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ne of the most important issues to Americans is how to manageprescription drug prices, especiallyfor seniors who depend on Medicarecoverage. Some policy advocates areurging the federal government to con-

tract directly with drug manufacturers to purchase drugs forseniors – at prices set by the government. Despite the high-minded intentions of these advocates, such price controlscould be very harmful to Americans’ future health.

When prices are held below natural levels, resourcessuch as talent and investor capital leave an industry to seeka better return elsewhere. This means that there will beless discovery and innovation, and fewer new drugs willbecome available to consumers. Often this change hap-pens over the long term — longer than the tenure of any pol-icymaker. Thus, it is vitally important to remind policy-makers of the effects of price controls whenever they areproposed as government policy.

DISRUPTING SUPPLY AND DEMANDthe determining of market prices through thedynamic interaction of supply and demand is the basicbuilding block of economics. Consumer preferences for aproduct determine how much of it they will buy at anygiven price. Consumers will purchase more of a product asits price declines, all else being equal. Firms, in turn, decidehow much they are willing to supply at different prices. Ingeneral, if consumers appear willing to pay higher prices for

a product, then more manufacturers will try to produce theproduct, will increase their production capacity, and willconduct research to improve the product. Thus, higherexpected prices lead to an increased supply of goods. Thisdynamic interaction produces an equilibrium market price;when buyers and sellers transact freely, the price that resultscauses the quantity demanded by consumers to exactlyequal the supply produced by sellers.

But when government adopts a price control, it definesthe market price of a product and forces all, or a large per-centage, of transactions to take place at that price insteadof the equilibrium price set through the interaction betweensupply and demand. Since supply and demand shift con-stantly in response to tastes and costs, but the governmentprice will change only after a lengthy political process, thegovernment price will effectively never be an equilibriumprice. This means that the government price will be eithertoo high or too low.

When the price is too high, there is an excessive amountof the product for sale compared to what people want. Thisis the situation with many U.S. and European farm pro-grams; government, in an effort to increase farm incomes,purchases the output that consumers do not want. This, inturn, prompts farmers to raise more cows and convertmore land to pasture or cropland. However, the higherprices discourage consumers from buying farm products,causing an excess of supply (e.g. a “butter mountain”). Gov-ernment then exacerbates this situation by continuing topurchase the excess crop at the set price.

Serious problems also result when government setsprices below the equilibrium level. This causes consumersto want more of the product than producers have avail-able. When the federal government restricted gasoline price

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History shows that these policies lead to shortages and stagnation;

so why do we want to control prescription drug prices?

The Problems of Price Controls

OB y Fi o n a M . S c o t t M o r t o n

Yale University

Fiona M. Scott Morton is an associate professor of economics and strate-gy at Yale University. Her academic interests include global competitivestrategy, E-commerce, and strategic management. She can be contactedby E-mail at fiona.scottmorton@yale.edu.

increases in the 1970s, long lines formed at gas stationsand only those motorists who waited long hours in linereceived the scarce gasoline.

In both cases of government price controls, serious wel-fare loss results because not enough of the good is sold. Thewasted chance to create both producer and consumer sur-plus from those sales is known as ‘deadweight loss’ becauseit is income that is lost forever. In addition to creating dead-weight loss, an artificially high price transfers profits fromconsumers to producers; these rents are often wastedbecause producers spend them on lobbying and other influ-ence activities to maintain the regulated price. In the case ofa low price, producers transfer profits to consumers. Con-sumers, in competing for a limited amount of the controlledproduct, may waste as much as they gain from getting it ata low price. For instance, the people who waited in the 1970sgas lines probably shouldered as much cost from the lost timequeuing as they saved from the price controls on gasoline.(Researchers Robert Deacon and Job Sonstelie have evenargued that the gas lines cost consumers morethan they saved from the controlled gas prices.)Thus, the artificially low prices not only hurt pro-ducers, but also consumers.

PRICE CONTROLS AND HISTORYgovernment gains favor with votersand constituents when it lowers the price ofpopular goods. Government also gains favorfrom lobbyists and firms when it raises pricesto promote the health of the industry. Giventhese benefits to policymakers, it should notsurprise us that price control is common inthe history of western economies.

Bread and revolution Early twentieth centuryeconomist Henry Bourne documented the

effects of price controls on France in the years followingthe French Revolution, when city residents found it dif-ficult to purchase grain. The grain shortages were not dueto any agricultural problems; Bourne noted that 1793France was a prosperous agricultural nation capable offeeding itself. Instead, the threat of famine was due tointernal procurement and distribution problems creat-ed by the government. For example, agents for the cityof Paris, the military, and the government competedwith each other in trying to purchase grain. This creat-ed local shortages where none had existed before, and ledto social unrest.

The city of Paris, in an effort to appease the public,decided to subsidize flour. This prompted bakers fromneighboring towns to travel to Paris to purchase flour, cre-ating even more shortages in the city.

The French Convention, which governed the nation atthat time, tried to address the problem by establishing max-imum prices for grain and instructing farmers to supply it

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THE COST OF CONTROLS: Motoristswait in line to purchase price-controlled gasoline.

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BREAD AND REVOLUTION: French women march on Versailles, 1789.

to local markets. As one might expect, farmers did not coop-erate with the new law. Markets were empty of grain; furthershortages developed; official tallies of grain supplies failedto find and keep track of stocks; urban riots continued.

The Convention passed another law later in 1793extending maximum prices to other essential supplies.Those price controls, in combination with governmentrequisitioning and corruption, created chaos in the Frencheconomy. Merchants responded by reducing the quality oftheir goods and the black market blossomed, Bourne noted.“It was the honest merchant who became the victim of thelaw. His less scrupulous compeer refused to succumb. Thebutcher in weighing meats added more scraps thanbefore…other shopkeepers sold second-rate goods at themaximum [price].... The common people complained thatthey were buying pear juice for wine, the oil of poppies forolive oil, ashes for pepper, and starch for sugar.”

Twentieth century examples The last century providedmany examples of price control-generated economicproblems in communist Europe. Economist David Tarrnoted some of these problems in his study of the distrib-ution of domestically produced television sets in com-munist Poland. Because the Polish government kept TVprices artificially low, demand far outstripped supply andtelevisions became scarce. A consumer who wanted a TVhad to sign on to a waiting list. In most cases, the consumerhad to visit the store every day to keep his place on the list.Tarr calculated that the social cost of the queue for tele-vision sets was 10 times the size of the standard dead-weight loss and that the cost of the price controls on tele-visions to the Polish economy was more than theindustry’s total sales.

In the 1980s, the Ministry of Finance in Japan regulat-

ed brokerage fees and prohibitedfirms from competing for cus-tomers on that basis. However, asdocumented by economists KevinHebner and Young Park, large cor-porate customers were very impor-tant and lucrative for the securitiesdealing industry. The industryfound other, possibly corrupt, waysto compete for corporate business.Securities firms would guaranteecorporate investors that certainfunds would achieve a minimumreturn, effectively reimbursing theclient if the investment declined invalue. Securities companies fund-ed this expensive practice with prof-its earned from the government-fixed charge for brokerage servicesto both small and large customers.Hence, the securities firms turnedthe price control scheme into atransfer scheme that moved

resources from household savers to large corporateinvestors.

If government prevents firms from competing over price,firms will compete on whatever dimensions are open to them.In the era of U.S. airline regulation when the Civil AeronauticsBoard set prices, airlines tried to attract customers with food,empty seats, and frequency of flights. This form of competi-tion can be as expensive as competing on price. Despite highprices and protection from new entrants, established carrierscompeted away their rents and did not earn high profits.

PRICE CONTROLS TODAYdespite this worrisome history of price controls,government continues to follow the practice. In some cases,government disguises these policies with elaborate pricingschemes, but they still lead to serious problems for producersand consumers.

Rent Control Rent control provides a classic example of thedistortions created by price controls. There are variousforms of rent control, but they all take the shape of legallyimposed below-market rates for rental housing. The resultsare well documented and perverse. First, a shortage of rentalunits arises as landlords become less interested in renting atbelow-market rates. Instead, the landlords choose to live inthe units themselves, rent them to relatives, or sell them.

This shortage leads to a host of related distortions. Forexample, since there is a queue of people willing to rent eachapartment and landlords are not permitted to discriminatebased on price, the landlords will discriminate on whatev-er characteristic they please. Landlords may also ask forunder-the-table payments from tenants or require rentersto hand over an initial fee in order to sign the lease. More-over, landlords have little incentive to maintain apartments;

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SOVIET CONTROL: Russian

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queue to purchase bread.

it is more difficult to recoup the cost of improvementsthrough the government-established price and, at the sametime, there is a strong demand for apartments regardless oftheir condition. Consequently, the quality of housing stockdeclines and the area may come to attract less affluent res-idents. This hurts neighborhood businesses. New housingstock is less profitable to construct if government controlsrental prices; thus fewer investors will engage in that activ-ity and economic development will slow.

Medicaid and drugs In 1990, the federal government passedlegislation setting new price levels that state governmentswould pay for pharmaceuticals provided by Medicaid. Therules varied across drugs, but in some cases Medicaid wasentitled to pay no more than the lowest price that the drugcompany charged to any other customer.

Such a scheme may sound reasonable, but it distortsincentives in the drug market. Medicaid uses the existing net-work of chains and independent pharmacies to distributedrugs to its members, but many of these organizations donot have the scale to bargain for good prices nor the con-trol to influence the prescribing physician. In these cir-cumstances, they would not nor-mally get the lowest price in themarket; that goes to large buyersand hmos or others who can“move market share.”

Faced with having tocharge Medicaid the low-est price given to any othercustomer, pharmaceuticalfirms reduced discounts.The legislation resulted in anincrease in drug expendituresfor many private buyers as drugmanufacturers tried to raise prices ongovernment sales.

MARKET FAILUREone of the reasons that governments invoke price controlsis to ensure that goods and services are sold at a ‘fair’ price. Ina situation with numerous well-informed consumers pur-chasing from multiple sellers who can develop a reputationfor high or low quality, the free market works well. The mar-ket price is ‘fair’ due to the competition between innovatorsand between buyers. However, there are occasions whenentrants are discouraged or the information available to oneor more parties is poor.

In such cases, government may impose price controlsin an effort to protect citizens from exploitation. This mightoccur if patients had to choose drugs without the help ofphysicians, for example. In such a case, patients might needgovernment protection from high prices for the wrongmedicine. Our modern healthcare system largely removesthis concern by employing informed physicians, pharma-cists, and formulary committees who affect drug choice.

Early Puritan communities, described in Hugh Rockoff’sbook Drastic Measures: A History of Wage and Price Controls in theUnited States, abandoned detailed wage and price controlsshortly after imposing them in 1630 and 1633 because theywere ineffectual. Subsequent laws against “excessive” priceswere more vague and, according to Rockoff, aimed to prevent“sales influenced by fraud, ignorance, or short-run monop-olies…rather than lowering the equilibrium price in a par-ticular market.” His interpretation is that the Puritans facedunderdeveloped colonial markets and so “competition couldnot be relied upon to regulate prices and protect consumers.”

A market failure, such as lack of entry, can be mitigated withthe right price control, at least in theory. The difficulty lies inthe execution. Typically, no entity is well informed enough tobe able to exactly identify the imperfection, choose the correctprice to rectify the situation, and then provide ongoing adjust-ment and enforcement. Competition is a better tool than pricecontrols for protecting consumers; the Puritans appear tohave realized that and gradually ceased using them. As Rock-off writes, “One would expect that as markets grew, produc-ing a smoother flow of information…the need for regulationwould have decreased. Indeed, that seems to have happened.”

More typically, governments try to fix the bad effects ofprice controls with subsidies to the discouraged activity. Inthe case of the pharmaceutical industry, these subsidies goto research and development. A subsidy could restore thefree market outcome by lowering the cost of research.Again, however, the difficulty arises in choosing the level ofthe subsidy, deciding whether and how to award it to for-profit corporations, and avoiding inefficient lobbying andcorruption. In practice, these are very difficult issues tomanage in a way that benefits consumers.

LOWERING PRICES THROUGH THE MARKETthe private sector has found several successfulmethods for reducing the price paid by a buyer. In most cases,government can use similar techniques to get a low price forprescription drugs without disrupting the competitive market.

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“The market price of any particular commodity, though it maycontinue long above, can seldom continue long below itsnatural price. Whatever part of it was paid below thenatural rate, the persons whose interest it affected wouldimmediately feel the loss, and would immediatelywithdraw either so much land or so much labor, or so

much stock, from being employed about it, that the quanti-ty brought to market would soon be no more than sufficient

to supply the … demand. Its market price, therefore, would soonrise to the natural price. This at least would be the case wherethere was perfect liberty.”

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— Adam Smith, The Wealth of Nations

Buying in bulk The most common approach is to takeadvantage of scale. A buyer representing a large volume ofmarket transactions can negotiate for a better price bythreatening to backward integrate or to move its businessto a competing supplier (if the product is not patent-pro-tected). Moreover, a large buyer provides efficiencies to theseller. Lower transaction costs (one invoice, one negotiation,one shipment), guaranteed volume, and economies of scalecreate cost savings for the supplier that the two parties canshare. The private sector provides countless examples of thisapproach; for example, big supermarket chains pay lowerprices for packaged goods than corner stores because oflarge-scale central purchasing.

A slightly more subtle point of relevance to the phar-maceutical industry is that a buyer with significant volumecan often get an even lower price by helping its supplierincrease market share. Insurance organizations can agree toeducate or encourage physicians to prescribe a certain drug.In return for altering market share in the provider network,the drug manufacturer offers the provider a lower price.

Foster Competition A buyer can explicitly foster competitionwhere none exists. For example, several large corporations inthe Detroit area recently began funding a small, low-cost air-line named Pro Air that operates out of that airport. TheDetroit airport is otherwise dominated by Northwest Air-lines, which charges relatively high prices due to the lack ofcompetition. General Motors, Masco, and Daimler-Chryslereach pay Pro Air a fixed sum of money per month in exchangefor a certain number of flights for their employees. This givesthe start-up airline stability and causes its competitors torealize that it cannot be driven out of business. By encourag-ing the entry and survival of a low-cost competitor to North-west Airlines, the companies save both on the flights theiremployees take on Pro Air and also through any price reduc-tion Northwest undertakes in response to the competition.

Information Another way to obtain lower prices through themarket is for an independent organization to provide infor-mation on the competing alternatives to individual buyers.Using this information, an informed consumer can identifythe product that best fits her needs and can demand a dis-counted price when purchasing a different product. Manylarge corporations take this approach with health plans foremployees; the employee may choose among a set of approvedplans and the corporation provides ratings or a scorecard tohelp employees compare the plans. The ratings cause plans tocompete for customers on the price and quality dimensions.

CONCLUSIONthe imposition of price controls on a well-functioning, competitive market harms society by reduc-ing the amount of trade in the economy and creating incen-tives to waste resources. Many researchers have found thatprice controls reduce entry and investment in the longrun. The controls can also reduce quality, create blackmarkets, and stimulate costly rationing. In the case of phar-

maceuticals, the most damaging area is likely to be thereduction in innovation, which will harm all future gen-erations of patients.

Although policymakers know that price controls can bevery harmful, they continue to have strong incentives to leg-islate low prices for themselves. This often leads to theadoption of more sophisticated price controls. The gov-ernment pegs its price to some reference price in the econ-omy rather than choosing a fixed number, or sets its pricea fixed amount below that of other customers. Theseschemes destroy welfare by inserting a new incentive intowhat would otherwise be a well-functioning market; eitherthe price to non-government customers is higher or the priceto poorer customers rises. More generally, the referenceprice chosen by the government rises because of the pricecontrol, not because of a change in the underlying forces ofdemand or supply.

The overwhelming evidence against price controls nat-urally leads to consideration of other methods of loweringpurchasing costs. The private sector uses a number of meth-ods that are both effective and consonant with a marketeconomy. Such approaches, when used by the private mar-ket, are much less damaging to economic welfare than a gov-ernment price control.

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r e a d i n g s•Drastic Measures: A History of Wage and Price Controls in the UnitedStates, by Hugh Rockoff. Cambridge, England: Cambridge Universi-ty Press, 1984.

•“Food Control and Price-Fixing in Revolutionary France,” Parts Iand II, by Henry Bourne. Journal of Political Economy, Vol. 27, Num-bers 2 and 3 (1919).

•“Labor Rent Sharing and Regulation: Evidence from the Truck-ing Industry,” by Nancy Rose. Journal of Political Economy, Vol. 95,No. 6 (1987).

•“The Loss Compensation Practice of Japanese Securities Compa-nies,” by Kevin Hebner and Young Park. Japan and the WorldEconomy, Vol. 7, No. 3 (1995).

•Regulation and its Reform, by Stephen Breyer. Cambridge, Mass.:Harvard University Press, 1982.

•“The Strategic Response by Pharmaceutical Firms to the Medic-aid Most-Favored-Customer Rules,” by Fiona Scott Morton. TheRAND Journal of Economics, Vol. 28, No. 2 (1997).

•A Theory of Price Control, by John K. Galbraith. Cambridge, Mass.:Harvard University Press, 1952.

•“The Welfare Costs of Price Controls for Cars and Color Televi-sions in Poland: Contrasting Estimates of Rent-Seeking fromRecent Experience,” by David Tarr. World Bank Economic Review, Vol.8, No. 3 (1994).

•“The Welfare Costs of Rationing by Waiting,” by Robert Deaconand Jon Sonstelie. Economic Inquiry, Vol. 27, No. 2 (1989).

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