Bryan Caplan has a new post where he suggests that we’d be better off if firms raised prices enough to eliminate shortages. He also suggests that he does not want to raise aggregate demand. I believe his views are sensible, but I don’t entirely agree with his reasoning. Bryan suggests an analogy with price controls in a single market, and that analogy doesn’t hold in a macro context.
Here’s a graph showing the impact of price controls in a micro context:
When price controls are removed, production and consumption rise from 15,000 to 17,000, while quantity demanded falls from 19,000 to 17,000. It might seem odd that consumption should rise while quantity demanded falls, but there were 4,000 units demanded at the controlled price that were simply not available to be purchased. Phantom demand. Therefore we move from point Eo to E1 when controls are removed, and consumption rises.
Now consider what happens when firms raise prices to eliminate shortages in a macro context:
In this case, the economy moves from point b (where there is excess demand) to point c. Unlike in the microeconomic case, consumption falls after the price increase. At point c there are no longer any shortages, but people are buying fewer goods. This is because we’ve followed Bryan’s suggestion of avoiding a further increase in AD when prices rise. (He’s silent on whether to reduce AD, but he clearly doesn’t want an increase.) In contrast, in the microeconomic case the removal of price controls causes nominal expenditure in the affected market to rise. Macro is not like micro—beware of economists using analogies. Here’s Bryan:
The reason why we need more inflation is simple: ubiquitous shortages. This problem isn’t merely on the news; at this point, something I want to buy is unavailable practically every day. Pre-Covid, that would have happened roughly one a month.
So what? Well, as any standard econ text tells you, shortages exist because at the current market price, the quantity demanded exceeds the quantity supplied. To solve these shortages, we need market prices to rise. This discourages consumption and encourages production until everything you want is conveniently available. Like in the good old days before Covid.
Actually, removing price controls encourages consumption, by making goods more available. (It reduces quantity demanded, but increases quantity purchased.)
I suspect that Bryan believes that if retailers raised prices to eliminate these annoying shortages, he’d end up buying more goods. And that might be true, especially if Bryan is much richer than the average American. But if prices rise while aggregate demand (NGDP) remains unchanged, then output will necessarily fall. The average American will buy fewer goods. That still might be a good thing, as shortages cause a loss of utility in all sorts of subtle ways not picked up in the government’s real GDP data. Nonetheless, the microeconomic analogy that Bryan uses doesn’t really apply to the macro case.
PS. The AS/AD graph I used here is not optimal for making my point. A better graph would have shown no initial change in either AD and SRAS, with LRAS shifting left during Covid. Then firms raise prices to move the economy up and to the left to the new (reduced) LRAS, eliminating shortages. SRAS moves left. The big problem today is unusually low LRAS, not unusually high AD. But the basic point is the same; holding AD constant, eliminating shortages with higher prices means reducing output. That’s very different from the effect of removing a price ceiling in a single market.