The Problems of Price Controls

his article is excerpted from the latest edition of Regulation (Vol. 24, No. 1, 2001), the Cato Review of Business and Government.
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One of the most important issues to Americans is how to manage prescriptiondrug prices, especially for seniors who depend on Medicare coverage. Somepolicy advocates are urging the federal government to contract directly withdrug manufacturers to purchase drugs for seniors – at prices set by thegovernment. Despite the high-minded intentions of these advocates, suchprice controls could be very harmful to Americans’ future health.

When prices are held below natural levels, resources such as talent andinvestor capital leave an industry to seek a better return elsewhere. Thismeans that there will be less discovery and innovation, and fewer new drugswill become available to consumers. Often this change happens over the longterm ¾ longer than the tenure of any policy-maker. Thus, it is vitallyimportant to remind policy-makers of the effects of price controls wheneverthey are proposed as government policy.

DISRUPTING SUPPLY AND DEMAND

The determining of market prices through the dynamic interaction of supply and demand is the basic building block of economics. Consumer preferencesfor a product determine how much of it they will buy at any given price.Consumers will purchase more of a product as its price declines, all elsebeing equal. Firms, in turn, decide how much they are willing to supply atdifferent prices. In general, if consumers appear willing to pay higherprices for a product, then more manufacturers will try to produce theproduct, will increase their production capacity, and will conduct researchto improve the product. Thus, higher expected prices lead to an increasedsupply of goods. This dynamic interaction produces an equilibrium market price; when buyers and sellers transact freely, the price that resultscauses the quantity demanded by consumers to exactly equal the supplyproduced by sellers.

But when government adopts a price control, it defines the market price of a product and forces all, or a large percentage, of transactions to take place at that price instead of the equilibrium price set through the interaction between supply and demand. Since supply and demand shift constantly in response to tastes and costs, but the government price will change only after a lengthy political process, the government price will effectively never be an equilibrium price. This means that the government price will be either too high or too low.

When the price is too high, there is an excessive amount of the product forsale compared to what people want. This is the situation with many U.S. andEuropean farm programs; government, in an effort to increase farm incomes,purchases the output that consumers do not want. This, in turn, promptsfarmers to raise more cows and convert more land to pasture or cropland.However, the higher prices discourage consumers from buying farm products,causing an excess of supply (e.g. a “butter mountain”). Government thenexacerbates this situation by continuing to purchase the excess crop at the set price.

Serious problems also result when government sets prices below theequilibrium level. This causes consumers to want more of the product than producers have available. When the federal government restricted gasolineprice increases in the 1970s, long lines formed at gas stations and onlythose motorists who waited long hours in line received the scarce gasoline.

In both cases of government price controls, serious welfare loss resultsbecause not enough of the good is sold. The wasted chance to create bothproducer and consumer surplus from those sales is known as ‘deadweight loss’ because it is income that is lost forever. In addition to creatingdeadweight loss, an artificially high price transfers profits from consumersto producers; these rents are often wasted because producers spend them onlobbying and other influence activities to maintain the regulated price. Inthe case of a low price, producers transfer profits to consumers. Consumers, in competing for a limited amount of the controlled product, may waste as much as they gain from getting it at a low price. For instance, the people who waited in the 1970s gas lines probably shouldered as much cost from the lost time queuing as they saved from the price controls on gasoline. (Researchers Robert Deacon and Job Sonstelie have even argued that the gas lines cost consumers more than they saved from the controlled gas prices.) Thus, the artificially low prices not only hurt producers, but alsoconsumers.

PRICE CONTROLS AND HISTORY

Government gains favor with voters and constituents when it lowers the priceof popular goods. Government also gains favor from lobbyists and firms whenit raises prices to promote the health of the industry. Given these benefitsto policymakers, it should not surprise us that price control is common inthe history of western economies.

Early twentieth century economist Henry Bourne documented the effects ofprice controls on France in the years following the French Revolution, whencity residents found it difficult to purchase grain. The grain shortageswere not due to any agricultural problems; Bourne noted that 1793 France was a prosperous agricultural nation capable of feeding itself. Instead, thethreat of famine was due to internal procurement and distribution problemscreated by the government. For example, agents for the city of Paris, themilitary, and the government competed with each other in trying to purchasegrain. This created local shortages where none had existed before, and ledto social unrest.

The city of Paris, in an effort to appease the public, decided to subsidizeflour. This prompted bakers from neighboring towns to travel to Paris topurchase flour, creating even more shortages in the city.

The French Convention, which governed the nation at that time, tried toaddress the problem by establishing maximum prices for grain and instructingfarmers to supply it to local markets. As one might expect, farmers did notcooperate with the new law. Markets were empty of grain; further shortagesdeveloped; official tallies of grain supplies failed to find and keep trackof stocks; urban riots continued.

The Convention passed another law later in 1793 extending maximum prices toother essential supplies. Those price controls, in combination withgovernment requisitioning and corruption, created chaos in the Frencheconomy. Merchants responded by reducing the quality of their goods and the black market blossomed, Bourne noted. “It was the honest merchant who became the victim of the law. His less scrupulous compeer refused to succumb. The butcher in weighing meats added more scraps than before…other shopkeepers sold second-rate goods at the maximum [price].... The common people complained that they were buying pear juice for wine, the oil of poppies for olive oil, ashes for pepper, and starch for sugar.”

The last century provided many examples of price control-generated economicproblems in communist Europe. Economist David Tarr noted some of theseproblems in his study of the distribution of domestically producedtelevision sets in communist Poland. Because the Polish government kept TVprices artificially low, demand far outstripped supply and televisionsbecame scarce. A consumer who wanted a TV had to sign on to a waiting list.In most cases, the consumer had to visit the store every day to keep hisplace on the list. Tarr calculated that the social cost of the queue fortelevision sets was 10 times the size of the standard deadweight loss andthat the cost of the price controls on televisions to the Polish economy wasmore than the industry’s total sales.

In the 1980s, the Ministry of Finance in Japan regulated brokerage fees andprohibited firms from competing for customers on that basis. However, asdocumented by economists Kevin Hebner and Young Park, large corporatecustomers were very important and lucrative for the securities dealingindustry. The industry found other, possibly corrupt, ways to compete forcorporate business. Securities firms would guarantee corporate investorsthat certain funds would achieve a minimum return, effectively reimbursingthe client if the investment declined in value. Securities companies fundedthis expensive practice with profits earned from the government-fixed chargefor brokerage services to both small and large customers. Hence, thesecurities firms turned the price control scheme into a transfer scheme that moved resources from household savers to large corporate investors.

If government prevents firms from competing over price, firms will competeon whatever dimensions are open to them. In the era of U.S. airlineregulation when the Civil Aeronautics Board set prices, airlines tried toattract customers with food, empty seats, and frequency of flights. Thisform of competition can be as expensive as competing on price. Despite highprices and protection from new entrants, established carriers competed away their rents and did not earn high profits.

PRICE CONTROLS TODAY

Despite this worrisome history of price controls, government continues tofollow the practice. In some cases, government disguises these policies withelaborate pricing schemes, but they still lead to serious problems forproducers and consumers.

Rent Control

Rent control provides a classic example of the distortions created by price controls. There are various forms of rent control, but they all take the shape of legally imposed below-market rates for rental housing. The results are well documented and perverse. First, a shortage of rental units arises as landlords become less interested in renting at below-marketrates. Instead, the landlords choose to live in the units themselves, rentthem to relatives, or sell them.

This shortage leads to a host of related distortions. For example, sincethere is a queue of people willing to rent each apartment and landlords arenot permitted to discriminate based on price, the landlords will discriminate on whatever characteristic they please. Landlords may also ask for under-the-table payments from tenants or require renters to hand over an initial fee in order to sign the lease. Moreover, landlords have little incentive to maintain apartments; it is more difficult to recoup the cost ofimprovements through the government-established price and, at the same time,there is a strong demand for apartments regardless of their condition.Consequently, the quality of housing stock declines and the area may come toattract less affluent residents. This hurts neighborhood businesses. Newhousing stock is less profitable to construct if government controls rentalprices; thus fewer investors will engage in that activity and economicdevelopment will slow.

In 1990, the federal government passed legislation setting new price levelsthat state governments would pay for pharmaceuticals provided by Medicaid.The rules varied across drugs, but in some cases Medicaid was entitled topay no more than the lowest price that the drug company charged to any othercustomer.

Such a scheme may sound reasonable, but it distorts incentives in the drugmarket. Medicaid uses the existing network of chains and independentpharmacies to distribute drugs to its members, but many of theseorganizations do not have the scale to bargain for good prices nor thecontrol to influence the prescribing physician. In these circumstances, theywould not normally get the lowest price in the market; that goes to largebuyers and HMOs or others who can “move market share.”

Faced with having to charge Medicaid the lowest price given to any othercustomer, pharmaceutical firms reduced discounts. The legislation resultedin an increase in drug expenditures for many private buyers as drugmanufacturers tried to raise prices on government sales.

MARKET FAILURE

One of the reasons that governments invoke price controls is to ensure thatgoods and services are sold at a ‘fair’ price. In a situation with numerouswell-informed consumers purchasing from multiple sellers who can develop areputation for high or low quality, the free market works well. The marketprice is ‘fair’ due to the competition between innovators and betweenbuyers. However, there are occasions when entrants are discouraged or theinformation available to one or more parties is poor.

In such cases, government may impose price controls in an effort to protectcitizens from exploitation. This might occur if patients had to choose drugswithout the help of physicians, for example. In such a case, patients mightneed government protection from high prices for the wrong medicine. Ourmodern healthcare system largely removes this concern by employing informed physicians, pharmacists, and formulary committees who affect drug choice.

Early Puritan communities, described in Hugh Rockoff’s book DrasticMeasures: A History of Wage and Price Controls in the United States,abandoned detailed wage and price controls shortly after imposing them in1630 and 1633 because they were ineffectual. Subsequent laws against“excessive” prices were more vague and, according to Rockoff, aimed toprevent “sales influenced by fraud, ignorance, or short-runmonopolies…rather than lowering the equilibrium price in a particularmarket.” His interpretation is that the Puritans faced under-developedcolonial markets and so “competition could not be relied upon to regulateprices and protect consumers.”

A market failure, such as lack of entry, can be mitigated with the rightprice control, at least in theory. The difficulty lies in the execution.Typically, no entity is well informed enough to be able to exactly identifythe imperfection, choose the correct price to rectify the situation, andthen provide ongoing adjustment and enforcement.

Competition is a better tool than price controls for protecting consumers;the Puritans appear to have realized that and gradually ceased using them.As Rockoff writes, “One would expect that as markets grew, producing asmoother flow of information…the need for regulation would have decreased.Indeed, that seems to have happened.”

More typically, governments try to fix the bad effects of price controlswith subsidies to the discouraged activity. In the case of thepharmaceutical industry, these subsidies go to research and development. A subsidy could restore the free market outcome by lowering the cost of research. Again, however, the difficulty arises in choosing the level of the subsidy, deciding whether and how to award it to for-profit corporations, and avoiding inefficient lobbying and corruption. In practice, these are very difficult issues to manage in a way that benefits consumers.

LOWERING PRICES THROUGH THE MARKET

The private sector has found several successful methods for reducing theprice paid by a buyer. In most cases, government can use similar techniquesto get a low price for prescription drugs without disrupting the competitivemarket.

The most common approach is to take advantage of scale. A buyer representinga large volume of market transactions can negotiate for a better price bythreatening to backward integrate or to move its business to a competingsupplier (if the product is not patent-protected). Moreover, a large buyerprovides efficiencies to the seller. Lower transaction costs (one invoice,one negotiation, one shipment), guaranteed volume, and economies of scale create cost savings for the supplier that the two parties can share. The private sector provides countless examples of this approach; for example, big supermarket chains pay lower prices for packaged goods than corner stores because of large-scale central purchasing.

A slightly more subtle point of relevance to the pharmaceutical industry is that a buyer with significant volume can often get an even lower price by helping its supplier increase market share. Insurance organizations canagree to educate or encourage physicians to prescribe a certain drug. In return for altering market share in the provider network, the drugmanufacturer offers the provider a lower price.

A buyer can explicitly foster competition where none exists. For example, several large corporations in the Detroit area recently began funding a small, low-cost airline named Pro Air that operates out of that airport. TheDetroit airport is otherwise dominated by Northwest Airlines, which chargesrelatively high prices due to the lack of competition. General Motors,Masco, and Daimler-Chrysler each pay Pro Air a fixed sum of money per monthin exchange for a certain number of flights for their employees. This givesthe start-up airline stability and causes its competitors to realize that it cannot be driven out of business. By encouraging the entry and survival of alow-cost competitor to Northwest Airlines, the companies save both on theflights their employees take on Pro Air, and also through any pricereduction Northwest undertakes in response to the competition.

Another way to obtain lower prices through the market is for an independentorganization to provide information on the competing alternatives toindividual buyers. Using this information, an informed consumer can identify the product that best fits her needs and can demand a discounted price when purchasing a different product. Many large corporations take this approach with health plans for employees; the employee may choose among a set of approved plans and the corporation provides ratings or a scorecard to help employees compare the plans. The ratings cause plans to compete for customers on the price and quality dimensions.

CONCLUSION

The imposition of price controls on a well-functioning, competitive marketharms society by reducing the amount of trade in the economy and creatingincentives to waste resources. Many researchers have found that pricecontrols reduce entry and investment in the long run. The controls can alsoreduce quality, create black markets, and stimulate costly rationing. In thecase of pharmaceuticals, the most damaging area is likely to be thereduction in innovation, which will harm all future generations of patients.

Although policymakers know that price controls can be very harmful, theycontinue to have strong incentives to legislate low prices for themselves.This often leads to the adoption of more sophisticated price controls. Thegovernment pegs its price to some reference price in the economy rather than choosing a fixed number, or sets its price a fixed amount below that ofother customers. These schemes destroy welfare by inserting a new incentiveinto what would otherwise be a well-functioning market; either the price tonon-government customers is higher or the price to poorer customers rises.More generally, the reference price chosen by the government rises becauseof the price control, not because of a change in the underlying forces ofdemand or supply.

The overwhelming evidence against price controls naturally leads toconsideration of other methods of lowering purchasing costs. The privatesector uses a number of methods that are both effective and consonant with amarket economy. Such approaches, when used by the private market, are muchless damaging to economic welfare than a government price control.

Fiona M. Scott Morton

Fiona M. Scott Morton is an associate professor of economics and strategy at Yale University. Her academic interests include global competitive strategy, E-commerce, and strategic management.