A Theory of Price Control
Steven N. S. Cheung
Journal of Law and Economics, Vol. 17, No. 1. (Apr., 1974), pp. 53-71.
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A THEORY OF PRICE CONTROL*
STEVEN N . S. CHEUNG
University of Washington
PRICEor rent control is but one of many forms of legislative action which
interfere with private contracting in the market place. To delimit the scope
of my analysis, I shall use the term "price control'' to refer only to any set of
regulations which satisfies the following three conditions. First, the control
must fix the price (or income)l terms of private contracts; this categorically
excludes any laws which regulate the distribution of income among the con-
tracting parties on a share or percentage basis2 Second, the control must
involve no appropriation of proceeds to or from the government; taxation
and subsidization are thus excluded. Finally, the fixing of price must not be
associated with direct government sales, purchases, or manipulation of re-
sources so as to maintain the regulated price;3 by this stipulation, price
"support" is also excluded. Even on such terms, legal regulations to control
price are still many and varied.
To evaluate our understanding of the class of phenomena which we seek
to explain i t is essential that we discover implications refutable by facts. By
this criterion the available body of economic theory pertaining to price
control is deficient indeed: the massive literature on the subject offers few
such implication^.^ An alternative approach to analyzing the observable
effects of price control is presented here.
*This paper stems from an elaborate investigation of the various phases of rent control
in Hong Kong from 1921 to 1972. Thanks are due to Yoram Barzel, R. H. Coase, Harry
Johnson, Michael Rahm and A. A. Walters for their comments, and to the National
Science Foundation for supporting my research in the general area of contracts.
1By income terms of contracts I refer here to the terms of payments designed to
stipulate the distribution of income (or wealth) among the contracting parties. We will
discuss this further later.
2 Regulation on a percentage basis may be imposed on commission rates, dividends, or
the sharing percentage of a share contract. Because these control a parameter without a
dollar dimension, the associated analysis is simpler. See, for example, Steven N. S.
Cheung, The Theory of Share Tenancy, chs. 5 & 6 (1969).
3For example, we exclude such situations as maintaining a regulated taxicab fare by
restricting the number of medallions, or supporting the pegged price of corn by restricting
the amount of land devoted to its cultivation.
4 There are, however, economic studies which deal with the social desirability of price
control and others which estimate the effects of price control. These writings may indeed
THE JOURNAL OF LAW AND ECONOMICS
Demand and supply schedules are conceptual tools which restrict the
maximum quantities of a good individuals are willing to buy or sell a t varying
prices. With all the underlying qualifications, we are able to arrive a t situa-
tions where the observed prices and quantities transacted are said to be
determined and where these in turn determine income distribution and resource
allocation. As a corollary, specified changes in demand and supply conditions
will lead to implied changes in the transacted prices and quantities. But as
they stand, these conceptual tools are not equipped to handle a situation
where the price which they are designed to determine is controlled.
As an illustration, consider a case where the $10 market price of a theater
ticket is reduced by law to $6. A "shortage" is then said to exist, and the
plausible effects are many. Available tickets might be allocated by a wide
variety of methods including waiting in queue, "friendship" with the ticket
seller, different forms of rationing, or even physical violence. Alternatively or
concurrently, "black" markets of various shades might emerge, the quality of
the show might be allowed to deteriorate in a number of ways, or as still
another possibility the curtain might go down altogether. Any of these
events, or combinations of events, would be consistent with a shortage. But
what observation can refute that "shortage" hypothesis? None! If, for
example, we observe that queues are not longer or even shorter under the
control, the existence of a "shortage" is not necessarily falsified. Nor does
the hypothesis contain the weaker, but still useful, type of implication which
states that the control will lead to a restricted set of events, since the list of
events feasible under a shortage is prohibitively long. A theory potentially
consistent with everything explains nothing.
I t is frequently said that under price control the market will not clear. A
market exists whenever a transaction is made between two or more indi-
viduals, and the terms need not be confined to a monetary price. I t is true
that price control may generate a different criterion, or a combination of
criteria, such as allocation by waiting, by seniority, by height, or by strength.
Yet given whatever criterion of allocation, and that market transactions con-
tinue to exist under the control, the market will necessarily clear in the sense
be of interest in contributing to our knowledge of price controls in general. For a few
examples see Seymour E. Harris, Price and Related Controls in the United States (1945) ;
William D. Grampp, Some Effects of Rent Control, 16 So. Econ. J. 425 (1950) ; D. Gale
Johnson, Rent Control and the Distribution of Income, 41 Am. Econ. Rev. No. 2, at 569
(Papers & Proceedings, May 1951); J. L. Carr, Rent Control and Housing Policy, 64
Econ. J. 25 (1954) ; John Sbeahan, Problems and Possibilities of Industrial Price Control:
Postwar French Experience, 51 Am. Econ. Rev. 345 (1961); Ira S. Lowry, Joseph S.
DeSalvo & Barbara M. Woodfill, 2 Rental Housing in New York City (New York City
Rand Institute, 1971).
A THEORY OF PRICE CONTROL 5 5
that the quantity demanded will equal the quantity supplied. The simple
mechanism will be illustrated later. I t is also true that price control may
cause changes in the quality of the good transacted or that transactions which
would have occurred in a free market now cease to occur. Again, in any case
the market will necessarily clear. Even if we take the extreme case where
transactions in a particular good are completely eliminated by the price
control, the "clearing" of the market is identical to that of any other in which
trading ceases: given the constraints the contracting parties no longer find
any transaction of the good worthwhile. In each of these cases, previous
theory is incapable of predicting which of the alternatives will occur, but to
say that the market "does not clear" is simply to sidestep an unresolved
question.
I n an analysis where price control is said to result in "disequilibrium,"
refutable implications are absent. Merely to say that the price of a good or
the rental value of a property is by law set above or below the market price
is not sufficient to produce any predictable outcome. When additional con-
straints are specified, however, behavior becomes more restricted. To inter-
pret the effects of price control, as to interpret any economic behavior, the
specified constraints must be rigid enough to yield implications refutable by
facts.
Some writers on price control, apparently perceiving the futility of treat-
ing the problem in terms of ('disequilibrium7" have met the issue by assuming,
implicitly or explicitly, some given constaints sufficient to yield an equilibrium
~olu t ion .~Since they failed to investigate actual constraints, their imaginary
restrictions were devoid of empirical content and have produced hypotheses
interesting only as intellectual exercises and incapable of explaining real-
world phenomena. If certain outcomes are to be attributed to the control, the
constraints specified must conform essentially to those in real practice. Given
the usual complexity of any effective price control, and that one control
usually differs from another, it is highly unlikely that the actual constraints
can be guessed correctly. Furthermore, the use of imaginary constraints will
easily lead to ad hoc theorizing. The imposition of a particular set of con-
straints, if sufficiently comprehensive, will naturally yield a particular set of
implications. But it is always possible to pick and choose among these con-
For a few examples of such works, see K. E. BouIding, A Note on the Theory of the
Black Market, 13 Can. J. Econ. & Pol. Sci. 115 (1947) ;M. Bronfenbrenner, Price Control
Under Imperfect Competition, 37 Am. Econ. Rev. 107 (1947) ; id., Price Control Under
Imperfect Competition: The Joint Production Problem, 15 Can. J. Econ. & Pol. Sci. 210
(1949); Michael Michaely, A Geometrical Analysis of Black Market Behavior, 44 Am.
Econ. Rev. 627 (1954); Emre Gonersay, The Theory of Black Market Prices, 33 Eco-
nornica 219 (n.s. 1966) ; and J. R. Gould & S. G. B. Henry, The Effects of Price Control
on a Related Market, 34 Economica 42 (ns. 1967).
5 6 THE JOURNAL OF LAW AND ECONOMICS
straints so that, when confronted with adverse evidence, a favorite hypothesis
can be salvaged by altering or further specifying the constraints involved.
The central problem in interpreting the effects of price control is therefore
the one common to all empirical economic inquiry. On the one hand the
specification of constraints requires an investigation of the real-world situa-
tion; on the other, the investigation itself must be guided or restricted by
some theoretic framework. The latter condition is essential in the inevitable
process of sorting out the relevant constraints from the irrelevant, the signifi-
cant from the insignificant, so that the consequent effects subject to refuta-
tion can be restrictively implied. In other words, a theoretic framework which
restricts our freedom in choosing and simplifying the constraints is essential
to guard against ad hoc theorizing, or letting the facts speak for themselves.
The necessity of a theory to govern the investigation and specification of
constraints appears to be more imperative in the case of price or rent control
than with other forms of government regulations. To fix the price terms of
market contracts by law while not setting any standard rules to govern the
appropriation of proceeds and allocation of resources leaves a wide-open
range of constraints that may be relevant for decision making. Effective price
controls vary from time to time and from place to place, they entail immense
bodies of regulations and administrative enforcements, and they involve con-
straints on behavior not limited to legal provisions. Furthermore, as with any
empirical inquiry, no study of finite length could possibly incorporate in
detail all the relevant constraints. Simplification is necessary, but the greater
the simplification, the fewer and less specific will be the derivable implica-
tions. While the emphasis and the abstraction of constraints are left to the
discretion of the economist, his selection must be consistent with a given
theoretic framework.
The theory of price control offered here is, therefore, not intended to ex-
plain the effects of any specific control. Rather, i t sets forth some general
propositions about the way in which the constraints relevant to any price
control may be investigated. These propositions, in turn, are restricted by
the requirement of conformity to standard economic principles.
11. Two GENERAL FOR PRICE CONTROL PROPOSITIONS ANALYSIS
As noted earlier, price control restricts the income terms of private con-
tracts. The right to contract implies that the resources involved are, a t least
to some degree, exclusively owned. I t is, therefore, pertinent to derive our
propositions through an examination of some aspects of property rights and
contracting.
An economic good embodies a set of characteristics subject to legally or
A THEORY OF PRICE CONTROL 57
customarily defined limits. A good or an asset is "private property" if, and
only if, three distinct sets of rights are associated with its ownership. First
is the exclusive right to use, or to decide how to use, the good; this may be
viewed as the right to exclude other individuals from its use. Second is the
exclusive right to receive income generated from the use of the good. Finally,
the right to transfer, or freely alienate, its ownership to any individual the
owner sees fit includes the right both to enter into contracts with other
individuals and to choose the form of such contracts. Within the realm of
economic principles, these rights are specifically interrelated. A restriction
imposed on the right to receive income, as in the case of price control, will
yield predictable changes in behavior in the exercise of the other two sets
of rights.
By postulate, each individual will utilize his private property in such a
way as to generate the highest real income. He may either employ the good or
the resource himself in what he believes to be its most valuable use: or enter
into contractual arrangement with another individual to attain this use. Given
the distribution of wealth and the portfolios of asset-holdings chosen by
individuals, much is to be gained from forming contrack7 Thus, the value of
a good will decline either if its most valuable use is restricted, or if its trans-
ferability, in one way or another, is constrained by law. A free market, by
definition, requires not only the absence of legal regulation on contractual
terms but also the absence of restriction on the choice of contracts.
In making a contract, the owner of a good forgoes some or all rights to its
use in exchange for income. Depending upon the form of contract chosen, the
distribution of income may not be stated in terms of a unit price, but price
control is applicable to any contract so long as the income receivable by one
or more of the contracting parties is regulated to a fixed amount. While every
contract necessarily entails an agreement on the distribution of income (or
wealth), not all contracts stipulate the use of the resource itself. When a
good is transferred outright under caveat emptor in return for full and
immediate payment, no such restrictions will be present. However, other
contracts (such as for wages or rental) involve only a transfer of some of the
use rights to a good for a period of time. Containing implicit or explicit use
6 No distinction is made here among a good, an asset, a resource, or a factor of produc-
tion, so long as they satisfy the definition of an economic good.
?The gains from contracting are a complicated subject. For our present purpose it is
sufficient to recognize that such gains exist. For fuller discussions see R. H. Coase, The
Nature of the Firm, 4 Economics 386 (n.s. 1937) ; id., The Problem of Social Cost, 3 J.
Law & Econ. 1 (1960) ; Steven N. S. Cheung, Transaction Costs, Risk Aversion, and the
Choice of Contractual Arrangements, 12 J. Law & Econ. 23 (1969); Armen A. Alchian
& Harold Demsetz, Production, Information Costs and Economic Organization, 62 Am.
Econ. R&. 777 (1972).
58 THE JOURNAL OF LAW AND ECONOMICS
stipulations that vary with the physical attributes of the good and with the
form of contract chosen, such a contract will involve a structure and will
exist over a period of time.8 A price control which regulates a contract of
this nature (as in the case of rent control) acts on the flow of income. Let us
turn to our first proposition.
Proposition 1: When the right to receive income is partly or fully taken
away from a contracting party, the diverted income will tend to dissipate un-
less the right to it is exclusively assigned to another individual. The dissipation
of non-exclusive income will occur either through a change in the form of
using or producing the good, resulting in a decline in its value, or through a
change in contractual behavior, resulting in a rise in the cost of forming and
enforcing contracts, or through a combination of the two.
Under the postulate of constrained maximization, the loss of exclusive
right to receive income from the use of a good will lead to the same sort of
behavior as though the right of use were non-exclusive. That is, the individual
will not exercise his prerogative because he is denied the right to income from
the use. He will have no incentive to contract with others and to stipulate the
use of a good or a resource if he cannot derive any exclusive income from that
contract. Furthermore, he will have no incentive to use his resource as if it
were private property, or to exclude others from its use. For example, if all
income-pecuniary or nonpecuniary-derivable from a privately owned fish-
ing ground is effectively reduced to zero, although the use rights remain
exclusive, its utilization will be identical to that of another fishing ground
lacking exclusive-use rights. By parallel reasoning, a partial attenuation of
the exclusive right to receive income will operate in the same way as a partial
attenuation of the exclusive right to use.
Before we discuss why price or rent control will generate non-exclusive
income, i t is helpful to consider the fairly familiar thesis of the dissipation of
"rent" for a "common" property resource, frequently exemplified by the
case of a f i ~he ry .~ If no one holds exclusive rights to use a resource, the thesis
8That some contractual stipulations are not stated, either orally or in writing, poses
another issue which will not be elaborated here. While the presence of contracting costs
will lead to omissions of stipulations, common laws or customs will avoid the necessity of
setting forth many terms which would otherwise be explicitly stated. For a fuller dis-
cussion of a structured contract, see Steven N. S. Cheung, The Structure of a Contract
and the Theory of a Non-Exclusive Resource, 13 J. Law & Econ. 49 (1970):
9 An early major contribution to this thesis is in Frank H. Knight, Some Fallacies in
the Interpretation of Social Cost, 38 Q.J.Econ. 582 (1924). The extension of the Pigou-
Knight example from that of two roads to that of a hhe ry is seen in H. Scott Gordon,
The Economic Theory of a Common Property Resource: The Fishery, 62 J. Pol. Econ.
124 (1954). The mechanism of the dissipation of rent is discussed in Cheung, supra note
8.
A THEORY OF PRICE CONTROL 59
tells us, any rent which would have accrued from its exclusive use will be
dissipated
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