Free market vs. price controls: as gas prices hit record highs, calls are inevitable for government to remedy the "problem" through price controls--though that solution hasn't worked in the past.

It wasn't hard this semester to get my freshmen students in Principles of Macro-economics interested in supply and demand. With headlines warning that gas could hit $5 per gallon, they had no shortage of questions, and answers.

"That'll be $100 for a fill-up," said one student, adding, "Why doesn't the government just put a lid on prices?" Suggested another: "They're going to have to increase the minimum wage, so people can afford to get to work."

My explanation about how things can't be fixed that easily, explaining why a government-imposed price "ceiling" in the case of gas and mandated price "floors" in the case of minimum wages will most likely only have the unintended consequence of producing more gas shortages and more unemployment, provided this freshman class with their initial lesson in why economics is called "the dismal science."

Supply and Demand

Here's how Milton Friedman explains the problem with price controls in Free to Choose: "Economists may not know much. But we know one thing very well: how to produce surpluses and shortages. Do you want a surplus? Have the government legislate a minimum price that is above the price that would otherwise prevail."

An example is the government's minimum prices for farm products, which have the effect of producing massive surpluses of butter, wheat, etc. It's the same in the labor market. Raise the minimum wage to $10 so people can afford higher gas prices, and the result will be a government-induced production of a surplus--a surplus of workers, i.e., higher unemployment.

That jump in unemployment, directly hitting the intended beneficiaries of the government intervention, inevitably happens because a hike in the mandated minimum wage has the direct effect of attracting more people into the labor market at exactly the same time that employers are seeking to cut their newly inflated payrolls. The result is more supply and less demand, either of which produces a surplus. Generate both of these supply and demand changes simultaneously, and it's a double blow to employment.

Continues Friedman: "Do you want a shortage? Have the government legislate a maximum price that is below the price that would otherwise prevail. That is what New York City and, more recently, other cities have done for rental dwellings, and that is why they all suffer or will soon suffer from housing shortages."

From Surplus to Shortage

With housing or gasoline, or anything else, prices rise in a free market when the amount demanded exceeds the amount supplied at existing prices. The result is a shortage and a higher price, a price that encourages more supply and a drop in demand, the exact two things that are necessary for the elimination of the shortage.

That's how the price system works in a free economy to organize resources and automatically eliminate surpluses and shortages, without human interference. Instead, impose government-mandated price lids and floors and the inevitable result, respectively, will be persistent shortages and surpluses.

The artificially low prices of Manhattan's rent-controlled apartments have the effect of discouraging new supply while simultaneously expanding demand, the perfect formula for a chronic shortage. And, as a footnote, the perfect formula for crime. In March 2003, brothers William and David Lavery of Queens found themselves fighting off knife-wielding assassins hired by their landlord. His motive? To get the Laverys out of their $400-a-month rent-controlled apartment, so that, with a new tenant, he could up the rent.

What Manhattan does with apartments, the heavily-Democratic Hawaiian state legislature is now doing with gasoline. Starting on September 1, the Aloha State put into effect a law that slaps a ceiling (adjusted weekly) on what wholesalers can charge for gasoline. Hawaiians currently pay the highest gasoline taxes in the nation--57 cents per gallon, or 13 cents more than the national average. Not surprisingly, that money grab by the government wasn't much discussed by Hawaii's politicians before they voted to come to the rescue of consumers by way of targeting the state's oil wholesalers as the greedy enemy.

The end result in Hawaii is likely to be the same as it was across the U.S. in 1979-80 when President Jimmy Carter succeeded in putting a lid on the price of oil--fuel shortages, rationing systems, and long lines at the pumps. It's estimated that at that time American drivers burned up 150,000 barrels of oil per day idling their engines while waiting in lines for gas.

In contrast, President Ronald Reagan cancelled the price caps on gas in one of his first acts in office. Drilling went up, prices came down, and the gas lines disappeared. That worked because it removed the government controls that took away the incentives for oil companies to respond to high prices as they normally would--by increasing production.

Ralph R. Reiland is the B. Kenneth Simon Professor of Free Enterprise at Robert Morris University, a restaurateur, and a columnist with the Pittsburgh Tribune-Review.