Introduction to Economic Reasoning - Chapter 6: Price Controls

Dr. Gordon illustrates the effects of price controls by first showing that at the market price there is buyer for every seller and vice versa using reductio proof. In a reductio proof, the negative of the proposition to be proved is shown to be contradictory, thus proving the proposition itself is true.

Starting with an assumed price for a gallon of gasoline at $1, Dr. Gordon assumes there are more buyers than sellers. This, he explains, will lead to buyers bidding the price up to a price of, say, $1.30. Buyers unwilling to pay the $1.30 will leave the market until the number of buyers matches the number of sellers. This contradicts the proposition that supply and demand do not balance, proving the opposite.

One can show supply and demand balance without resorting to a reductio proof. Who bids prices up or down? Buyers who are willing to pay for a good than a marginal buyer cause prices to rise. For example, a marginal buyer will not pay more than a $1 for a gallon of gasoline, and are driven out of the market by buyers willing to pay $1.30. There are also marginal sellers who will not sell below a certain price, whereas other sellers will. Sellers willing to sell gas at $0.80 a gallon will drive out sellers who will not sell below $1.00. At a market price there are no sellers looking for buyers, nor buyers looking for sellers.

When governments intervene to keep prices low by establishing price controls, say by imposing a price of $1.00 when the market price is $1.30, shortages result. Demand for gas at $1.00 will exceed the supply available. Note that if the government imposed a price of a $1.60, though, no shortages would result in this case. Demand for gas at $1.30 would still match supply. On the other hand, should buyers expect the price of gas to exceed $1.60 in the future, the price control would have an affect. Still another case; if a price control of $1.00 is imposed when the market price is $1.30, but market participants expect the market price to fall to $0.95 the price control will have no effect. Price controls either cause shortages or have no effect.

Price controls can cause shortages. Does this mean they should not be instituted? Not necessarily; it does not follow that because price controls can cause shortages that they are bad. Many people acknowledge that price controls cause shortages but argue there are benefits that result from them that outweigh the costs. For example, because dentists cause pain, and pain is bad, would it follow that dentists should be outlawed?

Those who advocate price controls, however, while maintaining that they do not cause shortages are mistaken. It is this idea that is irrational.