Prices, Price Ceilings, and Subsidies

Originally posted at on May 3, 2011

There’s an old saying that if you lay all the economists in the world in a straight line, you still wouldn’t reach a conclusion. That is very true on many matters economic, but there are a few instances where universal agreement exists. Two of those instances are the effects of price ceilings and subsidies. However, many economists still deny that specific price ceiling and subsidies will be harmful, because… well they never really say. Sometimes they point to an empirical study for “proof”, but for every empirical study proving one thing, there is another one that proves the exact opposite. So we must rely upon theoretical and analytical tools, to obtain logical answers to difficult and intertwined phenomena. Here we’ll examine the role of prices in the economy, and how their manipulation never has the effect intended.

A price ceiling is when, by government mandate, the price of good cannot exceed some level. But before we get into price controls, let’s first understand what prices are. Prices are the by-product of the interaction between buyers and sellers, each of whom has their own subjective valuations. That is, prices don’t exist until after a sale has been made. When we colloquially say the price of something is $1, what we are really saying is some previous buyers have paid $1 for it and anything else (including “fair” and “just” pricing) is an imaginary construct, as anyone can come and pay and charge anything for anything at any moment. In short, prices are past events–that is, the price isn’t, the price was. After a price has been established, it gives a lot of information to buyers and sellers: it allows them to calculate their own profit and loss, budget for the future, and allowing the possibility to quantify their own values for other purchases. Prices also allow other entrepreneurs to seek out the possibility of arbitrage (that is, the mismatch in prices of the same good that is not attributable to transportation costs, etc.), or even if it is worthwhile to sell a certain good.

Now, let’s assume a politician announces that the price of an iPhone is too high. How can people make important phone calls and experience the human right of Angry Birds if iPhones cost several hundred dollars? So the government enacts a price ceiling of, let’s say, $5–meaning any price lower than $5. Will the economic consequences of this type of control be that all iPhones that were previously on sale at $500 would now only be sold at a 99% discount? No, what is most likely to happen is that all iPhones would be pulled from the market, instead of being sold at a loss. And, indeed, a black market would arise in illicit iPhone sales, which would be sold at a premium.

Most politicians today understand the above. However, they have moved their targets from actual goods to the more abstract interest rates. Very few people, and even fewer politicians, realize that interest rates are prices, too. But before we get into interest rate control, let’s first understand what interest is. An interest rate is the price a borrower gives to a lender for the lender having to give up present consumption. If you, for instance, had $10, and someone came and asked to borrow that money and promised to pay you back in a year, you would want more than $10 back–because think of the things you could have bought for $10 dollars during the year that you’re forgoing, so this other person can spend the money! And surely if there is inflation, or you’re not sure how likely it is that you’re going to be paid back and on time, you’re going to want a higher premium. With this understanding, let’s see why an interest rate cap is silly.

Now, let’s assume a politician announces that the interest rates on credit cards are too high. How can people make important purchases and pay their iPhone bills if interest rates on their credit cards are 35%? So the government enacts a price ceiling of, let’s say, 5% over prime. Will the economic consequence of this type of control be that all credit card customers who were being charged at 35% per year will now be charged at prime plus five? No! What is most likely to happen is that all customers who are not worth the new cap will be denied the service. Indeed, it would promote an increase in illicit lending, where borrowers can be charged 35% per month (and let’s not think about the penalties for making a late payment).

Subsidies are somewhat different. A subsidy is, in effect, free money the government just gives away, usually to an industry or organization. Subsidies are often sold to the public as being needed in order to “save” an industry, or to promote a good product or activity. “We must subsidize General Widgets,” claim the politicians, “because they employ thousands of workers, and those workers support thousands of other workers in hundreds of local restaurants and stores, which buy goods from thousands of other businesses all across the country…” and so on, until the entire global economy is shown to be dependent on the sole existence of General Widgets.

But this is evidently absurd. Because a subsidy is paid out of taxes, the taxpayers lose at least as much as what the subsidy recipients gain. Taxpayers will have that much less income to purchase other goods and services in the economy, which results in jobs being lost anyway. And if we go back to our definition of an interest rate, if what the economy gets back out of the subsidy is less than what it could have produced if it were able to keep the money, then society loses even more. (To say nothing of the fact that when a company goes bankrupt, other, more successful businesses can pick up the pieces and reorganize them into even more productive uses.)

Subsidies also serve to raise prices. If a company is failing, a likely cause is that consumers are not buying goods from the company because they feel the good being offered is too expensive. The natural solution is to lower the price. However, a subsidy to the mismanaged firm will postpone that price adjustment. Another, more subtle way this can happen is if consumers are subsidized to make purchases from the already expensive industry.

Knowledgistan is a part of the country where everyone knows everything about everything, and so everyone has jobs and is super productive and happy; thus, demand to go to Knowledgistan is very high. Let us say that travel tickets to the land of Knowledgistan are very expensive, because it is very far away–so far away, in fact, that it takes four years to get there, at a cost of about $1000 per year. Politicians see that some people cannot get to Knowledgistan because of the prohibitive cost, and so announce the creation of a Knowledgistan Passport, where anyone who wants to go to Knowledgistan gets $4000. Will the creation of this program mean it will be free to go Knowledgistan for everyone now? The answer is “of course not”. The travel agencies can only take so many people at a time, and since this program will increase demand, the agencies will–you guessed it–increase their prices by exactly what the subsidy is. Thus all that this subsidy will do is to make the travel agencies richer.


Prices (which always reflect the past) are very good communicators of information. They tell entrepreneurs if they’re having a profit or loss or if a certain industry is worth getting into. They tell consumers how to budget, and allow quantification of means and ends. Their manipulation distorts their role as a tool for judgment.

While not an exhaustive examination, we saw how price ceilings and subsidies never achieve the goals they are set out to. They promote illicit and dangerous activities, raise prices, and end up hurting the poor more than anyone else.