HOW PRICE CONTROLS FAIL
Price controls have always been a theme for debate and confrontation between economists, politicians and political commentators in the media. In most developed countries, price controls were abandoned as a public economic policy some decades ago, due to the great variety and diversity of goods and services, supplied at various price ranges and accessible to more people each time, thanks in great part to the process of globalization. Recently, the debate about price controls in developed economies was brought back into light with house prices and rent controls all around Europe. This is an issue I already commented about in a previous post, so I won’t analyse it again in this one. What surprised me this week and incentivized me to write this post was a fact I read at the World Bank “Global Economic Prospects” report. According to the World Bank, 89% of developing countries control the price of energy, 76% set price controls on food and food complements (as sauces, spices, etc…), and finally, 13% of developing countries meddle with the price of construction components and materials, as various metals. Even though price controls have repeatedly demonstrated to be a failure, according to empirical evidence (which I’ll analyse throughout this post), many politicians continue to implement them, because politically it is a cheap and easy measure to introduce, easily sellable to voters and attractive in the short term for those suffering from a high inflationary pressure. One clear example of this was Mauricio Macri’s price control policy. When he arrived at the Casa Rosada, he promised that he would gradually eliminate price controls and allow markets to adjust following what he predicted that would be higher economic growth and lower inflation. At the end, he didn’t only not end up with the precios cuidados (food and basic products price controls), but even introduced price controls for 60 other goods. Price controls therefore, have shown to be a very politically profitable policy, but a complete economic disaster. Let’s analyse some empirical evidence showing its effects.
First of all, price controls can be imposed in two different ways: price floors or price ceilings. Price floors are introduced with a goal of guaranteeing a minimum revenue for producers, as has been the case for price floors for agricultural products in many European countries throughout the last decade, as one of the main points of the European Common Agricultural Policy (CAP). The other type of price control are price ceilings which are implemented with the goal of benefiting consumers by lowering prices below the market equilibrium, but which tend to lead to excess of demand and scarcity. The vast majority of economists, independently of their political positioning, are against both kinds of price controls, arguing that they have a dysfunctional effect on markets and end up by causing excess of stock (price floors) or scarcity (price ceilings). In the same World Bank dataset, we can find an astonishing fact, making reference to how food price controls were responsible for nearly 40% of the increase in the price of wheat in the period between 2010-2011.
Prices do not only reflect how much money you have to pay for something. Prices are signals the market sends to consumers and producers, which at the same time help to coordinate market forces and reach a dynamic market equilibrium. In other words, prices show the relative scarcity of a product or service, allocating those goods and services to consumers which can and are willing to buy at that price. So, when price controls are imposed, price signals are distorted and not valid anymore for that good or service, which is why market imbalances occur, causing excess demand or excess supply. Price ceilings, which fix a price below the one set by the market can cause firms to reduce their profit margin and disincentivize many of them from investing in a certain country or region, leading to underinvestment, a reduction of investment in innovation and lower productivity rates, being all of these some of the negative effects of price controls analysed by the economists D. Dhananjay, K. Gode and S. Sunder in their paper Double auction dynamics: structural effects of non-binding price controls.
But price controls do not only have effects on the short term… once they are implemented, their effects will last for many years, and even decades, depending on the case. This doesn’t relate only to the vast disrupting effects they can have on a country’s economy, but also on the longevity of price controls throughout History, due to the extreme political difficulties of removing them. Small price increases prompted by a certain government action can ignite a social revolution, and it won’t be the first time it happens. A simple example, of a government regulated price change which started a revolution was the small variation in the Chilean metro fare last year in Santiago. The metro ticket fare was increased by a mere 3.5% ($0.04, or 30 pesos), and caused more than two months of political and social unrest, brought the army to the streets to control violent protesters, and caused 29 deaths of various causes. Obviously, protesters didn’t only argue about the politically-controlled metro fare, but about a wide array of issues, ranging from inequality to poverty, passing through social mobility. But it was this small change in a government regulated price which ignited the flame. Another example was Iran recently. In November the Iranian government decided to rise fuel prices (another government-controlled price), and protesters went furiously to the streets, starting another social revolution. Other governments as Mexico or Rwanda were able in the past to lift price controls on fuel, by profiting from market slumps in 2014, and compensating the worse-off citizens with subsidies and greater spending on health and education, but overall, publicizing all these compensatory public policies to prevent a social upheaval.
Admittedly, it’s true that some prices in many countries around the world may be excessively high for many consumers to be able to access those goods and services. Form renting a house in the main European city centres, to being able to buy enough food for a whole family in the Cuban communist regime. I’m not saying we don’t need to find a solution to all these problems, and of course policymakers should propose solutions that could be studied, analysed and implemented. But price controls, as evidence has shown are just a long lasting economic failure, by causing severe market dysfunctions and being extremely difficult to remove. Price controls are the seed of future socio-political instability.
The market as a natural and spontaneously-formed institution has several solutions for the problems previously presented, and which have tended to be tackled by governments with price controls. In a free market, production will oscillate to where it is more profitable to be done, in a global sphere, so if for a European entrepreneur, producing a certain good or service is not profitable anymore, due for example to globalization, he or she might need to focus in producing other goods in which he or she presents a relative advantage, or even generate that advantage through innovation. Schumpeter’s theory of creative destruction, in action! On the other hand, for those prices which are excessively high for certain consumers, and paradoxically cause at the same time an excess of demand (as occurs right now with the residential markets in many Spanish cities), due mainly to government restrictions to supply (caps on land uses and building)… well the solution might come from deregulating those markets and allowing a greater supply, causing a lowering of prices, more accessibility to those products and services, and greater allocative efficiency.
Price controls are the problem. Free markets, the solution.