Case study: Markets and Control

Lines at the Gas Pump>>

In 1973 the organization of Petroleum Exporting Countries (OPEC) raised the price of crude oil in world oil market. Because crude oil is the major input used to make gasoline, the higher oil prices reduced the supply of gasoline. Long lines at gas stations became common place, and motorists often had to wait for hours to buy only a few gallons of gas.

What was responsible for the long gas lines? Most people blame OPEC. Surely, if OPEC had not raised the price of crude oil, the shortage of gasoline would not have occurred. Yet economists blame US government regulations that limited the price oil companies could charge for gasoline.

Before OPEC raised the price of crude oil, the equilibrium price of gasoline, P1 was below the price ceiling. The price regulation therefore had no effect. When the price of crude oil rose, however, the situation changed. The increase in the price of crude oil raised the cost of producing gasoline and this reduced the supply of gasoline. In an unregulated Market this shift in supply would have raised the equilibrium price of gasoline and no shortage would have resulted. Instead, the price ceiling prevented the price from rising to the equilibrium level. At the price ceiling, producers were willing to sell and consumers were willing to buy. Thus, the shift in supply caused a severe shortage at the regulated price.

Eventually the laws regulating the price of gasoline were repealed. Law makers came to understand that they were partly responsible for the many hours Americans lost waiting in line to buy gasoline. Today when the price of crude oil changes the price of gasoline can adjust to bring supply and demand into equilibrium.

Rent Control in the short run and long run>>

One common example of a price ceiling is rent control. In many cities, the local government places a ceiling on rents that landlords may charge their tenants. The goal of this policy is to help the poor by making housing more affordable. Economists often criticize rent control, arguing that it is a highly efficient way to help the poor raise their standard of living. One economist called rent control the best way to destroy a city, other than bombing.

The adverse effects of rent control are less apparent to the general population because these effects occur over many years. In the short run, landlords have a fixed number of apartments to rent, and they cannot adjust this number quickly as market conditions change. Moreover the number of people searching for housing in activity may not be highly responsive to rents in the short run because people take time to adjust their housing arrangements. Therefore, the short run supply and demand for housing is relatively inelastic.

The short run effects of rent control on the housing market. As with any binding price ceiling, rent control causes a shortage. Yet because supply and demand are inelastic. In the short run, the initial, shortage caused by rent control is small. The primary effect in the short run is to reduce rents.

The long run story is very different because the buyers and sellers of rental housing respond more to market conditions as time passes. On the supply side, landlords respond to low rents by not building new apartments and by failing to maintain existing ones. On the demand side, low rents encourage people to find their own apartments (rather than living with their parents or sharing apartments along with roommates) and induce more people to move into a city. Therefore, both supply and demand are more elastic in the long term.

The housing market in the long run. When rent control depresses rents below the equilibrium level, the quantity of apartments supplied falls substantially and the quantity of apartments demanded rises substantially. The result is a large shortage of housing.

In cities with rent control, landlords use various mechanisms to ration housing. Some landlords keep long waiting lists. Others give a preference to tenants without children. Still others discriminate on the basis of race. Sometimes apartments are allocated to those wiling to offer under the table payments to building superintendents. In essence, these bribes bring the total price of an apartment including the bribe) closer to the equilibrium price.

To understand fully the effects of rent control, we have to remember one of The Ten Principles of Economics: People respond to incentives. In free markets, landlords try to keep their building clean and safe because desirable apartments command higher prices. By contrast, when rent control creates shortages and waiting lists, landlords lose their incentive to respond to tenants concerns. Why should a landlord spend money to maintain and improve the property when people are waiting to get in as it is? In the end, tenants get lower rents, but they also get lower quality housing.

Policymakers often react to the effects of rent control by imposing additional regulations. For example, there are laws that make racial discrimination in housing illegal and require landlords to provide minimally adequate living conditions. These laws however are difficult and costly to enforce. By contrast, when rent control is eliminated and a market for housing is regulated by the forces of competition such laws are less necessary. In free market the price of housing adjusts to eliminate the shortage that gives rise to undesirable landlord behavior.