Aside from rent control, there are not many price ceilings in the United States today. But at times they have been widespread. Price ceilings are typically imposed during crises—wars, harvest failures, natural disasters—because these events often lead to sudden price increases that hurt many people but produce big gains for a lucky few.

The U.S. government imposed ceilings on many prices during World War II: the war sharply increased demand for raw materials, such as aluminum and steel, and price controls prevented those with access to these raw materials from earning huge profits. Price controls on oil were imposed in 1973, when an embargo by Arab oil-exporting countries seemed likely to generate huge profits for U.S. oil companies. Price controls were instituted again in 2012 by New York and New Jersey authorities in the aftermath of Hurricane Sandy, as gas shortages led to rampant price-gouging.

Rent control in New York is, believe it or not, a legacy of World War II: it was imposed because wartime production produced an economic boom, which increased demand for apartments at a time when the labor and raw materials that might have been used to build them were being used to win the war instead. Although most price controls were removed soon after the war ended, New York’s rent limits were retained and gradually extended to buildings not previously covered, leading to some very strange situations.

You can rent a one-bedroom apartment in Manhattan on fairly short notice—if you are able and willing to pay several thousand dollars a month and live in a less desirable area. Yet some people pay only a small fraction of this for comparable apartments, and others pay hardly more for bigger apartments in better locations.

Aside from producing great deals for some renters, however, what are the broader consequences of New York’s rent-control system? To answer this question, we turn to the model we developed in Chapter 3: the supply and demand model.

To see what can go wrong when a government imposes a price ceiling on an efficient market, consider Figure 5-1, which shows a simplified model of the market for apartments in New York. For the sake of simplicity, we imagine that all apartments are exactly the same and so would rent for the same price in an unregulated market.

The table in Figure 5-1 shows the demand and supply schedules; the demand and supply curves are shown on the left. We show the quantity of apartments on the horizontal axis and the monthly rent per apartment on the vertical axis. You can see that in an unregulated market the equilibrium would be at point E: 2 million apartments would be rented for $1,000 each per month.

Now suppose that the government imposes a price ceiling, limiting rents to a price below the equilibrium price—say, no more than $800.

Figure 5-2 shows the effect of the price ceiling, represented by the line at $800. At the enforced rental rate of $800, landlords have less incentive to offer apartments, so they won’t be willing to supply as many as they would at the equilibrium rate of $1,000. They will choose point A on the supply curve, offering only 1.8 million apartments for rent, 200,000 fewer than in the unregulated market.

At the same time, more people will want to rent apartments at a price of $800 than at the equilibrium price of $1,000; as shown at point B on the demand curve, at a monthly rent of $800 the quantity of apartments demanded rises to 2.2 million, 200,000 more than in the unregulated market and 400,000 more than are actually available at the price of $800. So there is now a persistent shortage of rental housing: at that price, 400,000 more people want to rent than are able to find apartments.

Do price ceilings always cause shortages? No. If a price ceiling is set above the equilibrium price, it won’t have any effect. Suppose that the equilibrium rental rate on apartments is $1,000 per month and the city government sets a ceiling of $1,200. Who cares? In this case, the price ceiling won’t be binding—it won’t actually constrain market behavior—and it will have no effect.

The housing shortage shown in Figure 5-2 is not merely annoying: like any shortage induced by price controls, it can be seriously harmful because it leads to inefficiency. In other words, there are gains from trade that go unrealized.

Rent control, like all price ceilings, creates inefficiency in at least four distinct ways.

In addition to inefficiency, price ceilings give rise to illegal behavior as people try to circumvent them. We’ll now look at each of these inefficiencies caused by price ceilings.

Inefficiently Low Quantity In Chapter 4 we learned that the market equilibrium of an efficient market leads to the “right” quantity of a good or service being bought and sold—that is, the quantity that maximizes the sum of producer and consumer surplus. Because rent controls reduce the number of apartments supplied, they reduce the number of apartments rented, too.

Figure 5-3 shows the implications for total surplus. Recall that total surplus is the sum of the area above the supply curve and below the demand curve. If the only effect of rent control was to reduce the number of apartments available, it would cause a loss of surplus equal to the area of the shaded triangle in the figure.

The area represented by that triangle has a special name in economics, deadweight loss: the lost surplus associated with the transactions that no longer occur due to the market intervention. In this example, the deadweight loss is the lost surplus associated with the apartment rentals that no longer occur due to the price ceiling, a loss that is experienced by both disappointed renters and frustrated landlords. Economists often call triangles like the one in Figure 5-3 a deadweight-loss triangle.

Deadweight loss is a key concept in economics, one that we will encounter whenever an action or a policy leads to a reduction in the quantity transacted below the efficient market equilibrium quantity. It is important to realize that deadweight loss is a loss to society—it is a reduction in total surplus, a loss in surplus that accrues to no one as a gain. It is not the same as a loss in surplus to one person that then accrues as a gain to someone else, what an economist would call a transfer of surplus from one person to another. For an example of how a price ceiling can create deadweight loss as well as a transfer of surplus between renters and landlords, see the upcoming For Inquiring Minds.

Deadweight loss is not the only type of inefficiency that arises from a price ceiling. The types of inefficiency created by rent control go beyond reducing the quantity of apartments available. These additional inefficiencies—inefficient allocation to consumers, wasted resources, and inefficiently low quality—lead to a loss of surplus over and above the deadweight loss.

Inefficient Allocation to Consumers Rent control doesn’t just lead to too few apartments being available. It can also lead to misallocation of the apartments that are available: people who badly need a place to live may not be able to find an apartment, but some apartments may be occupied by people with much less urgent needs.

In the case shown in Figure 5-2, 2.2 million people would like to rent an apartment at $800 per month, but only 1.8 million apartments are available. Of those 2.2 million who are seeking an apartment, some want one badly and are willing to pay a high price to get it. Others have a less urgent need and are only willing to pay a low price, perhaps because they have alternative housing.

An efficient allocation of apartments would reflect these differences: people who really want an apartment will get one and people who aren’t all that anxious to find an apartment won’t. In an inefficient distribution of apartments, the opposite will happen: some people who are not especially anxious to find an apartment will get one and others who are very anxious to find an apartment won’t.

Because people usually get apartments through luck or personal connections under rent control, it generally results in an inefficient allocation to consumers of the few apartments available.

To see the inefficiency involved, consider the plight of the Lees, a family with young children who have no alternative housing and would be willing to pay up to $1,500 for an apartment—but are unable to find one. Also consider George, a retiree who lives most of the year in Florida but still has a lease on the New York apartment he moved into 40 years ago. George pays $800 per month for this apartment, but if the rent were even slightly more—say, $850—he would give it up and stay with his children when he visits New York.

This allocation of apartments—George has one and the Lees do not—is a missed opportunity: there is a way to make the Lees and George both better off at no additional cost. The Lees would be happy to pay George, say, $1,200 a month to sublease his apartment, which he would happily accept since the apartment is worth no more than $849 a month to him. George would prefer the money he gets from the Lees to keeping his apartment; the Lees would prefer to have the apartment rather than the money. So both would be made better off by this transaction—and nobody else would be made worse off.

Generally, if people who really want apartments could sublease them from people who are less eager to live there, both those who gain apartments and those who trade their occupancy for money would be better off. However, subletting is illegal under rent control because it would occur at prices above the price ceiling.

The fact that subletting is illegal doesn’t mean it never happens. In fact, chasing down illegal subletting is a major business for New York private investigators. An article in the New York Times described how private investigators use hidden cameras and other tricks to prove that the legal tenants in rent-controlled apartments actually live somewhere else, and have sublet their apartments at two or three times the controlled rent.

This subletting is a kind of illegal activity, which we will discuss shortly. For now, just note that landlords and legal agencies actively discourage the practice. As a result, the problem of inefficient allocation of apartments remains.

Wasted Resources Another reason a price ceiling causes inefficiency is that it leads to wasted resources: people expend money, effort, and time to cope with the shortages caused by the price ceiling. Back in 1979, U.S. price controls on gasoline led to shortages that forced millions of Americans to wait on lines at gas stations for hours each week. The opportunity cost of the time spent in gas lines—the wages not earned, the leisure time not enjoyed—constituted wasted resources from the point of view of consumers and of the economy as a whole.

Because of rent control, the Lees will spend all their spare time for several months searching for an apartment, time they would rather have spent working or in family activities. That is, there is an opportunity cost to the Lees’ prolonged search for an apartment—the leisure or income they had to forgo.

If the market for apartments worked freely, the Lees would quickly find an apartment at the equilibrium rent of $1,000, leaving them time to earn more or to enjoy themselves—an outcome that would make them better off without making anyone else worse off. Again, rent control creates missed opportunities.

Inefficiently Low Quality Yet another way a price ceiling creates inefficiency is by causing goods to be of inefficiently low quality. Inefficiently low quality means that sellers offer low-quality goods at a low price even though buyers would rather have higher quality and would be willing to pay a higher price for it.

Again, consider rent control. Landlords have no incentive to provide better conditions because they cannot raise rents to cover their repair costs but are able to find tenants easily. In many cases, tenants would be willing to pay much more for improved conditions than it would cost for the landlord to provide them—for example, the upgrade of an antiquated electrical system that cannot safely run air conditioners or computers. But any additional payment for such improvements would be legally considered a rent increase, which is prohibited.

Indeed, rent-controlled apartments are notoriously badly maintained, rarely painted, subject to frequent electrical and plumbing problems, sometimes even hazardous to inhabit. As one former manager of Manhattan buildings described: “At unregulated apartments we’d do most things that the tenants requested. But on the rent-regulated units, we did absolutely only what the law required…. We had a perverse incentive to make those tenants unhappy.”

This whole situation is a missed opportunity—some tenants would be happy to pay for better conditions, and landlords would be happy to provide them for payment. But such an exchange would occur only if the market were allowed to operate freely.

Black Markets In addition to these four inefficiencies there is a final aspect of price ceilings: the incentive they provide for illegal activities, specifically the emergence of black markets. We have already described one kind of black market activity—illegal subletting by tenants. But it does not stop there. Clearly, there is a temptation for a landlord to say to a potential tenant, “Look, you can have the place if you slip me an extra few hundred in cash each month”—and for the tenant to agree if he or she is one of those people who would be willing to pay much more than the maximum legal rent.

What’s wrong with black markets? In general, it’s a bad thing if people break any law, because it encourages disrespect for the law in general. Worse yet, in this case illegal activity worsens the position of those who are honest. If the Lees are scrupulous about upholding the rent-control law but other people—who may need an apartment less than the Lees—are willing to bribe landlords, the Lees may never find an apartment.

We have seen three common results of price ceilings:

Given these unpleasant consequences of price ceilings, why do governments still sometimes impose them? Why does rent control, in particular, persist in New York?

One answer is that although price ceilings may have adverse effects, they do benefit some people. In practice, New York’s rent-control rules—which are more complex than our simple model—hurt most residents but give a small minority of renters much cheaper housing than they would get in an unregulated market. And those who benefit from the controls are typically better organized and more vocal than those who are harmed by them.

Also, when price ceilings have been in effect for a long time, buyers may not have a realistic idea of what would happen without them. In our previous example, the rental rate in an unregulated market (Figure 5-1) would be only 25% higher than in the regulated market (Figure 5-2): $1,000 instead of $800. But how would renters know that? Indeed, they might have heard about black market transactions at much higher prices—the Lees or some other family paying George $1,200 or more—and would not realize that these black market prices are much higher than the price that would prevail in a fully unregulated market.

A last answer is that government officials often do not understand supply and demand analysis! It is a great mistake to suppose that economic policies in the real world are always sensible or well informed.