THEORY OF THE FIRM FACING PRICE CONTROLS: A RATIONAL EXPECTATIONS APPROACH (MICROECONOMICS, STABILIZATION, CONSTRAINT)

A method is developed for determining the effects of government price control policies on output and prices at an industry level. This method is demonstrated for the paper mills industry during the Economic Stabilization program in the United States in the early 1970's.;The structural parameters of the model are estimated for the paper mills industry using the unconstrained model during the period prior to the imposition of the price control program. These estimates are used to simulate the constrained and unconstrained versions of the model during the period of the Economic Stabilization Program.;The results of the simulation show that the price control constraint was binding on paper mills and that output was greater and prices lower during the period of price controls than they would have been if the controls had not been imposed.;A further simulation quantifies the effect of a hypothetical constraint that does not bind right away but is expected to bind in the future. This simulation shows that firms will restrict output and raise prices in anticipation of a future binding constraint more than they would have in an unregulated environment. The policy implication is that if the government desires to prevent early price hikes in the anticipation of binding controls, it should announce the beginning of controls as a surprise and announce the lifting of controls well ahead of time.;A model of firm behavior is used to determine specifications for output behavior in an uncontrolled and in a controlled environment. The firm model is dynamic and considers a firm that maximizes its expected present value. The model includes the adjustment costs of changing output from one period to another and uses the assumption that the firm forms expectations rationally. Two output paths are derived; one for an unregulated environment and one for the case where the firm is constrained by a price control rule. In the constrained case, the constraint may be binding as soon as it is imposed or may be expected to bind in a future period.