction to Economics Part 5 - Price Controls

Today I'd like to go into more detail regarding the nature of price, and how artificially altering the prices determined by the wisdom of crowds affects the economy.

Why would anyone want to alter prices?

1. Consumers want prices to be lower so they can buy more stuff.
2. Producers want prices to be higher so they can acquire more money.

In this regard the desires of producers and consumers are in direct conflict.  In order for trade to take place, each side must give in slightly to appeal to the desires of the other side.  This is what happens every day, and when such a resolution cannot be met, the transaction simply does not occur.

But what would happen if one of these sides were to acquire a weapon?  If one side can force the other to succumb to a threat of violence, the potential gains are tremendous.  Why would this ever be legal?  As it happens, our society has an institution with the legal right to use violence.  Since people act in a way to best serve their desires, both consumers and producers fight to gain control of this institution.  This institution is, of course, the state.  Consumers have their lobbies arguing and bribing for lower price regulations, while producers have their lobbies arguing and bribing for monopoly protection.

PRICE GOUGING

Every once in a while prices for a necessary product will skyrocket and consumers will complain about price gouging.  Price gouging is when a producer sells a resource at a much higher price than is considered reasonable or fair.  This is only possible through a government-enforced monopoly.  In the absence of a government-enforced monopoly, enormous profits made by the monopoly would motivate other capitalists to enter the field and undercut the monopoly's prices.  Because of this, in the absence of violence, producers cannot exploit consumers in this way.

If prices rise and are not due to a monopoly, it is usually the result of a disaster or some other extra-market force.  For example, when hurricane Katrina hit, several gasoline refineries were knocked out and prices went through the roof.  Though many consumers mistook this for price gouging, it was actually a shortage in the quantity gasoline supply due to the disaster.

Gas companies could not produce the same amount of gasoline at the same price level.  Due to the drop in quantity, the supply curve shifted to the left, resulting in higher prices.  Mistaking this for price gouging, some governments instituted price ceilings.  We did this at a nation-wide level in the 1970s.

By artificially setting prices, the market was unable to rise to its equilibrium point.  Demand was higher than supply.  More people wanted to buy gas than there was gas available.  The result was endless lines and hoarding, preventing many from getting the gasoline they needed.  Capping the price did not increase the availability of gasoline.  Instead, it just shifted the competition for the scarce resource from being one of price to one of "first-come, first-served."

MINIMUM WAGE

Minimum wage works in a similar way, since as far as the economy is concerned, labor is another resource. Wages are the price of labor, and the quantity of labor is the number of workers.  The workers make up the supply, and the employers comprise the demand.  The supply curve is upwards sloping because more people want a job if it has a higher wage.  The demand curve is downward sloping because a firm can hire more people if they don't have to pay individual employees as much.  Again, there's an equilibrium quantity, which comes out as the number of jobs, and there is an equilibrium price, which becomes the wage to be paid.

When you institute a minimum wage, there are two possibilities.  If the minimum wage is below the equilibrium wage, there is no effect.

If the minimum wage is above the equilibrium wage, it has the same effect as a price set above the equilibrium price.  There is a greater supply of workers than there is a demand for employment.  The difference between these two quantities is unemployment.

The only way the economy has to establish full employment is to allow prices and wages to adjust based on economic conditions.  If the economy is in a bad situation, and the market cannot support wages at a certain price level, and paying below a certain price level is banned by the government, anyone who's work is worth less than that price level will simply not be employed.

When you understand this, you realize that far from being a law that forces employers to respect their workers' time, the minimum wage is devastating for the worker.  The minimum wage is a law which bans anyone from working who cannot produce more than the minimum wage's worth of value for their employer.  It is the single greatest cause of unemployment in modern society.

This is why minimum wage is such a gruesome law against the poor.

INTEREST RATES

In the funds market we have supply and demand as well.  The supply is the amount of loanable funds. The demand consists of everyone out there who wants to take out a loan.  The government manipulates interest rates by manipulating the supply of loanable funds.  As with other products, there is competition between the consumers and the vendors.  Borrowers wish to borrow more money at lower interest rates while lenders wish to lend at higher interest rates.

Through trial and error banks have learned of the terrible disasters that occur when you impose a price floor or a price ceiling on interest rates.  Instead of taking these actions, the Federal Reserve manipulates interest rates by depositing money into or taking money out of the banking system.  If the Federal Reserve wishes to inject money into the banking system, they may announce that they are buying bonds.  The banks sell the bonds to the Federal Reserve, the Federal Reserve prints money to give to the banks, and the banks now have more money they can lend to borrowers.  This increases the supply of loanable funds, dropping the price of the loans (the interest rates).  This can also be done in the other direction by selling bonds back from the banks, thus raising interest rates, decreasing the overall amount of money in the system, and decreasing the amount of loanable funds.

This activity has consequences of its own.  When you increase the amount of money in the system, you get inflation, or the devaluing of the currency.  When you decrease the amount of money in the system, you get deflation, or an increase in the value of the currency.  The capacity to manipulate interest rates comes at the cost of price stability.

Thanks so much for reading!  Have a nice day!