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Government price caps DO NOT cause market distortions.

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gocrew Posted: Fri, Mar 16 2012 1:44 PM

 

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It is argued by, among others, members of the Austrian School of Economics that a government-imposed price cap has distorting effects on the market. It is no such matter, as I shall demonstrate below.

Let us consider a hypothetical example to see how market distortions are largely, though not entirely, avoided when government imposes a price ceiling. Say that tomatoes are fungible, just to make things easy, and that the market rate for a tomato is $1.00 per unit. Imagine that government orders that no tomato shall sell for more than $0.50. Austrians would leap to the conclusion that there would be an overconsumption of tomatoes, but as we shall see, this is quite impossible.

The reason that few distortions are felt from a government price ceiling is that the consumers have rational expectations. They know the government has set the legal price below the market price. They therefore know that they must reduce their consumption below what it would be if the market price were $0.50 per unit. Since it is well known that the market price brings supply and demand into equilibrium, then the purchases of tomatoes at any time, in order to imitate the consumption at the market rate, must equal the supply of tomatoes ready to be sold.

All consumers have to do, in other words, is count how many tomatoes are up for sale and coordinate their activities so that no more than this total quantity is demanded, and see to it that what demand there is come only from those who would have made the purchase at the price of $1.00, and at the exact quantity these same purchasers would have demanded.

How is this to be accomplished? Consumers are no strangers to coordinating massive numbers of market participants. Before the government imposition, this was done every day, in a decentralized fashion, by means of price. However, we must grant that since the price is now artificial, this will no longer serve as a means of efficiently coordinating consumer activity. In order to prevent market distortions from government interventions, we must use Skype.

During the seven billion person Skype conference, the event organizer, let’s call him Byron Lapcan, must require that everyone give an account of how many tomatoes they were going to sell before the price ceiling (since we are talking about a single government’s price ceiling, we must only know who would have sold tomatoes in that particular jurisdiction and in what quantity). Once this is tallied, we will know how much consumption must be. Now it is only a matter of determining which individuals would have purchased tomatoes at $1.00, and how many each would have purchased. This will require absolute honesty on the part of everyone involved, so Byron will require consumers, all seven billion of us, to pinkie swear at the outset of the conference call.

This method is pretty much foolproof. Once pinkie sworn, the Earth’s populace will be honest about what they would have done under a market price, and it’s not like there is a small percentage of them who would answer honestly but be mistaken, just because in going to the tomato seller they might have been distracted by another product and changed their mind at the last instant. It is also unthinkable that, say, the owner of an Italian restaurant on the verge of going out of business would take the opportunity to sneak in an order of tomatoes at a reduced price to help his bottom line and perhaps preserve the one hundred year old restaurant bequeathed to him by his father which he has nearly run into the ground. No one will break ranks once they have joined the Brotherhood of the Oath of the Diminutive Digit.

There is still a little left to be accomplished, because those tomato purchasers are not allowed to pay more than half a buck for their fruit, which leaves them with too much change left over. Mr. Lapcan will therefore institute a policy whereby tomato buyers agree to purchase a smile from the tomato sellers, one per tomato, at the price of $0.50 per unit. Thus, the same number of tomatoes exchange for the same amount of money, and the same individuals are involved in the same transactions, with the small addition of a showing of the pearly whites.

We can now see how no government interference in decentralized market regulators could ever produce large distortions. Tomato buyers will still have all the tomatoes they would have had, and tomato sellers have all the money they would have had. Demand for tomatoes does not surge, nor does supply of tomatoes drop. This means that demand for the factors of production in the tomato industry remains the same as well, and no black markets need emerge. All we have are some extra smiles and a certain amount of time, energy and resources spent on Skype. I suppose it is conceivable that tomato sellers will purchase a bit more floss in preparation for the new program. Not perfect, perhaps, but nothing to be unduly worried about.

The ramifications of the insights of rational expectations should not be underestimated. Once we realize that a Skype call can mitigate or even completely annul distortions produced by government interventions, even the mighty Austrian Theory of the Business Cycle is seen to be of no great concern. After all, if consumers can coordinate to precisely offset the effects of a price ceiling, why shouldn’t entrepreneurs be capable of something similar when lendable funds are created out of nothing?

Skype does not discriminate.

The previous essay was fictional. Any similarities to real people, living or dead, is purely a coincidence. Furthermore, no Bryan Caplans were harmed during the writing of this essay.

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Nice.

My humble blog

It's easy to refute an argument if you first misrepresent it. William Keizer

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Took me way too long to realize the sarcasm. 

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Wheylous replied on Fri, Mar 16 2012 8:00 PM

Byron Lapcan

Totally a reference to Bryan Caplan :P

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gocrew replied on Fri, Mar 16 2012 11:29 PM

Smiling Dave:
Nice.

Thank you!

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gocrew replied on Fri, Mar 16 2012 11:29 PM

NonAntiAnarchist:
Took me way too long to realize the sarcasm. 

Probably not. It was not supposed to be obvious early on.

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gocrew replied on Fri, Mar 16 2012 11:30 PM

Wheylous:
Totally a reference to Bryan Caplan :P

I hadn't noticed the similarity. ;-)

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John James replied on Sat, Mar 17 2012 12:47 AM

gocrew:

Wheylous:
Totally a reference to Bryan Caplan :P

I hadn't noticed the similarity. ;-)

(Just in case you're not being sarcastic) http://en.wikipedia.org/wiki/Anagram

 

I'm pretty sure that's precisely the moment a reader was supposed to realize where the story was going.

What I want to know is what exactly the purpose of this piece was.  Is the author making a dig at some specific claim Caplan made, or is this just about rational expectations in general?

 

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gocrew replied on Sat, Mar 17 2012 12:25 PM

John James:
(Just in case you're not being sarcastic)

LOL. I was.

John James:
I'm pretty sure that's precisely the moment a reader was supposed to realize where the story was going.

Either that or the assertion that mass coordination can be done by means of Skype.

John James:
What I want to know is what exactly the purpose of this piece was.  Is the author making a dig at some specific claim Caplan made, or is this just about rational expectations in general?

Caplan argued against the validity of ABCT by means of rational expectations. How could increasing the money supply and lowering the interest rate cause a boom/bust, he argues, if entrepreneurs know that lendable funds are being created out of nothing. The point of the piece was to show that simply knowing the central bank was doing this does not mean that entrepreneurs can act in a coordinated fashion to precisely nullify its effects, something I am sure he would understand if the topic were price caps and consumers.

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Andrew replied on Sun, Mar 18 2012 3:50 AM

Thank you for pointing out the absurdity of the rational expectations argument vs. the ABCT.  Bryan Caplan's argument was just begging for a reductio ad absurdum.  

What I can't understand is how could Bryan Caplan actually believe what he's saying?  But then again, how can Keynenians believe, like Krugman, that endless spending is the solution to literally every economic problem known to man?  

I understand how their theories are wrong, I just don't understand how they can possibly believe them while at the same times show signs of intelligence - such as basic motor skills.  

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gocrew replied on Sun, Mar 18 2012 9:01 AM

Andrew:
What I can't understand is how could Bryan Caplan actually believe what he's saying?

Yeah, that's what I find so confounding. I've read him before when he has made some great comments with some keen insights. He's a solid libertarian, from what I have read, and it's not as if he is clueless when it comes to economics. The scenario with the price caps is not different, in any important way, from the scenario he posits for businessmen.

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