Price Controls: Part of the problem or part of the solution?

Attempts by rulers and governments alike to control the market prices of goods and services goes way back hundreds of years before Christ, at least to the code of laws compiled and enforced by the Babylonian King Hammurabi around 1800 B.C. Other historical records also points out a long list of price ceilings on foods and other products imposed during the reign of Diocletian, emperor of the then already in decline Roman Empire to clamp down on inflationary pressures faced by the state. Ironically, attempts by authorities to impose and enforce price controls have normally backfired in the long run and caused widespread social unrest among citizens subject to them.

A prime example would be during the winter of 1777-1778, when George Washington was beset by many enemies including the British and Hessian mercenaries at Valley Forge and decided to implement price controls to reduce the prices of the commodities needed to supply his army.[1] At that time, the idea of price controls seemed like a life-saving economic instrument to protect Washington’s already impoverished financial coffers from depleting any further. But the price controls had a more complex economical effect and did not work out the way the President wanted. Contrary to it’s intended purpose, the price controls prompted the prices of uncontrolled goods, which were mostly imported, to rise to sky high records.

Robert L. Schuettinger and Eamonn F. Butler (1979) stated that most farmers at Valley Forge who were subjected to price controls refused to sell their produce for what they regarded as an unfair price. Some families who were financially desperate even started selling their food to the more ‘generous’ British who paid them higher prices in gold. When it became clear that the price controls had these unintended effects, George Washington was given a choice to abolish the price controls and pay farmers at the price they were willing to accept or risk starving his army to death. Fortunately, the president was wise enough (for his own sake) to choose the former.

Yet another dramatic example in history was how the downfall of emperors in Russia, Austria-Hungary, and Germany during World War I in 1914 to 1918, could be traced to the implementations of price controls. At the start of hostilities, there was a widespread illusion that countries like Russia which had a large peasant population would provide it with an enormous advantage in food production. In reality however, Russia though possessing a big pool of manpower was poor in aggregate terms and quickly implemented price controls to buy food from farmers at artificially low prices. Unfortunately for the Russian Tsar, farmers subjected to price controls also had an economic weapon of their own: which means seceding from farming.

Consequently, peasant farmers started to refuse selling their produce for unprofitable low returns and the supply of food to urban areas dried up.[2] As the food situation became more severe, urban famine became a widespread issue in Russia and this ultimately led to the Bolshevik Revolution in 1917. In sharp contrast to Russia, the British and American farmers were offered higher prices for their crops and responded normally to incentives by rapidly increasing agriculture production. This gave both the British and the Americans which followed the market system a considerable advantage compared to countries adopting price controls on the agriculture sector.

Equally disastrous but not immediately felt were the wage and price controls adopted by Richard Nixon in 1971. The real reason behind the implementation of these measures was to prevent inflation from harming Nixon’s bid for reelection. Not surprisingly, the price controls worked well in the short-run with inflation tamed and the economy booming in 1972. In the long run however, the price controls acted only to delay the inevitable. When the price controls were removed in 1974, inflation in the United States shot up to an alarming double digit figure of 12 percent![3]

How price controls disrupt the market system

The market system is often characterized by the presence of private ownership of resources and the usage of the market and prices to coordinate and direct economic activity.[4] In a market or capitalist system, individuals and businesses are given a relatively free hand to decide for themselves how they would achieve their economic goals. According to Adam Smith (1776), the operation of a market system creates a curious cooperation between private and public interest. This happens when individuals and businesses that are operating in a highly competitive environment will simultaneously work to promote both public and social interest as though guided by an “invisible hand.”

The implementation of price controls would disrupt the market system by distorting the pricing of the goods and commodities subjected to it. Because price controls is implemented by establishing a price ceiling (maximum price) or price floor (minimum price) on a good or commodity, the market would no longer be able to determine their correct pricing. This means that sellers and buyers would be forced either to trade at a price either above or below their true preference (depending on whether it is a price ceiling or price floor).

A look at Figure 1 and Figure 2 gives us a glimpse of the effects of price controls towards the supply and demand of a certain commodity (all other things held constant). Without price controls, the market price for the commodity in Figure 1 would be at point E, where price is Rm4 for 55 units of the commodity. For the price ceiling to be effective, the ceiling price must be below the equilibrium price of Rm4. But by setting the price at Rm2 for example, the quantity demanded of the commodity will be 75 units at point B whereas the quantity supplied will be only 35 units at point A. In other words, the diagram shows us that the implementation of a price ceiling would result in a shortage of 40 units of the commodity.

In contrast to the diagram in Figure 1, price floors will generate an opposite effect when implemented on the commodity. The market price of the commodity in Figure 2 should be at point E. The implementation of an effective price floor would have to be above the equilibrium price, for example, at Rm6. But with a price floor at Rm6, the quantity demanded of the commodity would only be 35 units at point C compared to the quantity supplied of 75 units at point D. The price floor would therefore at the end the day produce a surplus of the commodity of 40 units.

Generally either a severe shortage or an overabundant surplus is bad for the economy. Instead of giving the “invisible hand” the flexibility of guiding the economy’s resources to the most productive investments, the very “visible hand” of price controls distorts both supply and demand resulting in a wrong market signal to sellers and buyers in the market. This creates a perfect recipe for misallocation of resources.

The other main problems with price controls are in its unenforceability and rigidity. Authorities may be able to put a price ceiling on rice for example, but not on the imported fertilizers needed for rice production. If the cost of fertilizers increase (a situation the world is currently facing), farmers will be caught in a squeeze between a higher cost of production and a stagnant selling price of rice. In the long run as shown above, a persistent shortage develops as more and more farmers leave the agriculture industry in search of other jobs with higher wages.

The perils of price controls do not end here because in an event of persistent increase in cost of production, the true equilibrium price of rice would rise further and further away from the price ceiling. When this happens, it will become more attractive to illegally supply rice through a “black market” rather than selling it legally in markets regulated by price controls. Compounding these adverse effects is that the prices in the illegal markets will most certainly be higher than those in the free market as illegal traders will incorporate a “risk premium” for selling the rice illegally. The end result is that everyone in the market is left at a worst off situation.

A good example of this whole scenario is the recent reported incident of a shortage of government subsidized rice in Kedah, Malaysia. Originally, the controlled price of the local (ST) super grade rice is a between Rm16.50 and Rm17.50 for a 10 Kg packet.[5] Due to the spike in the cost of rice production, the citizens of the state of Kedah face a 15 to 40 percent increase in the prices of rice and also a shortage of government subsidized rice.[6]

Figure 3 is a simple representation of the adverse effects of price ceilings on rice in the long run. Because the price ceiling is set below the market price at point E, investment in rice production will start to decrease as rice becomes a less profitable product relative to other commodities. This will shift the supply curve from S to S1. In an event whereby the price of fertilizers increase, the supply curve will shift further to the left as farmers that caught between the squeeze of low rice selling prices and high production costs continues to reduce production. Adding to that, food items are essentials with their demand being highly inelastic (lack of substitutes). Some consumers would therefore increase their consumption of subsidized rice as the prices of other types of rice increase. This would then shift the demand curve from D to D1 while at the same time pushing the price of rice higher to point E1. However, at this new equilibrium price, the price ceiling will generate an even more severe shortage which will create an irresistible incentive for hoarding and smuggling.

The same concept would apply to government subsidies on oil. According to the International Herald Tribune, the ones reaping the biggest windfalls are not the poor consumers, but highly organized smuggling rings that siphon off the subsidized gasoline, diesel and kerosene to sell at a premium price abroad.[7] Instead of solving the problem of high oil prices, government subsidies may actually be fostering an ever growing illegal business of oil smuggling by providing them a very large profit margin incentive! What is worst is that increasing the number of patrols and security restrictions may not work the way authorities want them to. On the contrary, smugglers might increase smuggling activities and the price illegal oil prices because of the higher perceived risk and ever increasing demand.

Despite the long term adverse effects of price controls, they remain a very popular measure among authorities and urban citizens to this very day. The idea of using price controls to quickly and openly suppress the prices of certain goods and commodities in a relatively short time have always appealed greatly to many ruling governments as a fast solution to economic and political problems. When international food and fuel prices spike in recent years, Vladimir Putin was quick to imposed price controls on selected types of bread, cheese, milk, eggs and vegetable oil. Similarly, the Chinese government recently froze the prices of energy, transport and water, and announced that producers of essential food items, such as meat, grain, eggs and cooking oil must seek approval before raising prices.

While price control may work well in the short run, the marginal costs they incur will most certainly outweigh their marginal benefits in the long run. But because price controls will benefit one group (normally the urban citizens) at the expense of another group (normally the rural citizens), their implementation will enjoy a strong support from their beneficiaries. Besides that, the justification that price ceilings on agriculture produce are to help the poor is also a theory that should be viewed skeptically as a big portion of the poor that are involved in the agriculture sector would not benefit from lower selling prices. More often than not, price controls will be part of the problem rather than part of the solution.

References

1. Abolish ceiling on chicken price: farmers (21st April 2008), the Sun, pp10

available at: http://www.economist.com/finance/displaystory.cfm?story_id=10733112 (7th May 2008, 12:44 Am)

2. Campbell R. McConnell and Stanley L. Brue (2008), Economics: Principles, Problems, and Policies, Mc Graw-Hill Companies, Inc, pp598-612

3. Daniel Gross (30th October 2007), Cry for Me, Argentina (and Russia and China), available at: http://www.newsweek.com/id/67042 (7th May 2008, 12:44 AM)

4. Donald Greenlees (27th September 2005), Asia oil subsidies bring windfall to smugglers, International Herald Tribune

5. Harga beras terus naik (2nd May 2008), Utusan Malaysia

6. In a fix: Putting caps on prices is only a short-term solution (21st February 2008), The Economist print edition,

7. Mark Harrison (2004), Why the Rich Won: Economic Mobilization and Economic Development in Two World Wars, University of Warwick, Department of Economics, United Kingdom

8. Ministries to tackle chicken price issue (1st May 2008), Nation N20, Star Newspaper

9. Rice bowl state runs out of grain (4th May 2008), Nation N3, Star Newspaper

10. Robert J.Samuelson (6th February 2008), It Ain’t the Economy, Stupid: Why no president can control our $14 trillion engine, available at: http://www.newsweek.com/id/108382 (7th May 2008, 12:44 AM)

11. Robert J.Samuelson (7th January 2008), Maybe it’s Not The Economy…That Matters in Picking The President, Because Today’s Boom Wasn’t Made In The White House, available at http://www.newsweek.com/id/85714 (7th May 2008, 12:44 AM)

12. Stephen Broadberry and Mark Harrison (2006), Economics of the Two World Wars, University of Warwick, Department of Economics, United Kingdom

13. William J. Baumol and Alan S. Blinder (2006), Economics: Principles and Policy, Mc Graw-Hill Companies, Inc, pp53-73


[1] See William J. Baumol and Alan S. Blinder (2006), Economics: Principles and Policy

[2] Stephen Broadberry and Mark Harrison (2006), University of Warwick

[3] Robert J.Samuelson (2008), It Ain’t the Economy, Stupid: Why no president can control our $14 trillion engine

[4] See Campbell R. McConnell and Stanley L. Brue (2008), Economics: Principles, Problems, and Policies

[5] See Rice bowl state runs out of grain (4th May 2008), Nation N3, Star Newspaper

[6] See Harga beras terus naik (2nd May 2008), Utusan Malaysia

[7] See Asia oil subsidies bring windfall to smugglers (27th September 2005), International Herald Tribune

Comments
3 Responses to “Price Controls: Part of the problem or part of the solution?”
  1. lastmagwati says:

    It is part of problem because it leads to shortage of goods o the markert leading to the formation of black market and a mere increase on inflation on the parallel markert.

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