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Independent Researcher PRICE CONTROLS Social Benefit or Social Cost? Published by Bridgestone Associates Date: January 14th, 2020 The use of price controls by governments is common across markets and economies. While sometimes used as a tool for social dogma, price controls can throw cold water on investment and growth, deteriorate poverty outcomes, cause heavy fiscal burdens on countries, and jeopardize the effectiveness of monetary policy. Better socioeconomic nets along with market competition and a sound regulatory environment, can be both pro-poor and pro-growth. However, such developments need to be carefully communicated and sequenced to ensure political and social acceptance. Where price control exist, it should be transparent and sponsor by well-capitalized stabilization funds or national hedging strategies to ensure fiscal sustainability. Independent Researcher Governments have been trying to set maximum or minimum prices since ancient times. If we look at the history, we see a lot of situations where policy makers influenced the markets through price controls. Although application of price controls is understandable, as it holds out the promise of protecting groups that are particularly hardpressed to meet price increases, they fail to protect many consumers and hurt others. One of the reason for this is that Price Controls tends to create Price Distortions. Price distortions are defined as instances “when prices and production are higher or lower than the level that would usually exist in a competitive market”. Price controls can be imposed in a variety of ways. They may involve price ceilings, or price floors, imposed on selected goods and services by the authorities. In emerging market and developing economies, price controls on goods are often imposed to serve socio-economic objectives. They may be part of government efforts to protect vulnerable consumers, by addressing market failures or subsidizing the cost of essential goods. Or they may be intended to maintain the incomes of producers, as part of a pricesupport program. Alternatively, they can serve the purpose of price smoothing, especially for key commodities subject to high volatility in international markets. This can lower uncertainty about households’ real incomes and firms’ production costs. Nonetheless, Price Controls tends to force challenges to growth and development in the economy. UNDERSTANDING PRICE FLOOR & PRICE CEILING Price Ceiling means firms are not allowed to set prices above a certain level. The aim is to reduce prices below the market equilibrium price. Whereas Price Floor is the minimum price that producers are allowed to charge. They are usually set above the market equilibrium. Both, Price Ceiling and Price Floor tends to effect the supply and demand of the products and services. When prices are established by a free market, then there is a balance between supply and demand. However, when the government imposes price controls, then there will be either excess supply or excess demand. A price ceiling creates a shortage when the legal price is below the market equilibrium price, but has no effect on the quantity supplied if the legal price is above the market equilibrium price. A price ceiling below the market equilibrium price creates a shortage that causes consumers to compete vigorously for the limited supply. Supply is limited because suppliers are not getting the prices that would allow them to earn a profit. Likewise, price floor creates excess supply if the legal price is above the market price. Suppliers are willing to supply more at the price floor than the market wants at that price. CHALLENGES OF PRICE CONTROL As discussed previously, intentions behind price controls is to improve social outcomes, however it often hinders growth and development prospects, impose fiscal burdens and can weaken the usefulness of monetary policy. Growth challenges. The use of price controls can have adverse consequences for growth for several reasons: • Stifled competition and reduced investment. Price ceilings can depress producer margins and discourage domestic investment and entrepreneurial activity. If margins depend on Independent Researcher subsidies to local businesses to compensate for price controls, they can discourage foreign investment in those sectors by increasing the country risk premium. In the opposite case, where the controlled price is above that required for a competitive return to investment, its maintenance requires barriers to entry or costly government stockpiling of excess supply. Price-support controls can depress competition and sustain high producer margins. • Distorted financial markets. Price controls in the financial sector, such as ceilings on interest rates can distort financial markets. These measures reduce the supply of credit to safer borrowers and small and medium-sized enterprises, increase the level of nonperforming loans, reduce competition and innovation in lending markets, and increase informal lending. Moreover, they can exacerbate inequality by limiting the poor’s access to lending. • Lower productivity. Price control regimes may tilt the allocation of resources towards the subsidized sector. Yet, such policies can end up reducing productivity, and worsening income inequality. They may lead to inefficient use of subsidized inputs. They can also adversely affect incentives to adopt productivity-raising new technologies. Empirical evidence suggests that marketoriented structural reforms, including the reduction of price controls and their related subsidies, are strongly associated with improved firm-level productivity. Conversely, in the case of petroleum products, high subsidies that underpin price controls appear to be associated with lower per capita output growth. • Increased vulnerability to climate change. Price controls and subsidies on energy products may heighten vulnerability to climate change and inhibit the transition to a climate-resilient, lowcarbon economy. • Increased informality. Price controls that distort consumption towards pricecontrolled goods, can cause chronic shortages of these goods, the formation of parallel markets with higher prices, and substitution towards lower-quality alternatives. Similarly, producers of pricecontrolled goods may turn to black markets which have elevated transaction costs and lack basic regulation. In addition, the situation encourages production to shift to firms in the informal sector, which avoid regulation. Socioeconomic Challenges. The use of price controls combined with large subsidies is an inefficient tool for redistributing domestic income. These policies tend to be inequitable, as wealthier segments of the population, usually urban consumers, benefit disproportionately given their greater consumption of the price-controlled good compared to rural consumers and producers. For example, subsidies and below-market prices for gasoline and liquid natural gas have proven highly regressive, with only a small share of the subsidy benefiting the poorest segments of the population. Fiscal challenges. Price controls impose an explicit or implicit set of taxes and subsidies that varies over time, and their enforcement may require additional regulations to constrain consumption and production. Typically, a system of price controls on goods ends up as a growing burden on either the fiscal budget and public debt or the profitability of producers. Subsidies for products subject to price controls, such as petroleum, can be a large portion of government expenditures, in some cases exceeding 10 percent of GDP. Independent Researcher Monetary policy challenges. Monetary policy has played a major role in reducing inflation to a low, stable rate, often in the context of an explicit inflation-targeting regime. The key has been a transparent strategy aimed at the medium and longer term. This has largely stabilized longer run expectations of inflation, in line with central bank objectives. In these circumstances, the one-off impact on the inflation rate of the removal of price controls can be handled with the help of careful communication from policymakers as to the strategy they will employ to get inflation back on track. In LICs, however, the monetary policy challenges go deeper. First, the wider use of price controls complicates the choice of inflation target by weakening the usefulness of the overall CPI as a measure of underlying inflation pressures. Second, it can raise inflation because the authorities tend to respond asymmetrically when faced with cost increases, as is often the case in response to food price shocks. Third, it can increase the stickiness of the inflation process as changes in controlled prices often involve a lengthy regulatory process. Fourth, one-off changes in controlled prices can have persistent effects on inflation in LICs, where inflation expectations are less well anchored. Lastly, price controls in the financial sector, including ceilings on interest rates can reduce the ability of monetary policy to affect financial conditions. Collateral damage from foreign price controls. LICs are also more vulnerable to the collateral damage from other countries’ price controls on food and energy, because of the high share of food and energy in their consumption baskets and trade. Policies by individual countries to contain the effects of spikes in global commodity process in their local markets have been shown to have had the perverse effect of raising global prices. Export restrictions in major commodity producers exacerbate global shortages, thus contributing to higher prices on the international market. POLICY IMPLICATIONS Price controls have been used to mitigate the impact of commodity price volatility on the most vulnerable members of society. However, most governments have had difficulty designing frameworks that deliver lasting benefits. Over time, price stabilization policies often result in costly and distortionary subsidies, posing important challenges to growth, development, and macroeconomic policy suggesting that other policy instruments may be more effective in achieving social protection objectives. Comprehensive reforms of price control policies and related subsidies. Replacing price controls with expanded and better-targeted social safety nets, coupled with structural reforms, can be both pro-poor and pro-growth. Indeed, policies to lower subsidies that underpin price controls appear to be associated with higher per capita output growth, in part because savings generated by lower subsidies can fund productivity-enhancing education and infrastructure. The removal of price controls needs to be coupled with targeted support for those segments of the population that might be adversely affected. The different prongs of reforms, however, need to be carefully sequenced and communicated. Enhanced competition. Improving the competitive environment can be a more effective means of lowering costs to consumers and producers than the use of price controls. Carefully designed and properly enforced antitrust laws and consumer protection legislation, are essential components of institutional frameworks that support market mechanisms. A sound legal and regulatory framework favoring competitive markets provides a more effective response to many of the problems that price controls attempt to address. Even in the case where incumbent firms maintained outsized market shares, the presence of competition, and the potential for new entrants, significantly lower their markups. Independent Researcher Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of any agency of the Pakistan government. Examples of analysis performed within this article are only examples. They should not be utilized in real-world analytic products as they are based only on very limited and dated open source information. Assumptions made within the analysis are not reflective of the position of any Pakistan government entity. Contact Us: Address: House 04, Street 39, Sector G-6/2, Islamabad. -.- www.bridgestoneassociates.com