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October 23, 2009

ECON 101: Price Controls Create Shortages

"When Western countries in the past were as poor as Third World countries are today, these Western countries nevertheless had one big advantage: There was no large and influential class of the intelligentsia to impede their progress with unsubstantiated theories and counterproductive propaganda." -- Dr. Thomas Sowell

Nothing demonstrates the gap between abstract theories and practical consequences quite like an object lesson in cause and effect:

"There's no question people have left because of uncertainty of our ability to pay," said an executive at one of the affected firms. "It's a highly competitive market out there."

At Bank of America, for instance, only 14 of the 25 highly paid executives remained by the time Feinberg announced his decision. Under his plan, compensation for the most highly paid employees at the bank would be a maximum of $9.9 million. The bank had sought permission to pay as much as $21 million, according to Treasury Department documents.

At American International Group, only 13 people of the top 25 were still on hand for Feinberg's decision.

It is downright scary to think that this country is being run by supposedly educated people who insist on making policy that ignores the effect of incentives, supply and demand on human behavior. The idea that prices can be manipulated without affecting either supply or demand doesn't even make sense in theory. So why would any rational person expect it to work in the real world?

Whether government officials who have demonstrated a stunning ignorance of basic economic principles should be formulating economic policy is a question no one seems to be asking. But then again, understanding that prices, supply and demand are interrelated is so fundamental a concept that anyone with common sense ought to be able to grasp it:

When there is a "shortage" of a product, there is not necessarily any less of it, either absolutely or relative to the number of consumers. During and immediately after the Second World War, for example, there was a very serious housing shortage in the United States, even though the population and the housing supply had both increased about 10 percent from their prewar levels and there was no shortage when the war began.

In other words, even though the ratio between housing and people had not changed, nevertheless many Americans looking for an apartment during this period had to spend weeks or months in an often vain search for a place to live, or else resorted to bribes to get landlords to move them to the top of waiting lists. Meanwhile, they doubled up with relatives, slept in garages or used other makeshift living arrangements.

Although there was no less housing space per person than before, the shortage was very real at existing prices, which were kept artificially lower than they would have been because of rent control laws that had been passed during the war. At these artificially low prices, more people had a demand for more housing space than before rent control laws were enacted. This is a practical consequence of the simple economic principle already noted in Chapter 2 that the quantity demanded varies with how high or low the price is.

Some people who would normally not be renting their own apartments, such as young adults still living with their parents or some single or widowed elderly people living with relatives, were enabled by the artificially low prices created by rent control to move out and into their own apartments. These artificially low prices also caused others to seek larger apartments than they would ordinarily be living in. More tenants seeking both more apartments and larger apartments created a shortage, not any greater physical scarcity of housing relative to the population. When rent control laws expired or were repealed, the housing shortage likewise quickly disappeared.

As rents rose in a free market, some childless couples living in four-bedroom apartments decided that they could live in two-bedroom apartments. Some late teenagers decided that they could continue living with mom and dad a little longer, until their pay rose enough for them to afford their own apartments, now that apartments were no longer artificially cheap. The net result was that families looking for a place to stay found more places available, now that rent-control laws were no longer keeping such places occupied by people with less urgent requirements.

None of this was peculiar to the United States. The same economic principles can be seen in operation around the world and down through history.

How's that whole "offering more services to more people for less money" thing going again?

If something sounds too good to be true, it probably is.

Price controls don't work in real estate and they don't work in medicine. In fact, I'd be shocked if anyone can show me a single instance where they didn't have disastrous consequences?

It's interesting, and of course to be expected, that Gralla frames the downside of this in terms of how it might hurt government coffers. The real bad part is the lack of freedom it gives to the building owners--and the lack of incentive to provide apartments for all future New Yorkers that will create widespread aggravation and shortages down the line.

Prices operate as signals in a free marketplace, efficiently allocating goods to those who want them and are able to pay for them. Few Americans would accept the proposition that we don't need information to make intelligent decisions and yet too many Americans buy off on the notion that markets will operate efficiently if the federal government restricts the free flow of information between consumers and producers.

It's almost as though we were living in an alternative universe where reality is kept strictly at arm's length.

Then again, maybe that's the problem.

"One of the most important reasons for studying history is that virtually every stupid idea that is in vogue today has been tried before and proved disastrous before, time and again." -- Dr. Thomas Sowell

Posted by Cassandra at October 23, 2009 12:30 PM

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So why would any rational person expect it to work in the real world?

Since we're dealing with people who firmly believe Mao Tse-Tung was a poet-orator, yours is obviously a rhetorical question...

Posted by: BillT at October 23, 2009 03:05 PM

The difficulty is that while the laws of economics apply to societies at large they can frequently be flouted on an individual basis if you have sufficient power, money or "connections". Our current ruling class is shielded from the personal consequences of their decisions and thus it all becomes an abstraction which makes the cause and effect relationship open to considerably more interpretation.

For example, in the case of rent control in NYC, it has always been possible for the rich and powerful to find cheap apartments, c.f. Charlie Rangel. Thus, Charlie can walk into any real estate brokerage in Harlem and mention he is looking for an apartment and have no difficulty finding one, thus when his constituents complain that they can't find an affordable apartment it must be because some other factor is operating, HE never had a problem.

Posted by: James at October 23, 2009 06:15 PM

James stole some of my thunder. I agree with the basic premise, exceptions do occur, however, in market "bubbles" or rigged circumstances.

In each such exception, the PERCEIVED value is artificially inflated by various factors and does no reflect the true fair market value. For example, Wall Street is clearly a good old boy network that artificially inflates salaries irrespective of performance.

I have no problem with performance-based salaries or bonuses. In those circumstances, you may deserve a 10 million bonus if you produced 100 million. If you get a 20 million dollar salary even though the company LOST 100 million, just because you, the Board of Directors, and every other chairman or executive officer went to Yale and Exeter together, belong to the same Clubs, and attend the same annual regattas together, and thus believe that "your sort" of fellows always should get a minimum 20 million salary, then that is a bunch of crap. This is nothing more than another version of elitist, insider traders.

Posted by: a former european at October 24, 2009 12:03 AM

Isn't it amusing (in a horrifying way) that Congress thinks nothing of fiddling with the economic system of this country, invariably causing more harm than good, whereas dumping a barrel of chemicals into a river would be cause for arrest? They're both examples of toxic interference with complex interconnected systems, with similar effects.

Posted by: alanstorm at October 24, 2009 08:25 AM