An approach to economic policy that seeks to avoid the alleged flaws of pure capitalism and pure socialism. An interventionist government will not tolerate the outcomes of a purely free market, but on the other hand it doesn’t completely abolish private property.
Consists of a price ceiling, which is a legal maximum the government sets on prices in the marketplace for a particular good or service, and of a price floor, which is a legal minimum, where the price of a good or service cannot fall below the floor.
The idea of a price ceiling is to keep important items affordable for the poor, for example rent control, in which the government imposes caps on rental rates for certain types of apartments. It is also used when a natural disaster strikes to prevent merchants from “taking advantage of” the situation. (e.g. bottled water, electric generators, gasoline…)
This sounds like a great idea for the general public, but we’ll see that it actually hurts the very people it is supposed to be helping.
If it is to have any impact, a price ceiling must be set below the market price. But as we saw earlier, the market price will tend to be close to the market-clearing price, which is the price at which the quantity supplied equals the quantity demanded. Let’s take the rent control for an example. If there was an equilibrium price of $800 to rent an apartment, where the consumers wanted to rent a total of 10,000 units and the owners wanted to rent out 10,000 units, the market would clear itself and everyone would engage in as many transactions as they wanted. But if the government imposed a price ceiling at $650, claiming that regular people cannot afford to pay higher rents, the quantity of apartment units demanded would rise to 12,000 while the quantity supplied would drop to 9,000. (even though the physical number of units wouldn’t shrink, the number that owners put on the market for rent could drop) There is now a shortage of 3,000 units, meaning that 3,000 people cannot find any available units.
While it’s true that the 9,000 people who have an apartment might be thankful for saving $150 per month on their rent, there are 1,000 people who would have had an apartment with market pricing but now have no apartment at all; we know they’d rather have an apartment than having none, so they are clearly worse off because of the rent control.
This is even more striking in other situations. Suppose a hurricane strikes a city, knocking out the power and causing flooding that contaminates the water. Now imagine the previous example happens with bottled water and what impact it will have.
A price ceiling will also have impact on the supplies in the long run, since most entrepreneurs and investors will respond by shifting their efforts and resource to other lines that do not suffer from price controls. If we go back to our bottled water example, the merchants who live in a town subject to flooding will not carry as large an inventory of bottled water and other goods if they know the government will impose price ceilings in situations where they otherwise could have tripled their prices.
Thus the expectation of price controls cripples one of the primary feature of a market economy – entrepreneurs can foresee potential crises and know how to ameliorate them, but they won’t act on their foresight because the government takes away the market’s usual rewards for such behavior. Not only this, also the product quality gets worse: why would anyone try hard to make the best product when they won’t get any rewards for their efforts? Plus the price ceilings provide a margin in which the sellers can reduce the quality of the good, without hurting their total sales revenues.
Price floors are usually used by the government to impose a minimum wage, making it illegal for an employer to pay a worker less than a certain amount per hour. This causes an immediate surplus, as there are more workers trying to find jobs at the going wage than employers want to hire. An employer hires a worker because he expects the worker to bring in enough extra revenues to justify the paycheck, otherwise he’d be losing money on the deal and would have no incentive to hire. By artificially raising the bar of the minimum paycheck, the government effectively makes it impossible for people with proclivities below a certain level to get a job.