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Windfall Profits and That Which Is Not Seen

Mises Daily: Tuesday, June 23, 2009 by


I was the teaching assistant for a course on the theory of property rights during the fall semester of 2002. We spent quite a bit of time discussing rent control, various rent-control cases, and the legal principles that informed judicial decisions surrounding rent-control cases.

One of these principles was an aversion to "windfall" profits. Windfall profits occur when an entrepreneur enjoys profits in excess of what he expected, usually as the result of a drastic change in market conditions.

People often point to the run-up in gas prices — some gas stations were charging over $3 a gallon — after the September 11 attacks as an example of firms enjoying windfall profits. The price per gallon is higher than the cost per gallon. This, it is argued, is unfair, especially when an entrepreneur/business owner enjoys profits that he doesn't have to "work" for.

We often discussed this in terms of what was called the rate-setting equation, in which the court set prices according to the formula

rate = operating cost + reasonable return

This ignores two things. First, the definition of "reasonable" is arbitrary. Second, expected prices determine the costs an entrepreneur is willing to incur. As a rule, people don't incur costs and engage in arbitrary productive activity irrespective of expected benefits. In short, the price one expects to receive for a product — say a gallon of gasoline — determines the prices he is willing to pay for factors of production, how he will produce the product, and the quantity he is willing to supply. Prices are not cost determined.

To better illustrate this principle, suppose you are a cotton buyer in 1860s England. Two boatloads of cotton arrive, one from the United States and the other from Egypt. Let's assume that Egyptian cotton and American cotton are perfect substitutes. As a merchant, do you care at all what it costs your suppliers to produce their wares? Suppose you're the one trying to sell the American cotton. Do your costs of production influence the price at which you agree to sell the cotton? At this point, all of your costs are sunk. (Economists are fond of the phrase "sunk costs are sunk," which is to say that there is no way to recover them.) As such, these costs shouldn't factor into your asking price.

Let's return to our discussion of windfall profits as it relates to rent-controlled apartments. The in-class examples concerned rent-control ordinances in Cambridge, MA and Berkeley, CA, which are reportedly nice places to live and where the demand for housing is stronger than in most parts of the country. The "windfall profits" rationale for rent control works as follows: suppose you've owned an apartment complex in Cambridge for 50 years. The apartments cost you $450 a month to maintain, and you can rent them out for $500 a month for a monthly profit of $50 each. Suppose now that the demand for Cambridge apartments skyrockets, and you can now charge $1,000 a month for the exact same apartment. The rent controllers maintain that it isn't fair that you can now enjoy such higher rents without really changing the product you offer or "working for it." Since people supposedly aren't entitled to what they don't "work for," the rent controllers step in and cap rental prices at $500 a month. Everyone should be happy because you're still earning a "reasonable" profit on each apartment, consumers are still able to get cheap apartments, and the Cambridge housing stock has not diminished.

Economics in One Lesson (MP3 CD)

Henry Hazlitt sums up the standard argument for rent control as follows:

Rent control is initially imposed on the argument that the supply of housing is not "elastic" — i.e., that a housing shortage cannot be immediately made up, no matter how high rents are allowed to rise. Therefore, it is contended, the government, by forbidding increases in rents, protects tenants from extortion and exploitation without doing any real harm to landlords and without discouraging new construction. (Economics in One Lesson, p. 111)

As the great proto-Austrian economist Frederic Bastiat points out, however, we should never merely take account of that which is seen. We must also consider that which is not seen — the hidden effects of a policy like rent control. And there is plenty that is not seen in the case of rent control.

First, there are the standard problems associated with holding prices below the market-clearing price, all of which are taken out of an everyday "Principles of Microeconomics" textbook. Queuing (people waiting in line for the good, in this case, apartments) and nonprice competition will set in. People will try to get apartments by making bribes or other side payments. Landlords may let their property deteriorate. Landlords may withdraw from the housing market and convert their apartments to offices. Et cetera.

But this is only the tip of the iceberg. Let's consider the normative issue first. In this situation, rent controllers objected to windfall profits for the landlord. But what of the renter who has the good fortune to secure for $500 an apartment for which someone else would gladly pay $1,000? This is just as much a windfall as anything else. Moreover, the rent-control board either consigns the second renter to the winds of fate — he will, in all likelihood, be banished to a waiting list — or shuts him out of the housing market altogether because his willingness to pay is not allowed to manifest itself through the market process.

Moreover, rent control distorts the structure of production by nullifying the valuable signaling role of profits. High profits induce others to enter a market. In this case, high profits signal that there is quite a bit of money to be made in the Cambridge housing market. One of the fundamental precepts of economics is that people respond to incentives; something has to induce people to engage in productive activity (supplying apartments, in this case). They don't just do so ad hoc. It may very well be that some people are willing to absorb heavy losses to supply cheap, high-quality apartments out of their compassion for the hardscrabble lives of Harvard, MIT, and Berkeley students and faculty who are trying to eke out a living in the unforgiving world that is academe.

Of course, what motivates most people is the prospect of being able to do more of the things they like, whether it is consuming Coca-Cola, alleviating third-world poverty, or reading economics articles. Regardless, wealth helps. Therefore, the prospect of increasing one's wealth is quite often the driving force that motivates behavior.

Let's look at who wins and who loses. The rent control board certainly wins; passing additional rent control measures usually solidifies their employment. Incumbent tenants and those lucky enough to get a cheap apartment win because they get a good at a price below that which would clear the market. People pushing for rent control "win" in the sense that they get to feel good about striking a blow for justice.

Let's look at what Henry Hazlitt had to say about attempts to hold prices below their market-clearing levels in his classic Economics in One Lesson:

Now we cannot hold the price of any commodity below its market level without in time bringing about two consequences. The first is to increase the demand for that commodity. Because the commodity is cheaper, people are both tempted to buy, and can afford to buy, more of it. The second consequence is to reduce the supply of that commodity. Because people buy more, the accumulated supply is more quickly taken from the shelves of merchants. But in addition to this, production of that commodity is discouraged. Profit margins are reduced or wiped out. The marginal producers are driven out of business. Even the most efficient producers may be called upon to turn out their product at a loss.

He continues:

If we did nothing else, therefore, the consequence of fixing a maximum price for a particular commodity would be to bring about a shortage of that commodity. But that is precisely the opposite of what government regulators originally wanted to do. For it is the very commodities selected for maximum price-fixing that the regulators most want to keep in abundant supply. But when they limit the wages and the profits of those who make these commodities … they discourage the production of the price-controlled necessities while they relatively stimulate the production of less essential goods.

And this is the consequence of the state attempting to control the price of any good. It is often objected that "necessities" such as food, housing, education, and health care are too important to be left to the wiles and whimsies of the market.

The reader may have seen a bumper sticker reading "health care is a right, not a privilege." This certainly makes for convenient political rhetoric, but when we get past the newspaper headlines, we see that we're dealing with issues of mind-boggling complexity.

The principles by which market forces allocate resources aren't particularly difficult to grasp. People agree to exchange because they expect to be better off as a result, and those who are willing to pay the most generally get their desired quantity of a good in question. So the market's mechanisms for allocating resources aren't that mysterious.

We run into problems when we start talking about a good being a "right" that should be provided by someone (presumably the state) irrespective of market forces or one's ability to pay. The most apparent problems arise when we start to consider exactly what the concept of a "good" entails.

Goods are extremely specific things. They are characterized by definite physical, spatial, and temporal characteristics — in other words, we're concerned with the "what, where, and when" of a good. For example, suppose I have an ice cream cone after lunch. The good "ice cream" is characterized by certain physical properties (it's a soft, cold substance of a particular chemical composition), certain spatial properties (in all likelihood, it's at our local Kroger), and certain temporal properties (after dinner).

While it isn't hard to wrap our minds around the goods-character of ice cream, serious difficulties become apparent when we start to think about more abstract classes of goods such as "health care" or "housing." First, "health care" and "housing" are descriptors used to classify broad arrays of goods and services that are very costly to measure and may not be interchangeable. If we go back to ice cream for a second, we see that one vanilla ice cream cone is usually a perfect substitute for another. Moreover, it's easy to substitute chocolate for vanilla, gelato for ice cream, and waffle cones for sugar cones. It isn't easy to substitute the services of a urologist for the services of a gynecologist (for example).

So what are we talking about when we talk about "health care?" Do we mean brain surgery? Do we mean basic physicians' services? Do we mean aspirin?

Similarly, what are we talking about when we talk about "housing?" Basic shelter might consist of a lean-to or a mud hut. Do we mean penthouses in midtown Manhattan? Most so-called progressives would say that the "housing crisis" is characterized by a shortage of "adequate" housing, but who is to decide what is "adequate?" My wife and I have a three-bedroom house. On some margins, this is more than adequate. On some margins, though, it is inadequate. I'd like to have a bigger desk, but the guest room is too small. We don't have space for another couch in the living room, but it would be nice. Do we have a right to all of this at someone else's expense?

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Market prices turn incomprehensibly complex relationships into very simple ones. Government policy does the opposite. It turns the simple into the extraordinarily complex, and, as Ludwig von Mises has argued in various places, government intervention in one aspect of the economy will displace resources, change prices, and likely lead to calls for government intervention in other areas of the economy. Establishing the boundaries and definitions of what constitutes "just" and "unjust" outcomes presents one set of problems, and measuring the valuable attributes of the goods and services that are to be regulated or subsidized presents another. At the very least, these problems should cause us to view government intervention with a skeptical eye.