Price Controls & Rent Controls (PDF)

# Price controls In some markets, governments have been seen to intervene to regulate price directly. This could be viewed as a response to market failure - for example, if it were apparent that price was not being set equal to marginal cost. Some governments in developing countries have at times i...

# Price controls In some markets, governments have been seen to intervene to regulate price directly. This could be viewed as a response to market failure - for example, if it were apparent that price was not being set equal to marginal cost. Some governments in developing countries have at times intervened to control food prices in urban areas in response to civil unrest. This can create a form of government failure if it provides weak incentives for farmers to raise production or improve their crops. Regulation of prices has also been introduced in other contexts, notably in the housing market, where rent controls have been used to prevent exploitation of tenants by landlords. There have also been proposals to set minimum prices for alcohol in an attempt to control drinking ## A minimum price for alcohol Can problems caused by excessive drinking of alcohol be tackled by setting minimum prices for alcoholic drinks? **Figure 8.6** represents the market. **Figure 8.6 A minimum price for alcohol?** - The graph shows the market for alcohol. - The supply curve is upward sloping, and the demand curve is downward sloping. - The equilibrium price is P* and the equilibrium quantity is Q*. - If the government sets a minimum price of Pmin, the quantity demanded will fall to Qd, and the quantity supplied will rise to Qs. - This will create a surplus of alcohol, as the quantity supplied will be greater than the quantity demanded. In equilibrium, the market price would be at P* and the quantity traded would be Q*. If the government wanted to discourage heavy drinking, they could introduce a minimum price, so that sellers were not able to charge a price below Pmin. ## Quantitative skills 8.1 ### Interpreting quantities on a graph Figure 8.6 shows a market in disequilibrium and it is helpful to be able to read off the relevant quantities. The equilibrium position is, of course, at the point where demand and supply intersect, at P*, Q*. However, if the price is set by government to be at least Pmin, the market is held away from that equilibrium. Buyers and sellers now want different things: - Buyers are only prepared to buy Qd at this price, whereas suppliers would be prepared to sell Qs. One effect of the minimum price is therefore that there is excess supply, given by the distance Qs - Qd. What is happening here is that, with the minimum price in effect, some consumers reduce their consumption, alcohol consumption falls by the distance Q* - Qd. Whether this would be seen as a successful policy is a different matter. As **Figure 8.6** has been drawn, the demand for alcohol is relatively inelastic with respect to the increase in price. If demand had been relatively more elastic, the impact would have been greater. An example of such a policy was seen in Scotland, where the government took the view that excessive use of alcohol was a major social concern. In other words, it viewed alcohol as a demerit good. In particular, it was perceived that low-price alcohol was encouraging behaviour that would cause health problems for individuals in the long term. It was possible for people to reach the recommended limit for alcohol consumption for only £2.50. In May 2018, a law came into effect setting a minimum price for alcohol, measured by alcoholic units. # Rent controls Another market in which governments have been tempted to intervene is the housing market. **Figure 8.7** represents the market for rented accommodation. The free market equilibrium would be where demand and supply intersect, with the equilibrium rent being R and the quantity of accommodation traded being Q*. If the government regards the level of rent as excessive, to the point where households on low incomes may be unable to afford rented accommodation, then, given that housing is one of life's necessities, it may regard this as unacceptable. The temptation for the government is to move this market away from its equilibrium by imposing a maximum price (level of rent) that landlords are allowed to charge their tenants. Suppose that this level of rent is denoted by Rmax in **Figure 8.7.** Again, there are two effects that follow: - First, landlords will no longer find it profitable to supply as much rental accommodation, and so will reduce supply to Qs. - Second, at this lower rent, there will be more people looking for accommodation, so that demand for rented accommodation will move to Qd. The upshot of the rent controls, therefore, is that there is less accommodation available, and there are more homeless people. It can be seen that the well-meaning rent control policy, intended to protect low-income households from being exploited by landlords, merely has the effect of reducing the amount of accommodation available. This is not what was supposed to happen. **Figure 8.7: Rent controls** - The graph shows the market for rented accommodation. - The supply curve is upward sloping, and the demand curve is downward sloping. - The equilibrium rent is R, and the equilibrium quantity is Q*. - If the government sets a maximum rent of Rmax, the quantity demanded will increase to Qd, and the quantity supplied will decrease to Qs. - This will create a shortage of rented accommodation, as the quantity demanded will be greater than the quantity supplied. # Exercise 8.2 The markets for rented and owner-occupied dwellings are likely to be interrelated, at least to some extent. Use demand and supply diagrams to examine how a rent control policy would affect the two markets in the short and long run. # Legislation and regulation In some markets, the government chooses to intervene directly through legislation and regulation, rather than by influencing prices. For example, it may limit the market power of large firms to protect consumers, or place direct controls on the emission of pollution. The aim of these interventions is to influence the quantity supplied of a good or service. Legislation may be used to prevent the supply of a good, whereas regulation seeks to limit the supply without banning it altogether, or in some cases to encourage more of a good to be supplied. Legislation can operate by declaring some goods illegal. This may also have unintended effects. Consider the situation in which action is taken to prohibit the consumption of a demerit good such as a hard drug. It can be argued that there are substantial social disbenefits arising from the consumption of hard drugs and that addicts and potential addicts are in no position to make informed decisions about their consumption of them. One response to such a situation is to consider making the drug illegal to prevent it being sold at all. Regulation is used to influence the supply of a good. In some markets, the authorities may think it important to limit the quantity of a good being supplied by imposing quotas on production and sale. For other goods, regulation may be used to limit the market power of large firms that otherwise could exploit consumers by raising price to increase their profits. This possibility is considered in **Chapter 23** in the discussion of competition policy. The economic effects of legislation and regulation are similar, in the sense that both have the effect of moving a market away from its equilibrium position. The effect of banning a product may be to establish a black market, so that sales are hidden from the authorities but continue regardless. # Asymmetric information Market failure can arise from information gaps, especially where there is asymmetric information or where economic agents lack information or the capacity to process the information available. In such circumstances, the solution would seem to be to find a way of providing the information to remedy the situation. One example discussed in **Chapter 7** was that of second-hand cars, where car dealers may find that they cannot find buyers for good-quality cars at a fair price if potential buyers cannot distinguish quality. The solution here may be to tackle the problem at its root, by finding a way to provide information about quality. In the case of second-hand cars, AA inspection schemes or the offering of warranties may be a way of improving the flow of information about the quality of cars for sale. Buyers may then have confidence that they are not buying a lemon. Similarly, in the case of the insurance market, the asymmetric information problem helps to explain why insurance companies try to cover themselves by insisting on comprehensive health histories of those who take out health insurance, and include exclusion clauses that entitle them to refuse to pay out if past illnesses have not been disclosed. It also helps to explain why banks may insist on collateral to back up loans. ## Test yourself 8.9 What is meant by "asymmetric information"? # Smoking Information problems may also be present in respect of some goods. Think back to the tobacco example discussed in **Chapter 7**. Tobacco is seen by government as a 'demerit' good on the grounds that smokers underestimate the damaging effects of smoking. There may also be negative externalities caused by passive smoking. At first, taxes were used to try to discourage smoking, but given the inelastic demand for tobacco, this proved ineffective. The taxes were reinforced by extensive campaigns to spread information about the damaging effects of smoking. When even this did not solve the problem, the government had to introduce regulation by prohibiting smoking in public buildings. The spread of e-cigarettes adds a new dimension to the situation. # Government failure Some roles are critical for a government to perform if a mixed economy is to function effectively. A vital role is the provision by the government of an environment in which markets can operate effectively. There must be stability in the political system if firms and consumers are to take decisions with confidence about the future. There must also be a secure system of property rights, without which markets could not be expected to work. In addition, there are sources of market failure that require intervention. This does not necessarily mean that governments need to substitute markets with direct action. However, it does mean that they need to be more active in markets that cannot operate effectively, while at the same time performing an enabling role to encourage markets to work well whenever this is feasible. Such intervention entails costs. There are costs of administering and of monitoring a policy to ensure that it is working as intended. This includes the need to look out for the unintended distortionary effects that some policies can have on resource allocation in a society. It is therefore important to check that the marginal costs of implementing and monitoring policies do not exceed their marginal benefits. Most governments see it as their responsibility to try to correct some of the failures of markets to allocate resources efficiently. As outlined above, this has led to a wide variety of policies being devised to address issues of market failure, such as taxes on polluting firms, levies to enable funding of public goods, or campaigns to combat information gaps. However, some policies have unintended effects that may not culminate in successful elimination of market failure. Indeed, in some cases government intervention may introduce new market distortions, leading to a phenomenon known as government failure. ## Key term **government failure** a misallocation of resources arising from government intervention to correct a market failure that causes a less efficient allocation of resources and imposes a welfare loss on society Many of the interventions discussed in this chapter can cause problems if they are not carefully implemented, or if the government itself does not have sufficient information to take good decisions. The main underlying causes of government failure are: - distortion of price signals - unintended consequences - excessive administrative costs - information gaps ## Distortion of price signals Some interventions by government have an effect on market prices. One example is where a sales tax is introduced, or when a tax is used to tackle pollution. Another is where prices are directly controlled, for example in setting a minimum price for alcohol or setting controls on rent. In such situations, prices are moved away from the market equilibrium levels. The issue with this is that prices in an economy are intended to guide resource allocation through the signals to producers and consumers. Interfering with the free working of the price mechanism may interfere with this process. As noted earlier in the chapter, a sales tax raises funds for the government, but also imposes a welfare cost on society, even where those funds are used for the benefit of the country's citizens. This represents a distortion of resource allocation in society. ## Unintended consequences Imposing rent controls in an attempt to protect vulnerable households may mean a fall in the availability of rented accommodation, with additional knock-on effects on other parts of the housing market. These impacts were not what was intended through the introduction of the controls. Given the complexity of interactions between markets in an economy, such unintended consequences of government actions can often arise. ## Excessive administrative costs Some interventions by government are administratively difficult to implement, so that the costs may exceed the benefits of the intervention. For example, recall the discussion of measures to tackle pollution. The costs of determining the size of the appropriate tax to tackle pollution or of monitoring whether firms are following the permitted levels of emissions are likely to be extremely high. Another possible hindrance stems from the layers of bureaucracy involved, which may raise the cost of taking action. ## Information gaps Government intervention can only be as effective as the information on which it is based. The government faces risk and uncertainty about market conditions, and does not always have full information about the market failures that it is attempting to tackle. There is a possibility of government failure that may leave matters worse than they would have been without the interventions. At the macroeconomic level, it takes time to collect data about how the economy is performing, so policy design may be based on information that has already been overtaken by events.