“THE FREE-MARKET HAS FAILED!”
by Andrew L. Frazier
There is perhaps no more divisive
topic in economics than the issue of Price Controls. The issue is especially
pertinent because it usually comes up in times of economic duress, times in
which, the consequences of action or inaction are most immediate. These times
are considered by Keynesians to be periods which the “Market has failed”. Only
the government, the Keynesians say, can correct the imbalances of a “failed”
In order to first consider price
controls, we must learn about the conditions which justify them; namely,
conditions in which “the market has failed".
Part 1: “The Market Has Failed”
To the proponent, “Market Failure”
is a phenomenon in which the market is not producing things as efficiently as
it otherwise could, and so the market must step aside - according to a
particular school of thought – and allow the government to correct the
Already, by mere suggestion of
“Market Failure” the economist in question has met a point of fundamental
contention. The market - by definition - cannot possibly fail, retorts the
opposition, because the market is an arbitrary term which describes the
progression of individual cost-benefit interactions. It is as if saying “the
process of evolution has failed”. The problem is, evolution cannot possibly
fail, because the surviving specie is by definition the more evolved one.
Sometimes the particular specie of animal you like dies out, but that’s not a
failure of evolution, it just is merely the impersonality of the process. The
process doesn’t care if the particular animal is cute, in so much as it has an
effect on the organisms’ ability to thrive and reproduce. The same is true for
economics, the market doesn’t fail when a particular company you like goes out
of business, to paraphrase again, it’s just the impersonality of the process;
or so say the opposition.
The opposition would contend that
the free market has no explicit purpose or goal, how then can it fail to reach
a goal which does not exist? The issue, say the opposition, generally comes when
economists impose their own standards of what the goal of the market should be.
Should it, for instance be to make every individual wealthy? And if so, how
wealthy should each individual be? How do you define what wealth is? These
answers are not as clear as they might seem; indeed, it may be far beyond what
any single person can answer. Yet however, it is not too difficult for everyone to answer, In a way, each
individual participating in the economy answers these questions through their
choice of what goods and services they wish to purchase; in the words of Von
Mises “the economy is a democracy in which every dollar has a vote”.
However, to the command economist,
these questions do not seem too fickle and complex to answer. How you might
ask? Does the command economist simply know what’s best for everyone? The
command economist of the mainstream kind that we see today, isn’t concerned
with micromanagement, instead he simply bonks the free market machine in order
to jumpstart it. According to this school of thought there are at least 4 ways
in which a market can Fail.
and Predatory Pricing - For large businesses, it can become more profitable
for companies to work through collusion rather than through open competition.
In this case, prices for a given product rise and increase the burdon on the
society. Price controls can be set to deter monopoly arbitration.
fluxuations – cyclical fluxuations can cause conditions that are not
conducive to business, such is the case when agriculture has a year in which
supply is overly plentiful, the price for the commodities drops, and that drop
can make it difficult for some farmers to make money. Price controls, in
conjunction with subsidies can allieviate difficulties, allowing for bountiful
production even in times of poor harvests.
Costs – Demerit costs exist when people in a society to do not do things
for their own benefit, such as drinking or buying drugs. Price controls can be
used to deter people from purchasing things which are bad for them. The recent
excessive tax increases in cigarettes are a good example.
– Eternalities are third parties which are affected by an operation which
should otherwise not involve them. People effected by pollution are
externalities to the plant producing the waste. There can be market
externalities as well, for instance when AIG sold credit default swaps and
defaulted on them, they caused many retirement funds to loose a large amount of
their value. The reciever of the retirement fund is an externality in this case
because he was not aware of what his future was invested in and what the implicit
risks were. Price controls can be established to deter people from taking
Part 2: Monopolization
According to the Book “Monopoly
Power and Economic Performance” by Edwin Mansfield. The problem of
monopolization exists when large businesses find that they can become more
profitable by collusion rather than competition. This causes prices for the
individual consumer to rise, raising the burden on society.
There is one powerful argument
against the viability of this thesis. It is this, to the extent that large
business profit from collusion is the extent to which they incentivize new
competition and innovation. This is the argument taken by Joseph Schumpeter.
Schumpeter’s thesis is then
partially taken down by the Predatory Pricing argument, which says that because
of the largeness of the monopoly, the monopoly can temporarily lower prices
below what it costs the monopoly to produce - for the sole intention of driving
the small competitor out of business.
Tom Woods retorts the Predatory Pricing Argument in his book “The Politically Incorrect Guide
to American History” and shows how entrepreneurs can ingeniously circumvent
severely underpriced goods monopolies sell during times of competition. The story
goes as follows:
There was a man by the name of
Herbert Dow, and Herbert Dow was a smart man, He was able to produce a chemical
called bromine for a substantially reduced cost than his competitors. The
German monopoly Brokomvention did not like the fact Herbert Dow could do this,
so they offered him a warning – they said if he ever decides to sell his
bromine in Europe they – Brokomvention - would lower their prices so
significantly in the U.S. that he would be put out of business. Herbert Dow was
not deterred, he began selling his chemical for .33/lb in Great Britain versus
Brokom’s price of .49/lb. So Brokom made good on their promise, they reduced
their price in the United States for Bromine to .21/lb – a price which Herbert
Dow could not possibly compete. So what did Herbert do? He did something very
smart, he contacted his buying agent and ordered him to buy up as much of
Brokom’s Bromine as he possibly could. He then took this Bromine and sold it to
Europe (where the price was still .49/lb). Brokom, unknowing of this tactic saw
the dramatic increase in demand for their bromine and saw that Herbert Dow was
still well in business. So the Germans lowered the price to .15/lb and Herbert
Dow bought and sold more, then they lowered the price to 10.5/lb until they
finally discovered what Herbert Dow had been up to – and promptly raised their
prices. But not before making Herbert a very wealthy man!
Indeed whenever a monopoly sells
below cost of production, it creates excesses in demand, and drives speculation
– which can then can become profitable when the price for the same good rises
during periods in which there is no competition. Speculation deters any
significant arbitrage of this sort.
Part 3: Real Cases
For every example in which Price
controls were to have said to have worked, there must be at least a hundred in
which they did not work. During my study, I could not find a single example in
which price controls actually worked to benefit society. Here are just some of
the examples. Every example (including those in the textbook), severely
criticized the viability of price controls.
THE CALIFORNIA ENERGY
The general impression people have of the California energy
crisis is that there was, basically, a condition where there was deregulation,
and the energy companies took advantage of it and jacked up prices. They might
think, like I did, that price controls would be an effective measure against
these price gouges. However, through
study, I discovered something very interesting, that price controls already
existed during the California Energy Crisis – and that those very price
controls were more responsible for the crisis – and the high costs of energy
than perhaps any other factor.
The real cause of the Crisis stated by the Federal Energy
"...supply-demand imbalance, flawed market design and
inconsistent rules made possible significant market manipulation as delineated
in final investigation report. Without underlying market dysfunction, attempts
to manipulate the market would not be successful."
So basically, because of imposed price controls, energy
companies had no incentive to grow with demand, because the market had no way
of signaling that increase in demand to the supplier. No energy company
bothered to increase the supply of energy through investment (of building a new
power plant or installing a new reactor) because there was no incentive for
them to do this – and all of this as a direct result of artificially low prices
imposed on the system.
Then as the problem of shortages became apparent the
legislature allowed for deregulation of interstate energy transactions – a
piece of legislation which was poorly engineered and allowed companies like Enron
and Reliant Energy who were starving for profits precisely due to the Price
control to essentially game the market for it’s own benefit.
THE BECHTEL WATER
Bechtel Water Scandal is another such situation where, Imposed price controls
would seem to be the solution to the problem, but was in reality was the
underlying cause of the problem.
The story most people get from the news goes as follows;
1999, Suffering under large debt loads, The Bolivian government was pressured
by the World Bank to Privatize it’s water operations. The Bolivian government
complied and sold part of its water utility operations in a consortium called
Aguas Del Tunari which was partly joined by a company called Bechtel. Soon
after operation Bechtel hiked rates up as much as 90% causing an uproar amongst
impoverished clients. As a result, the government cancelled the contract with
The Humanists contend that It was
right for the government to intervene, they argued that Bechtel had tried to
take advantage of these poor Bolivians. It may even be beneficial for the
government to impose price controls to prevent another such calamity - However
after further study, the real culprit of this injustice was not the
privatization of the water supply, but rather the government operation of the
This case again, while it may seem
that the solution to the problem would be price controls, it was actually the
underlying cause of the problem. Before the Bolivian government had privatized
it’s water operations to Aguas Del Tunari (a consortium in which the government
had a majority stake) they were in control of them. The government was running
the water system at a loss, and going into perpetual debt to fund the water
supply. (this can be seen as another form of price control, where the price can
be artificially suppressed) They were so bad at running water operations that
by four years time they run up debt of 35 million dollars. Their creditor, The
World Bank, was not to happy with the way the Bolivian government was running
their water operations and compelled them to privatize the water operations in
order for the water system to run at a profit. The reason why Aguas Del Tunari
had to increase the rates was to pay back the debts it had inherited under
contract. Bechtel, unlike the government, did not have the luxury of running
perpetual debts. The price of water was artificially low. The Bolivian citizens
were used to paying lower prices than the cost of production for that water,
and it should be the government that gets blamed for being so irresponsible.
However the story becomes more
ridiculous, because the truth was that the water rates had actually declined
for most of the poorest in the city, that was because those people had no
running water they had to get their water from tanqueros. Water from tanker
trucks which was both lower in qualtity and rougly 8-10 times more expensive.
The reason why water bills went up so drastically was not because of an
increase in rate price, but was related to a government regulation which
prevented people from pulling water from their wells, it increased the amount
of people using the city water supply, so while rates for the poor had declined
or only risen slightly, the amount of water being sold had increased.
Previous to Aguas Del Tunari, the
government had a regressive pricing policy on their water, since they were
taking up greater costs and risks for supplying water to the poorer
communities, they had opted to charge them more for their water, so much so
that as a result the poorer clients were paying more than 6 times more for the
same amount of water. It was actually such a price differential that the rich
who were partially comprised of cocaine farmers, were able to pull the water
from the city supply and sell it in tanqueros
to supply water to the poor
communities. Bechtel suspects that it was this financial incentive that was
behind the irrational protesting in Cochabamba Bolivia.
Zimbabwe had been suffering from severe inflation caused by the government
printing press, and the government-mandated elimination of a large portion of
Zimbabwe’s productive workforce. In order to counter inflation, the government
decided to physically impose price restrictions on the sale of certain goods.
It led to complete disaster. Within a matter of days the national supply of
food was completely gone. The producers - being forced to produce at a loss -
were unable to maintain production, and long term shortages began to arise.
Indeed, price restrictions in which
the price of a good is artificially low, the result is unfailingly a shortage.
Examples just from the textbook include the Energy Crisis in the 1970’s in
which the U.S. government tried to reverse the trend of rising gas prices by
implementing price caps on the sale of gasoline. It resulted in rationing,
which contained with it it’s own series of problems including counterfeiting of
the rations and black market transactions.
Part 4: Cyclical Failures
after a sharp decline in the stock market, the price of agricultural commodities
fell sharply, while the price of industrial goods remained relatively flat. The
increased relative costs of industrial goods made it difficult for farmers to
purchase equipment to maintain their farms. In order to help the farmers, the
government established price controls to bring the price of agriculture goods
back to parity to the cost of industrial goods. However, this did little good
to the farmer because the artificial rise in prices facilitated a commensurate
drop in demand, and a reduction of exports, which fell greater than
commensurately with the rise in price. So while farmers could charge more for
their goods, the amount of goods they were able to sell dropped in proportion,
so in the end they were no better off.
However the people who purchased these commodities were less well off,
since they had less food to eat.
Price controls can be justified by
arguments of intention. If people are having to pay exorbitant prices – at the
same time business are reaping massive profits, they say, a government would be
justified in establishing price controls. However, it is never asked how to conditions
of market failure come to pass - Is it just a natural outgrowth of the free
market system? Or is it the result of a previous intervention?
In the Austrian School of thought
the market price is established as the price of maximum utilization, proper
compensation is defined by market prices, or market demand. When a government
decides to impose its own standards of what proper compensation should be, it
often distorts the market, which then lead to unintended consequences. For example, If a government were to impose artificially
low prices for a certain good, what happens is the producer of that good is
forced to sell for a loss, and that producer will no longer produce, then
shortages arise. Ironically, this causes the price to go even higher, because
the only way to receive these products is by paying exorbitant prices on the
black market - prices which contain both a higher price due to the increased
scarcity and a premium to offset risk of government insubordination.
Alternatively, the government can
impose price floors, preventing the price from going down further. However, Artificially
imposing too high a price causes illiquidity in the market, the good is there –
perfectly consumable, but no one can buy it because the price is too high. The consumer isn’t the only one who suffers,
the farmer who wants the good sold can’t for the simple reason that the
government won’t let them. Imagine a situation in which there is the shopkeeper
at a market, who is desperately in need of money, and a customer who has some
money but is desperately in need of food, and yet, they cannot make the
transaction – even though the shop keeper is perfectly willing to part with the
good at the lower price, and the customer is perfectly willing to consume it,
they cannot reach that agreement, all because of this imposed price control. Of
course in the real world these insane policies are impossible to enforce which
is exactly what happened during the great depression – and is why the
government then decided to plow under fields. They thought that if they reduced
the supply, the price would go up – they were right, but why do that? they
actually used tax payer resources to destroy perfectly consumable goods! How is
that beneficial to anyone?
This just goes to show that sometimes
the scientific foresight of complex theories can cloud our perspective of what
is right in front of us. Sometimes people do their greatest damage when they
have the best of intentions.
Part 5: Demerit Costs and
Demerits are perhaps the most
controversial from of government intervention. The thesis of the intervention
proposed is usually ethical in nature. To prevent the people from harming
themselves. However, the result is usually antithetical to the intention.
are generally this notion that you cannot make choices for yourself, a good
example of this is prohibition, where price controls were imposed via excessive
taxes. These price controls did not work and only proliferated black market
operations, operations which fueled organized crime and gang violence.
The government may intervene in a variety of ways, but there
is generally one constant, to save the system from poor externalities. As a
result of some free-market wrongdoing some innocent fellow has been mal-affected.
So, the politician says he must saved from this unfortunate circumstance.
However, what this particular politician fails to realize is
that in the act of saving this particular individual the government has created
another externality. Namely, anyone who pays taxes for these solutions - or
pays for goods which have increased in price due to price controls are
externalities of Government Policy, and as a general rule, those externalities resulting from government policy tend to be
greater in both size and severity of affliction, than the supposed
externalities the government are trying to free from harm.
you accept the notion that the free market establishes prices as the most
efficient utilization of resources, then by that admission alone, you must admit
that establishing price controls can have nothing other than a net detrimental
The Keynesian/Humanist does not
address the issue of economics in totality, rather, only looks at the explicit
benefit rather than the implicit harm. The Austrian theory is more complete in
this sense because it concludes that the implicit harm must exist from first
principles. This can be seen as the Keynesian underestimating or ignoring
altogether the opportunity costs of their actions.