Chapter 4 Government Controls: How Management
Incentives Are Affected
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Unearned Profits
Many proponents of price controls view the supply curve for a controlled good as
essentially vertical. They believe that a price rise will not affect the quantity produced.
Consumers will get nothing more in the way of goods, but producers will reap a windfall
profit. Instead of an incentive to produce more, profit is seen as an economic rent—an
exploitative surplus received by companies fortunate enough to be in the market at the
right time.

Administered Prices
A technical argument for price controls is most often advanced by economists and public
officials. Many economists maintain that a significant segment of the business and
industrial community—the larger firms that control a sizable portion of industry sales—
no longer responds to the forces of supply and demand. Firms in highly concentrated
industries like steel, automobiles, computers, and tobacco can override market forces by
manipulating their output so as to set price levels. Furthermore, they can manage the
demand for their products through advertising campaigns. With market forces
ineffective, control must come from the government. Price controls are the only way to
avoid the production inefficiencies and inequitable distribution of income that result from
concentration of industry. As John Kenneth Galbraith, a leading advocate of price
controls, has put it, “Controls are made necessary because planning has replaced the
market system. That is to say that the firm and the union have assumed the decisive
power in setting prices and wages. This means that the decision no longer lies with the
market and thus with the public.”

social and environmental change.
When we say that the prices of certain products should be controlled by
government, what do we mean by “government”? Can government as we know it
consistently reflect the public interest? Is government immune to human failings?
Opponents of price controls emphasize that the pricing decisions made by any
government agency will reflect the will of its staff. Personal preference will loom large
in their decisions on what constitutes a just price and a just allocation of goods and
services. Political considerations may also play a role. Firms with a talent for political
maneuvering will have an advantage under a price control system. In other words,
competitive behavior is not necessarily reduced by price controls, though its form of
expression may be changed.
If price controls are complemented by a system of government allocation of
supplies, then strikes, demonstrations, and violence may also influence government
decisions. During the energy crisis of 1973—1974, and again in 1978, the federal
government regulated the allocation of crude oil between gasoline and diesel fuel
producers. When truckers received less fuel than they claimed they needed, independent
drivers stuck, threatening to paralyze the nation’s commerce unless they got more fuel at
lower prices. To ensure cooperation among drivers, the strikers blocked roads,
vandalized the equipment of nonstrikers, and shot at drivers who ventured out on the
road. One trucker was killed, and others were seriously injured. At least for a short time,
such tactics were productive. The government agreed to earmark more crude oil for
diesel fuel production and to lower the federal excise tax on diesel fuel. (Courts later
declared those decisions illegal.)

Shortages and the Effective Price of a Product
In a competitive market, any restriction on the upward movement of prices will lead to
shortages. Consider Figure 4.3, which shows supply and demand curves for gasoline.
Initially, the supply and demand curves are S
1
and D, and the equilibrium price is P

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held constant at P
1
, the effective price -- the sum of the pump price and the values of time
lost waiting in line -- will rise.
Shortages can raise the effective price of a product in other ways. With a long
line of customers waiting to buy, a service station owner can afford to lower the quality
of his service. He can neglect to clean windshields or check oil levels, and in general
treat customers more abruptly than usual. As a result, the effective price of gasoline rises
still higher. Again, during he energy crises of 1973-1974 and 1978, some service station
owners started closing on weekends and at night. A few required customers to sign long-
term contracts and pay in advance for their gasoline. The added interest cost of advance
payment raised the price of gasoline even higher. Figure 4.3 The Effect of Price Controls on Supply
If the supply of gasoline is reduced from S
1
to S
2
, but
the price is controlled at P
1
, a shortage equal to the
difference between Q
1


Chapter 4 Government Controls: How Management
Incentives Are Affected
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The coupon system may appear to be fair and simple, but how are the coupons to
be distributed? Clearly the government will not want to auction off the coupons, for that
would amount to letting consumers bid up the price. Should coupons be distributed
equally among all consumers? Not everyone lives the same distance from work or
school. Some, like salespeople, must travel much more than others. Should a commuter
receive more gas than a retired person? If so, how much more? Should the distribution
of coupons be based on the distance traveled? (And if such a system is adopted, will
people lie about their needs?) These are formidable questions that must be answered if a
coupon system is to be truly equitable. By comparison, the pricing system inherently
allows people to reflect the intensity of their needs in their purchases.
Once the coupons are distributed, should the recipients be allowed to sell them to
others? That is, should legal markets for coupons be permitted to spring up? If the deals
made in such a market are voluntary, both parties to the exchange will benefit. The
person who buys coupons values gasoline more than her money. The person who sells
his coupons may have to cut back on driving, but he will have more money to buy other
things. The seller must value those other things more than lost trips, or he would not
agree to make the exchange. The positive (and often high) market value of coupons
shows that price controls have not really eliminated the shortage.

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Figure 4.4 The Effect on Rationing on Demand
Price controls can create a shortage. For instance, at

Incentives Are Affected
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Perhaps the most damaging aspect of a rationing system is that the benefits of
such a price increase are not received by producers—oil companies, refineries, and
service stations—but by those fortunate enough to get coupons. Thus the price increase
does not provide producers with an incentive to supply more gasoline. (If the increase
went to producers, their higher profits would encourage them to search for new sources
of oil and step up their production plans.)

Consumer Protection
Less than one hundred years ago the general rule of the marketplace was caveat emptor—
“let the buyer beware.” The individual consumer was held responsible for the safety,
quality, and effectiveness of his purchases. The seller could assume liability for the
safety and effectiveness of goods and services, but only through a contract endorsed by
both parties. The same rule applied to contracts: the buyer was responsible for what he
signed. Although consumers could sue sellers for breach of contract or for fraud, no
government agency would initiate the suit. Nor did government protect citizens in other
ways from the products they bought.
During this century, however, product liability has gradually shifted from the
consumer to the producer and the seller. Both court decisions and changes in the law
have contributed to this shift. Many now see consumer protection as a government
function.

The Case for Consumer Protection
The argument for relieving consumers of product liability resembles the argument for
regulation of utilities in many respects. Both cases hinge on the costs of gaining