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A Wonky Note on Price Controls and Substitute Goods

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Here’s a multiple-choice question that I wrote and included on the second exam that I gave, last month, to my Principles of Microeconomics class (ECON 103) at George Mason University:

If beer and wine are substitute goods for each other, a government-imposed ceiling on the price of beer will cause the (i) ________ wine to (ii) _______.
a. (i) demand for; (ii) increase
b. (i) demand for; (ii) decrease
c. (i) supply of; (ii) increase
d. (i) supply of; (ii) decrease
e. Trick question: Even if beer and wine are substitute goods for each other, a government-imposed ceiling on the price of beer will have no effect on the market for wine.

The correct answer is a.

The relevant rule here, as typically taught in introductory economics, is that good X is a substitute for good Y if a change in the price of good X causes the demand for good Y to change in the same direction.  For example, if a rise in the price of orange juice causes the demand for apple juice to rise, then apple juice is a substitute good for orange juice.  The intuition is straight-forward: ceteris paribus (always!), the higher the price of orange juice, the less attractive is orange juice to consumers.  Consumers purchase less orange juice at the higher price of orange juice than at the lower price of orange juice.  When the price of orange juice rises, apple juice becomes a more attractive option for consumers.  So consumers shift some of their spending to the purchase of apple juice.

The above analysis is correct, but it is not sufficiently general.  A more-accurate way to state the substitute-good relationship is the following: good X is a substitute for good Y if a change in the cost to consumers of acquiring good X causes the demand for good Y to change in the same direction.  If the monetary price of good X is flexible (mainly, not controlled by a government dictate), then it’s acceptable to assume that the monetary price of good X is the only relevant cost to consumers of acquiring good X.  Therefore, if the price of good X is flexible, then a change in the price of good X is pretty much the same as a change in the cost to consumers of acquiring good X.  And, so, the typical way of stating the substitute-good relationship is acceptable.

But if the monetary price of good X is not the only significant cost to consumers of acquiring good X, then the typical way of stating the substitute-good relationship is no longer acceptable.  Thus the exam question above.

With a government-imposed ceiling on the price of good X, there results a shortage of good X.  Good X becomes more costly for the typical consumer to acquire, despite the fact that the nominal price of good X is held down artificially by government diktat.  With a price ceiling on good X, a queue for good X will likely arise.  But whether or not a queue arises, some rationing mechanism must arise.  The reason is that when the monetary price of good X is held below the market-clearing (“equilibrium”) price for good X, the quantity of good X that consumers demand per period of time is greater than the quantity of good X that suppliers supply per that same period of time.  The price ceiling on good X causes more people than otherwise to seek to purchase good X while this price ceiling simultaneously causes suppliers to offer fewer units of good X for sale.  The result, to repeat, is that the price ceiling on good X results in good X becoming more difficult – more costly – for consumers to acquire.

It follows that if, for example, beer and wine are substitute goods for each other, then a price ceiling on beer will make beer more costly for consumers to acquire, prompting consumers to increase their demand for wine.

The careless student, however, incorrectly chooses as the correct answer b.  The careless student looks only at the nominal price of beer.  Yet, again, if the nominal price of a good is pushed lower only by diktat rather than by market forces, then that good becomes more costly for consumers to acquire despite the fact that its nominal price is lower.

A perhaps even more elementary take on this matter is to recognize simply that a price ceiling causes the quantity supplied of good X to be less than it would be absent the price ceiling.  With fewer units of good X available per period of time to consumers, consumers search more eagerly for alternatives – for “substitutes” for good X.  The demand for each good that is a substitute for good X rises.

If you still don’t buy the above analysis, consider the extreme case of a price ceiling set at $0.  Suppose, for example, the government caps the price of beer at $0.  Obviously, no beer will be brewed and made available to consumers on the market.  With such a paucity of beer, consumers will therefore increase their demands for wine, whiskey, and other beverages (or substances) that they regard to be substitutes for beer.

UPDATE: David Henderson, in a comment on this post, sensibly says that I should have specified that the price set by the price ceiling is below the market-clearing price.  He’s correct.  I did, however, tell my class in my lectures that whenever I mention a price ceiling in class or on an exam, the students are to assume that it is an ‘effective’ one – that is, that the price-ceilinged price is below the market-clearing price (and, likewise, that any price floor mentioned in class or on an exam is above the market-clearing price).

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