Economics in One Lesson: Do Price Controls really work?

Economics in One Lesson: Do Price Controls really work?

This is the transcript of my video Economics in One Lesson: Do Price Controls really work? You can see the video here. 

Hello Guys,

Introduction

We are living in unprecedented times where we are staring at a global recession and even a depression in the worst-case scenario. Once the shutdowns are lifted the focus of all the governments will be to take unprecedented measures to reverse the economic damage caused by the shutdowns. These measures will be touted as temporary and would be purported to relieve the pain of the worst affected classes. On the face of it, they may look necessary and even seem to work but once you dig deeper you will discover the disastrous consequences of these measures which are influenced by economic fallacies on the society as a whole. These consequences have an impact on each an everyone one of us. Some of us will be affected very badly by it and some of us will do okay but none of us are immune to its consequences. Hence, it is important to understand the consequences of various government policies that may be enacted to fight with impending economics crisis on you as an individual, as a consumer, as an employee, as an entrepreneur, as a tax payer and take action to protect yourself against the adverse consequences of these governmental polices. Learnings from Economics in One Lesson just help us to do that. With that lets dive in.

About the Book

This book written by Henry Hazlitt was originally published in 1946 but the learnings from it are very relevant event today. This little book is merely an introduction to economics and written, specifically, for the beginner. It provides an analysis of economic fallacies that are widely prevalent across the globe. Economic policies of every major government in the world right now are influenced, if not almost wholly determined, by acceptance of some of these fallacies.

What causes economic fallacies?

This book revolves around economic fallacies so we must ask ourselves what is the root cause of this flawed thinking. Why is economics is haunted by more fallacies than any other study known to man. If we take any scientific discipline say physics, mathematics, or medicine, each of it has complexities. But the complexities of economics are multiplied manifold because of selfish interests. Every group has certain economic interests. Some of them are identical with those of other groups. For eg everyone wished to live in a clean environment. But every group also has, as we shall see, interests which conflict to those of all other groups. For example, interests of environmentalist calling for reduction is use of fossil fuel and oil is in conflict with the interest of the oil industry and its workers who earn money from the oil business. While certain public policies would benefit everybody in the long run for example free education, better healthcare, other policies would benefit one group only at the expense of all other groups. Eg higher wages for health care workers are beneficial for them but increases the cost of healthcare for everyone else. The group that would benefit by such policies, has a direct interest in them and will argue for them plausibly and persistently. They will hire the best minds money can buy to devote whole of their time to presenting its case. And they will finally either convince the general public that their case is sound, or confuse them to such an extent that clear thinking on the subject becomes next to impossible.

In addition to self-interest, there is a second main factor that gives birth to new economic fallacies every day. That is the persistent tendency of human beings to see only the immediate effects of a given policy, or its effects only on a special group, and to neglect what the long-run effects of that policy will be not only on that special group but on all groups. It is the fallacy of overlooking secondary order consequences of actions.

The Lesson

Thus, the whole of economics can be reduced to a single lesson, and that lesson can be reduced to a single sentence, that is 

“The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups"

90% of bad economic policies result from either one of two central fallacies, or both, that is of looking only at the immediate consequences of an act or proposal, and that of looking at the consequences only for a particular group to the neglect of other groups.

Now that we have learnt how to avoid fault thinking in analyzing economic policies lets apply our learning to the most common problem that we are currently experiencing throughout the world which is shortage of face masks. Now all of us have been told that face masks are important because it help to prevent and slow the spread of Covid-19. This has created an unprecedented demand for mask across the globe. Obviously, the production of mask has not been able to keep up with this unprecedented demand and we are hearing about a lot of instances of shortages of mask and of people paying exorbitant prices to get a supply of masks. Many of the governments have taken measures to reduce the shortages including ban on exports, price control orders etc. in order to ensure availability of masks at an affordable price for everyone. Despite the measures there has been a huge shortage of masks and it does not seem that the problem will be solved any time soon. Here we will try to answer the question why price control is ineffective and what it always leads to increasing rather than reducing the shortages of price controlled good. But before we analyze price controls, we must first understand how price system works.

How Price system works - An example

Let’s take an example of Bob. Bob runs a grocery store in a small town of Alphaville. Alphaville grows a variety of vegetable except potatoes. The residents are aware about potatoes and desire to consume it but no one supplies potatoes in Alphaville. Bob sees this as a great business opportunity to meet the demand of potatoes for the residents of Alphaville but does not know the actual demand. He does not know how much potatoes will be sufficient to meet the demands of residents and what price should he charge for it. After pondering for some time, he decides to follow a trial and error approach. He decided that he has $1,000 to spare for this experiment. He will go to the nearby town and buy as many potatoes as he can for $1,000 and mark up the prices by 20% to arrive at a selling price. He manages to procure 100kgs of potatoes at a price of $10 per kg. He comes back Alphaville and put the potatoes on sale for $12 per kg. Since potatoes is a novelty for residents of Alphaville as soon as the news arrives, they rush to Bob’s store and his entire stock of potatoes is emptied in an hour. Bob is delighted by the response and he decided to make a trip again and this time he decides to set aside $10,000 for purchase of potatoes. This time he manages to procure 625kgs but only at a price of $16 per kg. He decides to increase the mark up to 50%. This time as well consumers arrive enthusiastically to get their hands of potatoes. But this time consumers are buying lesser quantity as the price has more than doubled but nevertheless it is a novelty for most consumers so Bob still manages to sell out this entire potato stock but this time it takes him a week. Bob is delighted and decides to continue supplying the potatoes. Looking at success of Bob, Alice also want to get into the potatoes business. She also decided to invest her money to engage in procurement and supply of potatoes. The table shows the trading history of potatoes in Alphaville.

The Economic Problem

The economic problem that we are looking at is not merely the problem of allocating resources and products, but more accurately, the problem of allocating them using knowledge that is not available in its totality with any single individual or entity.  Bob does not know the exact demand of potatoes in Alphaville. He only has the knowledge of his own economic conditions i.e how much resources can he invest to engage in potato trade and what is his own cost of production. Thus, the economic knowledge of the conditions of production, the relative availability and abundance of the factors of production, and the preferences of individuals, is not objective knowledge that can be fully known to a single entity. Rather, the knowledge of economic conditions is by its very nature distributed and situated with the people concerned by their individual decisions.

Hence, to solve this problem we only need one data point i.e price of potatoes. When a consumer sees the price of potatoes, he can instantly decide how much he wants to buy to satisfy this demand for potatoes. Similarly, once the price is known it becomes very easy for Bob to decide if he should engage in supply of potatoes and how much he should supply. Thus, prices are knowledge, and the signals that communicate information. Each individual decision maker is only able to carry out her decisions by examining the prices of the goods involved, which carry in them the distillation of all market conditions and realities into one actionable variable for that individual. In turn, each individual's decisions will in turn play a role in shaping the price. Consumers by making their purchase decision influence the price. Suppliers do so by determining their supply price. Thus, in free markets the prices are determined by the interaction of demand and supply. No government or bureaucratic institution can act as a substitute for prices determined in free markets because no single person or entity has the entirety of knowledge necessary to set prices efficiently. Now that we understand how Price system works, let’s see what happens when the government disrupts this free market price setting mechanism by imposing price controls.

As an individual, as a business and as a society as a whole we have limited resources. Hence, businesses need to choose which goods or service they will provide to the market place using the limited resources they have. In making this decision they are guided by the price that they receive in the market place for providing a particular good or service. If it is profitable to provide a good or service at that price, they will continue to provide it and may even increase the supply by making further investment. If it is not profitable, they will cease the supply.

Shortage of Face Masks

Now let’s look at the case of face masks. Let’s assume that pre Covid-19 the daily demand for face masks was around 40Mn units per day. Various estimates show that the daily production capacity for face masks across the globe is was also 40Mn units per day and you can get a box of 100 surgical masks for $5. Covid-19 outbreak started in Wuhan and quickly spread to the entire Hubei province of which Wuhan is capital. Hubei itself has a population of approx. 55Mn. Assuming that one person each needs 1 mask per day the demand has increased to 55Mn masks a day whereas the global manufacturing capacity is just 40Mn. In a few weeks Covid-19 had spread to many of the part of China and there was an outbreak recorded in a lot of other countries as well. So, in a matter of weeks the demand of face masks has increased to 1.4Bn mask per day. The demand has increased more than 3.5 time in a matter of weeks. So even in absence of any price gouging and profiteering there is no way that the existing supply capacity can meet this demand. So, it is natural for price to rise as the demand has increased manifold but the supply has not. As the virus outbreak extends to more countries the demand keeps increasing but there is no way that the supply can keep up with the demand unless people put up new facilities to manufacture masks and the raw materials required for production. These capacities take time to build even in normal times and the task becomes even more difficult where there are lockdowns. Now that Covid-19 has spread almost all across the globe the daily demand for face masks can be estimated to be around 7bn masks per day which is same as the total population of earth. It will take years before the face mask production capacity can be ramped up to meet this demand. So, how do we solve this situation?

There are only two ways to resolve this situation. First is to reduce the demand. Second is to increase the supply. 

Impact of Price Controls

Let’s see what happens when a price control is imposed. Let’s assume that the government fixes the maximum price at $5 for 100 masks at pre-covid-19 levels. At this price the masks are affordable to vast majority of world’s population so everyone will demand for it. So this does nothing to reduce the demand for mask which is one of the solutions to deal with the problem. Let’s further assume that the average cost of production for face masks is $4.5 per 100 masks. This means that the manufacturers make profit of 10% on an average. The other way to solve for the shortage of masks is to increase the supply. Let’s assume all the existing manufacturers are working at full capacity. So, we need other manufacturers to step in to increase the manufacturing capacity by setting up new production line. As you can see that 10% is not a great profit margin and if a business man has an existing business where he is earning more than 10% profit there is no incentive to enter the business of mask production because the profit is not so great. Every Business has limited resources and they want to maximize the value they generate from them. Here we are assuming that cost of inputs like the machinery and raw materials do not change which is not true. The government has imposed a price control on masks and not on their inputs. Thus, with increasing demand for inputs the price of inputs will increase but the selling price cannot be increased which will further squeeze the margins of the manufacturers. Thus, we have a situation where new manufacturers are not entering the market and the existing ones may shut down the production as their profits are getting squeezed due to price control. This will only aggravate the existing supply situation. As we can see from this that imposing price control is counterproductive and it only increases shortage of goods instead of alleviating the shortage. Malaysia has imposed a price control on masks. The domestic manufacturers in Malaysia have told the government that they will cease production of masks as the prices are too low compared to the cost of inputs which have been rising. This confirms our theory that price controls are in fact detrimental and can worsen the shortages of essential commodities.

Free Markets Solution

Now let’s see how things would have worked in free markets where there are no price controls. Let’s assume that without government intervention the price of the masks increases 20-fold to $100 per 100 masks. At this price not a lot of people can afford the masks so they will try to economize by purchasing less of it. People try to go out less often and if there are 4 people in a household then only one of them may go out at a time. People try to find other substitutes like home made masks etc. If the masks were still available at $5 per 100 masks then people who may or may not need it will still demand it. A lot of people can actually avoid going but they go out of the home unnecessarily if they manage to get access to face masks. Once prices are high it acts to dampen the demand and prevent unnecessary use of masks.

On the supply side a price of $100 is attractive for a lot of producers. The profit margin is a phenomenal 95% of selling price. This expectation of profit will attract a lot of new producers to the industry who will want to supply masks by adding new production capacity. As this capacity is added and masks supplied the supply will increase and price will start falling. We will of course not reach pre-covid price levels of $5 per 100 masks immediately but it will be much lower than $100 per 100 masks and of course there will be less shortages and higher availability of masks. I can confirm this by my personal experience here in Hong Kong. Pre-covid you could get a box of mask for 40 HKD. During the first 2 weeks of outbreak there was a high demand and masks were in out of supply. For a week most of the places were out of stock then slowly the masks started arriving but the prices had increased 10-fold to 400 HKD a box. This incentivized a lot of businesses to source mask and in subsequent weeks masks were widely available almost everywhere. Initially the price were high but very recently the prices have come down to $100 per box which is higher than pre-covid levels but still is much less than the peak prices of HKD 400 per box. But the other places where the price controls were imposed like Malaysia, South Korea, India the situation has not improved.

Price controls see to ensure availability of essential goods at affordable prices. There are two important elements here availability and affordable prices. With price controls we only have affordable prices and not availability.  

Why do governments resort to Price Controls?

Now that we know that price controls are ineffective then we must ask ourselves why do governments still resort to it? Well because it is the easiest thing for them to do. It helps them to show to the people that government is doing something about the situation. It is much more difficult to increase the supply than to issue a price control order. Here again the two central fallacies that we spoke about earlier manifest themselves. Government is looking only at the immediate consequences of price control and looking at the consequences only from the perspective of consumer. Demand and supply situation are dynamic and the no government bureaucrat has the complete knowledge of demand and supply conditions required to efficiently set the price because it is contained with the million of consumers and thousands of producers. When government tries to substitute bureaucratic process for free market mechanism it almost always results in a disaster.

I hope you found this useful and that it has help you to improve you understanding of economics. Please share it with your friends who advocate price control to enlighten them. If you found this video intriguing and if you have some time, I would recommend you to read Economics in One Lesson. Do like and subscribe to my channel for more such content and let me know in the comments section what you think of this video. Stay safe, wash your hands and use a mask if you need to go out. See you guys soon.