My Book Gets This Right

Greg Mankiw writes: A Common Error in Pedagogy

I happened to be flipping through another introductory economics textbook. (Yes, some people have the temerity to try to compete with my favorite textbook.) I noticed an error that is, unfortunately, all too common in how introductory economics is taught.

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The issue is how one applies welfare economics to understand price controls, such as rent control and minimum-wage laws.

The sin that this book makes is to look at consumer surplus, producer surplus, and deadweight loss as if we were studying the welfare cost of a tax. The cost of a price control, the reader is taught, is the small Harberger triangle between the supply and demand curves.

This reasoning is problematic because it assumes perfect rationing. But rationing under price controls is never perfect. Under rent control, for example, apartments do not automatically go to those who value the apartments the most. The misallocation due to imperfect rationing makes the actual welfare cost of price controls much higher than the standard deadweight loss triangle.

My book gets this right. In Chapter 12, in the section on price controls, I describe what happens when we put price controls on baseball bats. I then write:

There are two wrongs that were done here—two sources of inefficiencies. First, on the production side, too few bats got made. Second, on the consumption side, those few bats might have gone to the wrong people: a person who valued the bat at $70 might have gotten one while a person who valued it at $500 might have gone home empty-handed. [page 73]

My guess is that the second inefficiency--distributing the already scarce goods to the wrong people--is the bigger source of damage. It definitely should not be ignored when trying to assess the cost of price controls.

There is also a tertiary source of loss: time wasted in rent-seeking activities. This includes standing in lines, calling your contacts, etc. to find the artificially scarce good.

All told, price controls are the worst. Far worse than taxes.