Unintended Consequences of Price Controls

Release Date
June 2, 2011

Topic

Basic Economics
Description

Prof. Antony Davies explains that prices are not levers that set value, but rather, are metrics that respond to value. Therefore, since government cannot legislate value, attempts to control prices will generate unintended consequences. Using the minimum wage as an example, Davies demonstrates that minimum wage laws increase unemployment rates amongst low-skilled workers.

Unintended Consequences of Price Controls
How do you cure fever? You’ve got a kid, you stuff a thermometer in him, take it out, it says 103. You can scratch off the numbers and write in 98.6 and the fever is cured, or you can give the kid medicine and the fever comes down if he was cured. Clearly the first way isn’t the right way to handle this. But, that’s exactly what happens when the government tries to legislate prices.
Prices are not levers that set value. They’re metrics that reflect value, like the thermometer. So price controls will tend to fail on two counts. First, legislating price does not legislate value. Second, prices serve a great purpose, that is, they signal value to the rest of the economy. When the government attempts to legislate prices, it stops the prices from signaling value.
Everything is scarce. Scarce resources will be rationed. The question is by whom and using what mechanism, and more importantly, who is excluded in the rationing. If we put a cap on interest rates, credit will be rationed by risk. The people who will be excluded are the high-risk people. If we put a cap on tuition, college admissions will be rationed by talent. The people who will be excluded are the less-talented students. When we put a cap on wages—or in the case of minimum wages, a lower cap, a lower limit—jobs are rationed by skill. So less-skilled workers are excluded from the job market.
Here you’re looking at unemployment in the United States amongst college-educated workers. Every dot is a year 1978 to 2008. The further to the right you go, the higher is the minimum wage. The further up you go, the greater the unemployment. And what you can see is, amongst college-educated students, there tends to be no relationship between unemployment and the minimum wage. But the college-educated students are the high-skilled students. These are not the ones who you would expect to be excluded from the market by imposing a minimum wage.
Here are high school educated workers, and you start to see now a positive relationship. There are exceptions, but on average there’s this trend: in years in which the minimum wage was higher, unemployment amongst high school educated workers was higher also. The situation is worse when you look at workers who do not have high school educations. Here the relationship is even stronger; as the minimum wage rises, the unemployment rate amongst those without high school diplomas rises much faster.
But, we have to do something. The rich are getting richer, the poor are getting poorer and minimum wage is one of the ways we address this. Well, in fact, that’s not the case. What you’re looking at here are U.S. households divided up by income. Everything is measured in 2006 dollars, so inflation is not an issue here. About 17, 16 percent of U.S. households in 1980 were earning the equivalent of under $15,000 today. There were about 14 percent of households in 1980 that were earning between $15 and $25,000. You can go over here, the bulk of U.S. households in 1980 were earning between $50 and $75. And there were a few that were earning more than that.
Now fast forward 10 years and let’s look at 1990. In 1990, the percentage of U.S. households that were earning under $15,000 dropped. The percentage of households who were in this bracket dropped. These dropped, these dropped, these dropped. Where did all these households go? It’s as if somebody stepped on this side of the picture and the households popped up over here. The lower-income households, the number of lower-income households was shrinking relative to the population, and the number of higher-income households was rising. That’s 1980 to 1990.
Let’s look at 2006, and you see the same phenomenon even more pronounced at the high level. Percentage of households earning less than $15,000 dropping, these were dropping, dropping, dropping, dropping. And here you have this huge bump in the over $100,000 mark. And remember, this is not a function of inflation. Inflation has been filtered out.
So two things to note: one, minimum wage creates unemployment amongst those who are less skilled—precisely the people who we’re looking to help. Two, this picture calls into question the need for it in the first place, because in fact the rich are getting richer, but the poor are getting richer also.