Prices are a fact of life, and so is complaining about them. You probably prefer lower prices on just about everything, but especially when buying a house or paying for college, and you wish for higher prices when it comes time to sell that house or negotiate your salary. Complaints aside, prices are the key to widespread prosperity.
Prices contain vital information: They show us how scarce resources are. They indicate what consumers want. Entrepreneurs and innovators rely on them to decide what to make and how to make it. But not all prices are meaningful. Too often, governments interfere. In an attempt to protect consumers, politicians mandate lower prices. Other times, governments push prices up to benefit certain industries. These efforts might be well intentioned, but they distort the information that prices convey and tend to make us poorer.
Why are prices so important, and what happens when policy makers forget this lesson?
The economy looks chaotic. Every day, millions of people independently make billions of decisions. From cups of coffee to new cars, consumers are making countless purchases; innovators are busy developing new products; and entrepreneurs are investing in new equipment, processes, and buildings. Somehow, though, the result isn’t chaos: it’s widespread prosperity.
In It’s a Wonderful Loaf, economist—and poet—Russ Roberts shows how, without any central planning, the economy delivers orderly outcomes:
This order, Roberts notes, is a consequence of prices and competition. Price signals help create order where chaos seems more likely. Higher prices encourage consumers to conserve or to buy other products. Likewise, prices show innovators where they should commit their time and effort. They help entrepreneurs decide where they should invest their money.
But prices are effective only when they reflect actual economic conditions. They should rise and fall as consumer preferences change or when inputs become more or less scarce. When prices don’t reflect these changes, the result will be shortages or excess. In the case of shortages, the cost to make more of the good is less than its value to society, yet no one has the incentive to produce more. Conversely, an excess supply means resources are wasted on goods that cost more to make than their value to society. Whether it is a shortage or an excess, the outcome is that society gets less of what it wants.
The COVID pandemic serves as a tragic example of the consequences of government price mandates. As demand rose for masks, personal protective equipment, and toilet paper, prices should have risen too. But, as the video below explains, that is not what happened. Anti-price-gouging laws prevented prices from rising. With the prices remaining largely fixed, businesses had little incentive to increase production and consumers bought more than they needed. Dangerous shortages followed. Hoarders bought up supplies, while doctors and nurses couldn’t get masks.
Government-mandated price controls are a problem not just during pandemics. In nearly every part of our economy—from housing to health care—there are regulations that prevent prices from adjusting as economic conditions change. These rules distort the signals prices send and result in less prosperity.
What about housing?
Governments often enact policies to push housing prices upward. At other times, they create policies to keep housing costs from rising. And occasionally they support policies that aim to raise and lower housing costs simultaneously.
Rent control is a classic example of a government-engendered price distortion. No one likes to pay more for rent, so politicians often resort to laws that simply prevent rents from rising. Advocates of these rules argue that landlords do little to deserve higher rent payments. In the San Francisco Bay Area, for example, landlords have been able to increase rents because of a booming job market. Why, rent control supporters ask, should these landlords collect higher rents when they just happened to buy a property at the right time?
Rent-control laws, however, distort incentives for renters and landlords. Those who don’t value the space have little reason to move to smaller accommodations, while would-be renters who need more space, such as families with children, can’t find adequate living room. The large family who needs more space would be willing to pay more, but rent-control laws mean there is no way for them to outbid those who don’t value the extra space.
Landlords have little incentive to maintain and invest in their properties. With rent so low, they can easily find renters, so why would they make any improvements? Other landlords may choose to stop renting. They turn their properties into condos or other types of units that are not subject to rent-control laws. Developers and prospective landlords meanwhile have no incentive to build additional rental units. Thus, as the video below highlights, rent-controls laws lead to housing shortages and reduce the quality of existing units.
Surprisingly, many places with rent control also have rules in place that lead to increased housing prices. In the video below, economist Lee E. Ohanian explains how strict land-use rules lead to large housing shortages that increase costs:
The people who benefit from these rules are current homeowners who see their home values rise. The artificially high prices, however, hurt families who can’t find housing or have to pay higher rents. Moreover, because restrictive land-use policies discourage workers from moving to areas with plentiful job opportunities, workers remain in jobs where they are less productive. This, of course, hurts these workers, but it also harms the entire economy.
How does the government interfere with prices in health care?
It’s not just housing. Politicians are eager to enact laws that will lower health care costs and increase insurance coverage. Sometimes these laws directly subsidize care, but this comes at a high price. Between Medicare, Medicaid, and other programs, the federal government spends more than a trillion dollars on health care programs each year. Lawmakers must raise taxes or borrow money to pay for these programs. Politicians, of course, prefer to avoid making these tough political decisions. They favor policies that appear to lower costs or increase coverage without increasing government spending. One attractive option is simply to mandate lower prices.
The Affordable Care Act (ACA), for example, created rules that prohibit insurance companies from charging higher premiums to individuals with costly health conditions. Congress hoped these restrictions would make health insurance more affordable. And, indeed, insurance companies lowered premiums for high-cost enrollees. But the insurers didn’t stop there. To pay for the premium reductions, insurers raised premiums on young and healthy individuals. In short, Congress didn’t lower health costs when it passed the ACA; it just shifted costs from one group to another. This cost shifting is called a cross-subsidy. Economist John H. Cochrane explains how these cross-subsidies corrupt the US health care system:
Lawmakers do not want to be seen taxing and spending, so they hide transfers in cross subsidies. They require emergency rooms to treat everyone who comes along, and then hospitals must overcharge everybody else. Medicare and Medicaid do not pay the full amount their services cost. Hospitals then overcharge private insurance and the few remaining cash customers.
These cross-subsidies do not merely affect who pays. They distort the health market in ways that harm our health in the long term. Cochrane writes:
Over the long term, cross-subsidies are far more inefficient than forthright taxing and spending. If the hospital is going to overcharge private insurance and paying customers to cross-subsidize the poor, the uninsured, Medicare, Medicaid and, increasingly, victims of limited exchange policies, then the hospital must be protected from competition. If competitors can come in and offer services to the paying customers, the scheme unravels.
No competition means no pressure to innovate for better service and lower costs. Soon everybody pays more than they would in a competitive free market. The damage takes time, though. Cross-subsidies are a tempting way to hide tax and spend in the short run, but they are harmful over years and decades.
Cochrane describes the harm of cross-subsidies in this video:
There are other ways prices are distorted in health care. For example, employer-provided health insurance premiums are tax deductible, which encourages workers to select insurance plans with high premiums and low out-of-pocket expenses. The video below explains how this tax deduction arose:
When insured people visit a doctor or choose to undergo a health care procedure, they don’t face the full cost of their decision. Because the price they pay is far below the cost, people tend to consume more health care than they would if they had to pay for treatments directly. That might seem like a good tradeoff. It ensures patients don’t have to worry about the cost when making decisions about their health. The excessive consumption, however, pushes premiums upward, making health insurance less affordable for all.
In the twenty-first century, fewer people are living in poverty and more needs are being met. Remarkably, this progress has come with little central planning. Most economic decisions are left in the hands of individuals. Their choices are guided only by their own preferences and by market prices. As we have seen, when politicians interfere with prices, they obscure and distort the guideposts that are integral to prosperity and ultimately weaken the delicate economic order that benefits so many.
Further Reading and Citations
In their essay “The Sobering Implications of Health Care Reform,” Hoover Institution fellow Lanhee Chen and Columbia University professor Julius Chen discuss the harmful effects of government policies that alter reimbursements rate for hospitals and doctors.
The downsides of minimum wage laws are a textbook example of the consequences of government-mandated prices. Economist Lee Ohanian analyzes the consequences of such labor regulations in his essay “The Effect of Economic Freedom on Labor Market Efficiency and Performance.”
There are times when governments may promote efficient market outcomes by interfering with prices. When economic decisions create negative externalities (e.g., pollution), prices are lower than the cost to society. In these cases, government can improve outcomes by adding a tax. For example, as this video explains, a carbon tax may be the best way to address the harmful side effects of carbon emissions.
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