Chapter 4 Government Controls: How Management Incentives Are Affected 4 4 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.” 1 Monopoly Power Later in the course, we will see how a monopolist can be expected to restrict output in order to push up its price in order to earn greater profits. The case for price controls under monopoly conditions is, for many advocates of controls, a matter of “fairness.” The controls give back to consumers what they “deserve” in terms of lower prices. However, as we will see, under monopoly conditions, if the producer is forced to charge a (somewhat) lower price, the producer will rationally choose to increase the output level. Hence, price controls benefit consumers in two ways, first through lower prices and then through greater output. The Case Against Price Controls Just as the case for price controls is tied closely to the existence of monopoly power, the case against controls rests heavily on the competitive market model. Economists who 1 John Kenneth Galbraith, Economics and the Public Purpose (Boston: Houghton Mifflin, 1973), p. 315. Chapter 4 Government Controls: How Management Incentives Are Affected 5 5 oppose controls feel that competition is sufficient to govern business behavior, including pricing decisions. Opponents of controls also stress the individual’s right to act without government interference—a right they see as crucial to a society’s ability to adjust to 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 1 . Now suppose that the supply of gasoline shifts to S 2 , and government officials, believing that the new equilibrium price is unjust, freeze the price at P 1 . What will happen to the market for gasoline? At price P 1 , which is now below equilibrium, the number of gallons demanded by consumers is Q 2 , but the number of gallons supplied is much lower, Q 1 . A shortage of Q 2 -- Q 1 gallons has developed. As a result, some consumers will not get all the gasoline they want. Some may be unable to get any. Because of the shortage, consumers will have to wait in line to get whatever gasoline they can. To avoid a long line, they may try to get to the service station early— but others may do the same. To assure themselves a prime position, consumers may have to sit at the pumps before the station opens. In winter, waiting in line may mean wasting gas to keep warm. The moral of the story: although the pump price of gasoline may be Chapter 4 Government Controls: How Management Incentives Are Affected 6 6 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 and Q 2 will emerge. Black Markets and the Need for Rationing Besides such legal maneuvers to evade price controls, some businesses may engage in fraud or black marketeering. During the winter of 1973—1974, a good many gasoline station owners filled their premium tanks with regular gasoline and sold it at premium prices. At the same time, a greater-than-expected shortage of heating oil developed. Truckers, unable to get all the diesel fuel they wanted at the controlled price, had found they could use home heating oil in their trucks. They paid home heating oil dealers a black market price for fuel oil, thus reducing the supply available to homeowners. As always, government controls bring enforcement problems. To assure fair and equitable distribution of goods in short supply, some means of rationing is needed. If no formal system is adopted, supplies will be distributed on a first- come, first-served basis—in effect, rationing by congestion. A more efficient method is to issue coupons that entitle people to buy specific quantities of the rationed good at the prevailing price. By limiting the number of coupons, government reduces the demand for the product to match the available supply, thereby eliminating the shortage and relieving the congestion in the marketplace. In Figure 4.4, for example, demand is reduced from D 1 to D 2. Chapter 4 Government Controls: How Management Incentives Are Affected 7 7 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. __________________________________________ Figure 4.4 The Effect on Rationing on Demand Price controls can create a shortage. For instance, at the controlled price P 1 , a shortage of Q 2 -- Q 1 gallons will develop. By issuing a limited number of coupons that must be used to purchase a product, government can reduce demand and eliminate the shortage. Here rationing reduces demand from D 1 to D 2 , where demand intersects the supply curve at the controlled price. Furthermore, if the coupons have a value, the price of a gallon of gasoline has not really been held constant. If the price of an extra coupon for one gallon of gasoline is $0.50 and the pump price of that gallon is $1.25, the total price to the consumer is $1.75 ($0.50 + $1.25). The existence of a coupon market means that the price of gasoline has risen. In fact, the price to the consumer will be greater under a rationing system than under a pricing system. This is because the quantity supplied by refineries will be reduced. Chapter 4 Government Controls: How Management Incentives Are Affected 8 8 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 information and the problems created by external benefits and costs and monopoly power. External Benefits When two cars collide, both cars will sustain less damage and both drivers less injury if just one of the cars is equipped with protective bumpers. Thus people who do not buy protective bumpers can benefit from others’ investments. If many car buyers ignore the benefits others may receive from their purchases, the quantity of shock-absorbing bumpers sold will be less than the socially desirable or economically efficient amount. This analysis of external benefits can be extended to include the concept of consumer protection. Suppose the supply curve in Figure 4.5 is the industry’s willingness to offer protective bumpers. The demand curve D 1 represents consumer demand based on the private benefits to consumers, while D 2 represents private plus public (external) benefits. Under competitive conditions, the quantity produced and sold in the marketplace will be Q 1 —even though up to Q 2 , the total benefits of bumpers exceed their cost. The private benefits of the bumpers are small enough that many people cannot justify purchasing them. Chapter 4 Government Controls: How Management Incentives Are Affected 9 9 Graphically, the vertical distance between the two demand curves, ab, represents the external benefits per bumper sold that are not being captured by the market. Government can close this gap by setting product standards. By requiring new cars to have shock-absorbing bumpers, government effectively increases demand from D 1 to D 2. It forces people to expand their purchases from Q 1 to Q 2 , thus capturing the external benefits shown by the shaded area abc. __________________________________________ Figure 4.5 The External Benefits of Consumer Protection Private demand for shock-absorbing bumpers is shown by the demand curve D 1 : total demand (private plus public, or external, benefits), by D 2. The vertical distance between the two curves represents the social benefits from each bumper. In a free market, Q 1 bumpers will be sold. If all benefits are considered, however, the efficient output level will be Q2. By requiring people to purchase Q 2 bumpers, government can capture the external benefits shown by the shaded area abc. If the government requires consumers to buy more than Q 2 bumpers, however, excess costs will be incurred. If Q 4 bumpers are purchased, their excess social cost, shown by the shaded area cde, will offset their social benefits (abc). The net social gain will be zero. This approach can be extended to a wide range of goods and services that offer significant external benefits, from safety caps for drugs to protective devices for explosives. This argument does not justify unlimited government intervention, however. We cannot conclude, for example, that all automobiles must have shock-absorbing bumpers. Such a requirement might result in the purchase of far more than Q 2 bumpers. Beyond Q 2 , the marginal cost of safety bumpers is greater than their marginal benefit. An excess burden, or net social cost, is incurred when the public must purchase more than Q 2 . If the public is required to purchase Q 4 bumpers, for instance, the excess burden will be equal to the shaded area cde. The social cost of extending purchases to Q 4 just equals the social benefits of extending purchases to Q 2 (shown by the area abc). Consequently, there is no real net social benefit in moving to Q 4 . If the required number of bumpers is greater than Q 2 but less than Q 4 , some net social benefit will be realized. At Q 3 , the excess social cost cfg is smaller than the social benefit abc. Some net benefit will be realized. Up to a point, then, consumer protection can be socially beneficial. Society, however, can end up purchasing too much of a good thing. It is possible to make the world so safe that few resources are available for any other purpose. Chapter 4 Government Controls: How Management Incentives Are Affected 10 10 Nevertheless, governments tend to require safety devices for all products in a category. Determining the optimum quantity is so difficult and costly that a blanket rule is preferable. Yet as opponents of consumer protection point out, the blanket rule itself may be extremely costly if it requires more than the socially beneficial quantity to be produced. Ultimately, the question comes down to the actual costs and benefits of particular product standards. External Costs The argument for consumer protection based on external costs is closely related to the argument for pollution control (a point to be taken up later in the book). If the consumers who use a product do not bear all the costs associated with its use, they will tend to consume more of the good than is socially desirable. In the process they will impose a cost on others. For example, a person who buys a spray deodorant incurs a private cost equal to its money price. If the release of the chemicals used in aerosol sprays has a harmful effect on the earth’s ozone layer, as many scientists believe, however, the use of such products imposes an external cost on nonusers. At the very least, the public incurs a risk cost from the use of aerosol sprays. Curve D in Figure 4.6 shows the market demand for spray deodorant. The supply curve S 1 shows the marginal cost of producing the good, not counting the ozone effect. In a competitive market, the quantity of spray deodorant purchased will be Q 2 . If producers have to compensate those who bear the external costs of their product, however, their supply curve will shift to S 2 , and the quantity purchased will drop to Q 1 . The vertical distance between the two supply curves represents the external, or ozone, cost of each can sold. By including this cost in the price of the product, the government reduces social costs by the shaded area. ____________________________________ Figure 4.6 The External Costs of Consumer Protection Curve S 1 represents the supply curve for spray deodorant, not including external costs. Curve S 2 represents the total cost, including harm to the earth’s ozone layer. Thus the vertical distance between S 1 and S 2 shows the external cost of producing each can of spray deodorant. In a free market, Q 2 cans will be produced—more than the efficient level, Q 1 . Government can eliminate over- production by internalizing the external costs of production, shown by the shaded area. The argument does not necessarily demonstrate that spray cans should be banned. The amount of government regulation should depend on the degree of external cost. If Chapter 4 Government Controls: How Management Incentives Are Affected 11 11 the use of spray cans will ultimately cause the destruction of life on earth, then the external costs are quite high and a complete ban is in order. If costs are lower, a less stringent policy might be appropriate. Monopoly Power Consumer advocates suspect that some firms use their market power to restrict the variety of products available to consumers and to reduce their quality, safety and effectiveness. The monopolist, in other words, can choose not only what price and quantity of a given product to offer, but what features it will have. Left to itself, the monopolistic firm will maximize profits by finding that one combination of price, quantity, and product features that minimizes costs and maximizes revenues. Consumer advocates argue that most consumers want safer, more effective products than they can now obtain and are willing to pay competitive prices for them. They see consumer protection laws as a means of forcing monopolistic producers to provide what the public wants. Information Costs The complexities of modern technology can be overwhelming. Proponents of consumer protection argue that consumers cannot hope to comprehend the ins and outs of the dozens of products they must consider, from color televisions to prescription drugs. For instance, the production of cereals and meats is so far removed from common experience that consumers have little idea what chemicals may be added during processing. Without adequate information and the technical ability to comprehend it, consumers cannot make rational choices based on true costs and benefits. Therefore product safety experts must protect them. This line of reasoning resembles the argument for a standard requiring shock- absorbing bumpers. Like the bumpers, consumer information benefits far more people than those who pay for it. That is, there are external benefits associated with its provision. The market demand for information, like the market demand for protective bumpers, will not fully reflect its social benefits. Because of external benefits, the quantity of information produced and purchased will fall short of the efficient level. By intervening in the market to supplement the information flow, government can increase social welfare. The Case Against Consumer Protection Some of the arguments against consumer protection have already been mentioned. In this section we will reemphasize them and highlight some additional points. As these arguments and counter arguments suggest, consumer protection is a complex issue, and it is difficult to find an efficient solution to the problem. Chapter 4 Government Controls: How Management Incentives Are Affected 1212 Competition as a Form of Consumer Protection No one can reasonably expect to be protected against all the whims and exploitative efforts of businesses. The cost of complete protection would be prohibitive, and the benefits often too small to justify the cost. Thus we should not expect the market system to protect consumers completely against unsafe products and services. The relevant question is whether the market or government is more efficient in accomplishing the task of consumer protection. In answering that question it is important to remember that few consumers are as powerless as consumer protection advocates maintain. Although one person can do little to coerce producers into providing safer, more effective goods and services, collectively consumers have considerable power of persuasion. They can offer to pay more for a safer product—and there is some price that profit-maximizing entrepreneurs will accept for such a product—or they can turn to different producers to obtain what they want. If producers do not offer what consumers want, and if they repeatedly produce shoddy merchandise, more and more consumers will move to other producers or purchase substitute goods. For example, if the Coca-Cola Company persisted in selling drinks that had lost their carbonation, consumers could move to Pepsi, 7-Up, or other substitute drinks. The fear of losing customers helps keep producers in line, pressuring them to offer the goods customers want. Differences in Risk Taking Some people are more willing than others to assume the risk that goods and services may be defective, ineffective, or unsafe. They differ in the personal value they place on avoiding risk. Thus some will participate in dangerous sports like hang gliding, while others would not dare. Some people will take a chance on buying a used car or toaster, while others would always insist on (and pay more for) new merchandise. If surveys are correct, most drivers are willing to accept the risk of driving without seat belts—although a few would not go around the block without them. Everything else held equal, people with a strong aversion to risk will demand safer products than those who prefer to take their chances. Such differences in the willingness to assume risk may reflect differences in economic circumstances. Some believe that the demand for safer products is positively related to income. The rich are far more likely to buckle their seat belts than the poor. Even the choice of restaurants by the rich and poor may reflect different attitudes toward risk. People with low incomes patronize greasy-spoon restaurants, accepting the risk of food poisoning. They may reason that they are better off by eating cheaply than by spending more to protect their health. If all consumers were willing to accept the same degree of risk, it would be relatively easy to protect them through product standards. Government regulators would simply determine the level of risk acceptable to all, and set their standards accordingly. Of course, consumer choice would be restricted. Some ineffective or less safe products would no longer be offered for sale. In the real world, as we have observed, consumers differ in their risk aversion. Uniform standards would force those who are comparatively Chapter 4 Government Controls: How Management Incentives Are Affected 13 13 efficient in coping with risk, or who have no real aversion to risk, to buy safer products. Assuming that safety is not a free good, the cost to consumers would increase—and in economic terms, that amounts to a misallocation of resources. People who do not have children, for example, must still pay for childproof caps on drug bottles. If full liability for product safety and effectiveness were shifted to the producer, the same type of problem could develop. Again, consumers would be unable to choose their preferred level of risk. When producers assume the risk, they might decide to discontinue certain product lines to avoid lawsuits and damage claims, or they might buy insurance to cover their newly acquired risk cost, raising the price to the consumer. In effect, consumers would be forced to buy insurance against unsafe or defective products. They would no longer have the option of insuring themselves, perhaps at a lower price. The Needs of the Poor Many people support consumer protection because of their concern for the poor, who may be unable to afford the information necessary to make an informed choice. The poor may also be the least capable of understanding technical product information, and the least able to endure the losses associated with defective goods and services. Opponents of consumer protection point out that the poor often prefer to buy low-quality goods and services because they are less expensive. They pay less so they can have more of other goods and services. If less safe (but cheaper) products are removed from the shelves, then, the burden of consumer protection falls disproportionately on the poor. MANAGER’S CORNER: The Importance of Manager Incentives in the Minimum-Wage Debate Political support in Congress for another hike in the federal minimum wage is growing. Following the lead of President Clinton, who called for an increase in the minimum wage in his 1999 State of the Union message, Senator Edward Kennedy (D-Mass.) and Representative David Bonior (D-Mich.) have proposed that the minimum hourly wage be raised by $1, or from $5.15 currently to $6.15 in two steps over the next year and a half. 2 Indeed, even Republican members of Congress appear ready to press for their own increase in the minimum wage this year. Representative Jack Quinn (R-NY) has argued, “I believe it is a forgone conclusion that some type of minimum wage increase bill will be approved in this session of Congress. Rather than fight the thing and have Republicans being dragged kicking and screaming to a vote on the minimum wage, I say to my party, ‘Why not take the lead?’” 3 Other political interest groups will draw on the support of many members of Congress in their effort to defeat any proposed increase. 2 The Kennedy and Bonior companion bills would, if passed, raise the minimum wage from $5.15 to $5.65 on September 1, 1999 and to $6.15 an hour on September 1, 2000 [House, U.S. Congress, 106 th Cong., 1 st Sess., “Fair Minimum Wage Act of 1999,” H.R.325 (January 19, 1999); Senate, U.S. Congress, 106 th Cong., 1 st Sess., “Fair Minimum Wage Act of 1999,” S. 192 (January 19, 1999)]. 3 As quoted by Janet Hook, “GOP Relaxes Opposition to Minimum Wage Increase Politics: Republican Leaders Hope to Head Off Campaign. Hike May Be Tied to Tax Cuts,” Los Angeles Times, April 12, . Affected 12 12 Competition as a Form of Consumer Protection No one can reasonably expect to be protected against all the whims and exploitative efforts of. protection because of their concern for the poor, who may be unable to afford the information necessary to make an informed choice. The poor may also be