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Economics: Effects of Price Controls

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About this Lesson

  • Type: Video Tutorial
  • Length: 6:32
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 70 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Evaluating Market Outcomes (15 lessons, $19.80)
Economics: Market Interference and Economic Value (5 lessons, $7.92)

In this video lesson, you will improve your understanding of the Effects of Price Controls. Taught by Professor Tomlinson, this video lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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Thinkwell
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In this lecture we'll look at another way that a government might interfere with the market. This interference is the price control, and we'll see that it has different consequences from a tax or a tariff. Let's start with a situation in which we have a baker who's willing to bake a loaf of bread and sell it for $1.00. That's his reservation price. Let's take a customer who has a reservation price of $5.00. Now as you know, with a reservation price of $5.00 representing economic benefit, and a cost of $1.00, the reservation price of the seller, there are $4.00 worth of economic value to be created if we can get this buyer and this seller together.
Suppose now that a price control is imposed in this situation, and the price control will be set at $2.00. The government says that no one can charge more than $2.00 for a loaf of bread. Would that have any effect on this market? The answer is, no, it would not. At a price of $2.00 this buyer would certainly buy the bread and get $3.00 worth of consumer surplus. The seller would certainly sell the bread and get only $1.00 worth of producer surplus. But there's no reason not to do the trade because the price control lies squarely between the reservation price of the buyer and the reservation price of the seller.
The situation gets more complicated, however, if the price control were to fall below the seller's reservation price. If the government decreed that bread could not sell for more than 50 cents a loaf, then this trade could not take place. The seller could not cover his opportunity cost with the price control and therefore the trade would be blocked, it would be a deadweight loss. That is, if the seller and the buyer observed the price control. If they got around the price control by doing some kind of deal in an informal market, they may still actually trade at a price between $1.00 and $5.00 per loaf. They would be ignoring the price control, and the cost there would just be whatever effort they had to expend in order to evade the government's controls.
Price controls in markets, however, can have consequences if we have a different kind of situation. Suppose we have a situation where two buyers are competing for the same loaf of bread. One buyer has a reservation price of $5.00 for the loaf, the second buyer has a reservation price of $4.00, and the baker, like before, has a reservation price of $1.00. He's willing to sell the loaf for any price above $1.00. If this were a free market, these two buyers would find themselves competing using the bidding mechanism, and the price would rise until one of the buyers was pushed out of the market. The market price for this loaf of bread would go slightly above $4.00 and this buyer, with the higher reservation price would wind up getting it. That's the way competition works in the market, and the baker would certainly be very happy for this competition because it allows him to charge a higher price and get more producer surplus.
However, suppose now the government intervenes with a price control. The price control blocks the bidding mechanism and keeps these two buyers from competing by bidding. That is, we can no longer use price as a means of competition. If these two buyers both want this loaf of bread, and certainly they would both be happy to buy it at a price of $2.00 per loaf, they're going to have to resort to some kind of competition besides prices, since the price has been fixed, or at least controlled, by the government. The baker's going to get $1.00 worth of surplus, but now these two guys have to wrestle it out to figure out who's going to be able to buy the loaf of bread at this low bargain price. What we will find the two buyers doing is resorting to non-price competition. That is, since price competition has been ruled out by the price control, they're now going to have to do something else to do the bread. Who's willing to stand in line the longest? Who's willing to run faster to get to the bakery early in the morning? Who's willing to hire someone to go to the bakery first and make sure that they buy that loaf of bread on their behalf? That is, there are other ways to compete to make sure you get the loaf of bread. But whereas the baker would prefer price competition, which gives him a bigger surplus, in this case, with a price control, the buyers would have to revert to non-price competition.
Economists don't like non-price competition, because it seems like resources always get wasted. Somebody wastes their time standing in line, someone wastes his time hiring a bread locator who goes out and looks for bread for you, someone wastes his time running fast to get to the bakery. This is what we call in economics, rent seeking behavior. Rent seeking behavior is the willingness to destroy resources, or expend resources to get a bigger share of the economic value for yourself. There's only one loaf of bread, and these two guys are willing to burn up resources wrestling, running, waiting in line, hiring assistants, in order to make sure that they take the bread away from each other. In the end it will be this guy with the high reservation price who is able to spend the most resources, and it becomes kind of like an arms race. He simply outlasts his competition. He burns up more resources than his competitor until finally his competitor is pushed out of the market.
This rent seeking is wasteful, because all of the resources that are used in competition, in non-price competition for bread--all the burned up shoe leather, all the burned up time, all the wasted energy, could be used producing other things of value. It could be used hooking rugs, writing children's books, anything like that--assembling computer boards. But instead, it's burned up in non-price competition, activity that does not create value, but merely redistributes it.
Evaluating Market Outcomes
Market Interference and Economic Value
Understanding the Effects of Price Control Page [2 of 2]

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