Monday, October 24, 2016

The Upside-down Economics of Regulated and Otherwise Rigid Prices

Although not always highly visible outside of Communist countries, price regulations apply to a large fraction of economic transactions, even in the United States.  There are, of course, controls on apartment rents and taxi fares in major cities, and minimum wages for low-skill workers.  A number of states regulate interest rates on loans with usury laws and the federal government regulates interest and insurance rates with redlining prohibitions and antidiscrimination rules. Outside the state of Nevada, the price of sex is legislated to be zero.  Basic telephone and cable TV rates are regulated.  Price controls are the norm in the health sector, which by itself is already a sixth of the U.S. economy.  Much modern research on business cycles features “sticky” prices, and the technology sector includes several markets with natural constraints on monetary prices: these are not exactly regulated prices but potentially share many of their economic characteristics.
One view is that price regulations are, in the neighborhood of the unregulated price, more redistributive than they are socially costly even though they reduce the quantity traded. For example, a price ceiling is supposed to create a benefit for buyers that almost offsets the loss it imposes on sellers.  A number of studies have qualified these incidence and efficiency presumptions, noting that in addition to reducing supply, price ceilings may harm consumers by allocating the good to low-value customers (Barzel 1997, Glaeser and Luttmer 2003) or wasting consumer resources through queueing and search costs (Bulow and Klemperer 2012, Deacon and Sonstelie 1985).  But product-quality changes, which have been widely documented and explicitly considered in a few of the previous models of price regulation, are another concern.  Using a more general model of the technologically possible quality-quantity tradeoffs, our paper shows how a price ceiling imposed on a competitive market may increase the quantity traded, benefit producers at the expense of consumers, and have worse than first-order effects on efficiency – solely because the regulation affects non-price product attributes.  We also concisely characterize the features of tastes and technology that lead to such outcomes.
Practically all goods and services have non-price dimensions (hereafter, “quality”), with sellers often spending considerable amounts as they attempt to make their product more attractive to buyers. Non-price product attributes provide markets considerable scope for complying with a price ceiling without necessarily trading less quantity.  Take apartments, for which it is sometimes said that the purchase price of land and structure equals the expected present value of the rental income to be received from tenants.  In fact, about half of the revenues obtained from tenants is spent on short-run variable inputs rather than financing the structure’s purchase or construction.  Figure 1 shows the claims on national tenant-occupied housing output for 2006, as reported by Mayerhauser and Reinsdorf (2007).  Almost half of housing output went to intermediate goods and services (e.g., banking, realtor and advertising activities) and depreciation (a proxy for normal repairs and maintenance).  Another five percent went to labor (largely management), and about three percent went to compensate landlords for holding vacant units.  Landlords could adjust any of these items in order to reduce the ratio of costs to revenue.

Price ceilings have, in many real-world instances, increased quantity by reducing quality.  One is the case of doctor appointments, where ceilings on the price per visit have sometimes resulted in patients’ visiting the doctor more frequently for the same health condition.  As Frech (2001p. 338) puts it, Japanese patients “are often told to come back for return visits.  And, even injections of drugs were often split in half to make two visits necessary.”  Cuba, among other places, has ceilings the retail prices of eggs and other grocery items.  Even though the grocery-price ceilings are far below what the retail prices would be, the grocery quantities sold are not.  Instead, groceries there are sold in large containers and without refrigeration and other retail amenities.[1] Another example is the case of rent control of pre-war premises in Hong Kong, which appears to have increased the number of leases and perhaps even the number of square feet under lease as tenants engaged in partial subletting and landlords rented to “rooftop squatters.”  Elsewhere, rent control appears to increase the fraction of apartments that are under lease.
The quality-quantity tradeoff may be the source of these results. Holding expenditure constant, a price ceiling prohibits low quantities.  Take retail grocery sales.  Absent regulations, suppliers spend resources to preserve, cull, and promptly deliver their produce inventories so that the consumer receives fresh items.  With a price ceiling set on, say, a per-ounce basis, suppliers cut down on their quality-enhancing expenditures and thereby reduce the fraction of the groceries obtained by the consumer that is edible.  Consumers with a price-inelastic demand for edible groceries purchase more total groceries because the survival rate of purchased groceries is reduced by the price ceiling.  A variety of goods from apartments to light bulbs to doctor appointments have this feature that the unregulated market serves customers with less, but more expensive, quantity because that quantity is efficiently managed to provide the maximum value for the customer’s dollar.  Our model does not assume that controlled goods necessarily have such ease of substitution between quality and quantity, but these examples begin to show why the textbook predictions may not be reliable.
Even if a price ceiling does not increase the quantity sold, changes in non-price product attributes mean that the impacts of a ceiling on quantity and the surplus of buyers and sellers have little to do with the supply and demand for the controlled good by comparison to not having/producing the good at all.  On the demand side, it is not the same when price falls by regulation as when it changes due to a reduction in the marginal costs of producing the services delivered by the controlled good.  On the supply side, it is not the same when price falls by regulation as when it falls due to a reduction in the buyers’ marginal willingness to pay for the services delivered by the controlled good.  Even when the curves are properly adjusted to reflect changes in non-price attributes, the usual supply and demand diagram is not necessarily suitable for welfare analysis.
To the extent that supply slopes up, producers tend to benefit, relative to the unregulated allocation, from the increase in quantity and lose from the reduction in quality.  Indeed, we find a simple supply-elasticity condition that indicates whether a price ceiling net redistributes from consumers to producers, or vice versa.  For some of the same reasons, the possibility for producer gains is still present even when the equilibrium quantity impact of a price ceiling is not positive.
For conciseness, the scope of price regulations considered here is limited in three ways.  First, the rest of this paper refers to ceilings, but not floors.  Our framework applies to price floors too, but ignoring them removes numerous provisos, inversions, etc., from the discussion.  Also, the contrast between our results and previous ones are less subtle with ceilings than floors.  Second, we do not consider price ceiling regulations that also specify the amount supplied. Third, this paper features regulation-induced changes in non-price attributes that, holding price and expenditure constant, primarily affect the services consumers receive from the controlled good, rather than affecting the resources that the consumer has available for consuming other goods. The featured case encompasses the examples cited above: the price regulation is misspecified in the sense that it normalizes expenditure with a quantity (say, ounces of produce received from a retailer) that is different from what consumers ultimately value from the controlled good (edible ounces of produce).  In the latter model, not treated in this paper, the price regulation is misspecified in that some of the expenditure on the controlled good occurs downstream of the price regulation, so that compliance is achieved by moving production downstream.
In formulating a competitive hedonic model with a variable quantity but a lack of heterogeneity among producers and consumers, our goal is ease of exposition.  As with the textbook analysis of price ceilings and other public policies, we view the competitive case as a helpful starting point that focuses on tastes and technology, which by themselves have interesting and subtle features.  Instead, the standard hedonic-model framework with unit demand must be extended to allow for variable quantity in order to highlight quality-quantity tradeoffs that occur in the marketplace.  Having a homogenous group of consumers (producers) allows us to show that quality adjustments are distinct in principle from the question of who consumes (produces) in the regulated market, respectively.  Market power and heterogeneity can be added later, and we presume that doing so will only enrich the already surprising range of market outcomes that come from quality adjustments by themselves.

[1] Take eggs.  Expressed as a ratio to the price received by producers in the U.S. market (there is no reliable data for the Cuban producer prices because the Cuban government has vertically integrated the production chain), U.S. retail egg prices are about 3 whereas the Cuban retail price is controlled at about 4/3.  Controlled Cuban eggs are sold in trays of 30 without lids or refrigeration (Mulligan 2016) while Cuban egg consumption per capita is at the world average and above that in comparable countries such as the Dominican Republic. 
This paper was updated at in January 2017. The June 2016 version is here.

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