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Review Question

Application of the Theory

The theory of the firm says that the firm produces at that level of output for which marginal revenue equals marginal cost. Thus, given the data below, the firm can be expected to produce the sixth unit but not the seventh. The sixth unit adds 6 to revenues and only 5 to costs, so profit increases by 1. The seventh unit adds more to costs than it adds to revenue, so it decreases profit.

Data for Hypothetical Firm
Total Cost

Suppose that the government decides to try to lower the price in this market by putting price controls on one of the key inputs. Would these controls result in lower prices for consumers? It may be a bit surprising, but the theory of the firm suggests that price controls on an input that is sold by price takers will not lower the price of the final product, but raise it instead.

Government price controls on an input affect a supply curve of a resource.1 The industry initially will be using some amount of this resource, say X, and paying a price, say P. The controls outlaw price P and make only lower prices legal. Will the amount X still be available at the new, lower price? Recall that one can view a supply curve as a boundary that limits buyers. The combination of amount X and the lower price is in the "not-permitted" area that the supply curve defines. At the new lower price, less than X of the resource will be available. This is a key link in the argument that follows.

What is available with a price ceiling

The price of the resource will decline, and so may average costs. But marginal costs will not fall at the level of output the firm produces because the supply of the resource is cut. The representative firm will use as much of this cheaper resource as it can, but it will no longer be able to get as much of the resource as it got before. Once it cannot get more, it will have to find substitutes that will cost at least as much per unit of output (otherwise, the firm would have preferred to use these substitutes in the first place). The increase in marginal costs, which the reduced availability of the input causes, will lead to higher prices for the consumer, although lower average costs may lead to higher profits for the firm.

In terms of the table, the effect of price controls on the input is to lower the marginal costs for lower levels of output, but to raise them for the levels of output at which the firm normally produces. New numbers in the MC column of the table might be: 4.1, 4.2, 4.3, 4.4, 6.1, 6.3, and 6.5. These numbers change the output level that is most profitable. You can check for yourself to see whether profits are increased or decreased, and whether price is lower or higher.

When the wage-price controls that President Nixon imposed late in his first term were removed, the controls on domestically produced oil were kept. The U.S. government could not control the price of crude oil that foreigners produced; as a result, refiners that were heavily dependent on foreign crude oil would have been at a serious disadvantage without help. The government imposed further provisions: refiners that controlled large amounts of domestic production had to pay refiners that did not. Although this reallocation complicates the computation of costs, the cost of the foreign oil was the approximate marginal cost of crude oil.

The issue of oil decontrol bubbled up throughout the Ford and Carter administrations. The Carter administration, in particular, opposed oil decontrol, arguing that it would raise gasoline prices. Domestic oil was finally decontrolled early in the Reagan administration.

The argument of the Carter administration, that price controls on crude oil kept the price of gasoline low, had almost unanimous support in the news media and had wide public appeal. But the argument is difficult to present in a logical, theoretical manner. It apparently rested on a belief that price is based on average costs plus some markup. Sellers often use markup rules for pricing, but one problem with markup theories is that they do not adequately explain the percentage that sellers use. In contrast, the economic theory of the firm suggests that price controls on domestic crude oil would not decrease the prices consumers paid for gasoline. The major effect of the controls should be, according to this theory, to transfer profits from the domestic producers to refiners, and to strengthen the OPEC oil cartel by discouraging domestic production.

Some evidence supports the hypothesis that the effect of price controls on crude oil was to transfer profits among firms. During the debate about whether to continue or eliminate crude-oil price controls, those large oil companies that were primarily refiners tended to favor continuing controls, whereas those that were relatively large producers tended to favor abolishing controls. In at least one company, the refining division initially lobbied to keep controls and the production division to abolish them; when the highest levels of management became aware of the difference, one division was stopped. Mobil Oil, which had been running a series of public-service ads proclaiming the virtues of the free market, was primarily a refiner and came out in favor of controls. This division of the oil industry is not surprising if a major effect of the controls on crude oils was to shift profits from producers to refiners.

When price controls on crude oil were finally eliminated, news media reported many predictions that gasoline prices would rapidly increase. There was no immediate change that could be attributed to the elimination, and within a year the price of gasoline had fallen. These results suggest (but of course cannot prove) that the economic theory of the firm gave a better explanation of the effects of government policy than did the various markup theories that the government and the news media preferred.

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1The assumption that the input is sold by price takers is important in this example. If it is sold by a monopolist, there will be no supply curve, and no prediction can be made about what effects price controls on the input will have.

Copyright Robert Schenk