From time to time, people will petition government to step in and correct perceived wrongs in the market. Often this leads to unexpected results. Without considering how people might respond to incentives, well-intentioned policies can go astray. Because people are not going to stop acting like people, governments must consider whether or not their actions create perverse incentives. Likewise, there are times when the market fails to provide goods or properly assign costs. This calls for government intervention to either provide or redirect incentives in such a way that the market functions better. Two approaches governments use are price ceilings and price floors.
In the early 1970s, America was faced with ever-increasing food prices. As a result, people clamored for the government to step in and halt the increases. Instead of considering the source of the problem and doing something about that, government attempted to treat the symptoms. In an effort to alleviate the suffering of households, the Nixon administration enacted price controls. One such price control was an effective price ceiling on food. Retailers could not charge a price higher than the government-mandated ceiling.
A price ceiling is a legal maximum price for a good, service, or resource. At the time, the theory was that if the government imposed a price ceiling on food, prices would stop going up and everyone would have the food they wanted at the price they wanted. Of course, this assumes that people do not behave like people. Remember that prices are the result of the equilibrium of supply and demand. Also remember that these two forces are completely shaped by human nature.
The law of demand, which governs consumer behavior, says that as prices fall, consumers have an incentive to buy more, and as prices rise, consumers have an incentive to buy less. The law of supply, which governs producer behavior, says that as prices rise, producers have an incentive to produce more, and as prices fall, producers have an incentive to produce less.
What effect does a price ceiling have on the market for food? Look at the incentives. A price ceiling encourages consumers to purchase, but discourages producers from producing. Assume that meat is currently selling for $5 per pound. Consumers feel that the price is too high, so they petition government for a price ceiling of $3 per pound. Representatives, senators, and presidents all like to get re-elected, so they cater to consumers and enact the price ceiling. The $3 price signals to consumers to purchase more, but signals to producers to produce less. The result of the price ceiling is a shortage of meat at the price of $3 per pound. At that price, more meat is demanded than is supplied. Consumers got a price ceiling of $3, but many consumers did not get any meat at all.
Price controls are inefficient for many reasons. One reason worth considering is that they increase the need for monitoring and enforcement. That means increased government bureaucracy, which does not come cheap. Increased government spending equals more taxes or more borrowing.
Eventually, America abandoned price controls, but it took a decade to get the underlying inflation under control. Even today you still hear of people demanding that government cap prices of various commodities. As late as 2007, people were asking for price limits on gasoline. People continue to behave like people, and they still want low prices. Government and consumers would be wise to learn from the mistakes of the past and realize that attempts to control the market result in unintended consequences.
Consumers are not the only ones who ignore the basics of supply and demand. Producers have at times called for price floors. A price floor is a legal minimum price for a good, service, or resource. Probably the best-known price floor is minimum wage. In the market for resources like labor, households supply and businesses demand. Politicians representing areas with large populations of unskilled labor are often pressured by voters to increase minimum wage. It’s believed that an increase in the minimum wage is justified because employers will pay the higher wage and maintain the same number of workers. However, that works only if you assume that people do not behave like people.
For example, suppose that the city council of a major city, under pressure from voters, raises the minimum wage from the federal minimum to a city minimum of $10 an hour. Further assume that the equilibrium wage in the inner city area was already $8 an hour and that in the suburbs it was $11 an hour. What will happen in the inner city and what will happen in the suburbs? In the inner city more producers (workers) will be willing to supply their labor at the higher price, but fewer consumers (employers) will be willing to employ that labor at the higher price. As a result, a surplus of unskilled labor develops, better known as unemployment. In the suburbs, the increase in the minimum wage has no effect, as the equilibrium wage was already $11. In the end, the policy meant to help the poor helped those who maintained their jobs, but resulted in unemployment for those who were laid off and those who entered the job market looking for work at $10 an hour.
Interestingly enough, those most in favor of increasing the minimum wage are often the same people who would be most harmed by the increase. Politicians know this now and will often pass increases in the minimum wage that keep it less than the average equilibrium wage for unskilled labor. For example, if the average market equilibrium unskilled labor wage is $8 an hour, then politicians will gladly increase minimum wage from $6 to $7.50, knowing that it will have little economic effect. Yet, they can still put a feather in their cap for “raising” the minimum wage.