It seems like the most charitable of things to do: to legally set a minimum level of earnings for workers, or a maximum price of healthcare for consumers. These two things might not seem connected, but they are each a form of the same thing: price controls.
If people understood the laws of supply and demand, I wouldn't have to explain why price controls are bad. But because our education system has been so deficient in teaching this concept, I feel I must do so now.
Inverse relationship between price and quantity demanded
We all are familiar with the inverse relationship between price and quantity demanded: the higher the price of an item, the lower the quantity of that item that buyers will demand. There's an inverse relationship between the price and the quantity demanded. If we were to graph this relationship, with the price on one axis and the quantity on another, the demand curve would be downward-sloping (a negative slope, because of the inverse relationship).
Graph of Demand Curve
Positive relationship between price and quantity supplied
We can also discern upon looking closely that there is a positive relationship between price and quantity supplied: the higher the price of an item, the higher the quantity of that item that sellers are willing to supply, as they will be attracted to the higher profits. (Some may leave other industries to come into this one, in search of greater profits.) There's a positive relationship between the price and the quantity supplied. If we were to graph this relationship, with the price on one axis and the quantity on another, the supply curve would be upward-sloping (a positive slope, because of the positive relationship).
Graph of Supply Curve
When you graph both together, they cross at an "equilibrium" point
So what if you put both the supply and demand curves for a product on the same graph? If the one is upward-sloping and the other is downward-sloping, then clearly they will meet somewhere. The point at which they cross is called the equilibrium point. Its coordinates in the two variables are the equilibrium price and equilibrium quantity.
Graph of Supply and Demand Curves
Graph of Surplus – Price Higher Than Equilibrium
Surpluses: Quantity supplied greater than quantity demanded
If the sellers charged a price for their product higher than the equilibrium price, the quantity supplied would be greater than the quantity demanded. The common name for this is a surplus, and it doesn't help the seller. For a tangible good like canned peaches, the good would sit on the shelf not being sold. For a service like a doctor's office, there would be time slots in the doctor's workday where there would be no appointments with customers. Once the time slot passes, the doctor can never go back and fill it with an appointment – the opportunity is gone forever.
The problems with the surplus for both the buyer and the seller
For some tangible goods like milk, a surplus might mean the good would spoil and become worthless. With a non-perishable good like canned peaches, the supermarket might later be able to sell those peaches, but only if they lower the price enough to get other buyers to buy all of them. Even with tangible goods that don't spoil, a surplus doesn't help the seller. And clearly it doesn't help buyers, either, as it would be better for them if they could obtain the price at equilibrium or lower.
Graph of Shortage – Price Lower Than Equilibrium
Shortages: Quantity demanded greater than quantity supplied
If the sellers charged a price lower than the equilibrium price, the quantity demanded would be greater than quantity supplied. The common name for this is a shortage. For a tangible good like canned peaches, the seller would run out of product, and some customers who expected to buy it at this low price would be greeted with an out-of-stock sign. A lower-than-equilibrium price is nice for the customer if they can actually get it at that price, but going below equilibrium guarantees a shortage, where someone can't get it. For some products, this is experienced as long lines. For a service like a doctor's office, this might be experienced as a waiting list. But however experienced, a shortage hurts some of the buyers by removing their opportunity to buy. Only at equilibrium prices or above are shortages removed.
The problems with the shortage for both the buyer and the seller
Of course, the sellers don't benefit from this shortage, either, because the out-of-stock signs, long lines, and waiting lists represent lost revenue opportunities, not to mention unhappy customers who expected a below-equilibrium price. They don't benefit from a price below equilibrium, or a price above it. It's in their best interests to charge at the market equilibrium price.
Graph of Market Equilibrium
The market tells sellers when their price is too low or too high ...
So why not force them to charge equilibrium prices? As it turns out, you don't have to – the free market creates an incentive for them to do so without the government forcing anything. If they have out-of-stock signs, long lines, or waiting lists; they know they have a shortage and they raise their price. If they have products on the shelf not being sold, or time slots not being filled with appointments, they know they have a surplus and they lower their price. The amount of the shortage or surplus hints to them how much to change their price. Longer lines and waiting lists mean greater price raises, and larger surpluses on the shelf or the appointment schedule mean greater price reductions. They all are led by free-market forces to charge equilibrium prices, where quantity supplied is equal to quantity demanded (hence the name equilibrium).
The advantages of allowing free markets to go to equilibrium on their own
Businesses can charge the highest prices at which all of their product will actually be sold, and sell the highest quantity that people will actually buy. Customers can buy at the lowest price at which there are no shortages, and have available the exact quantity that they demand. Equilibrium, on the whole, benefits both buyers and sellers, and in the long run, it is reached without government having to force it there. Adam Smith's "invisible hand" of the free market moves prices to equilibrium on its own.
The problems of price controls
But a lack of understanding of economics sometimes causes government to try and set prices anyway. How? By price controls.
The Capitol Dome
What happens when governments set prices below equilibrium (as with maximum healthcare prices)?
On the one end of the spectrum, governments sometimes try to guarantee customers a low price for some good (say, healthcare), but find that setting prices below equilibrium guarantees nothing but a shortage, where some customers cannot buy at the “guaranteed” price or any other. Some guarantee. The long lines and waitlists in countries with socialized medicine are exactly what you would predict from an understanding of supply and demand; but the public isn't taught this concept well, and the statistics cited by the proponents of socialized medicine often don't take these long lines and waitlists into account.
What happens when governments set prices above equilibrium (as with minimum wages)?
On the other end of the spectrum, many governments try to guarantee workers a high price for their labor (they would say a “fair” price) with the minimum wage. But this guarantees nothing but a labor surplus, where either their hours are cut, or the human labor surplus is unemployed, and unable to find work at the “guaranteed” price or any other. Again, some guarantee, and some fairness to boot. Much of the unemployment our land currently experiences, particularly among poor people, comes from the minimum wage. If the wage were really at equilibrium, we would not need to set it there with price controls. Free-market forces (namely, employers bidding up the price of labor until they can actually buy it) would push it there on its own.
Both policies are forms of price controls, and are guaranteed to fail
The legal minimum wage and the legal maximum healthcare price might not seem related at first, but they are both forms of price controls, and an understanding of supply and demand helps to show why they don't work. Refraining from price controls by allowing free markets would do much to help our economic situation. It would give us the cheapest healthcare possible without shortages (in the form of long lines or waitlists), and the highest wages possible without a human labor surplus (namely, cut hours or unemployment). The free market is infinitely better than any price controls. But you wouldn't know that from listening to Obama.
Why Adam Smith is still relevant today