How price controls suffocate the economy

The government issued a notification last month giving officials largely unconstrained powers to monitor and control the prices of fifty categories of products. Then, on August 30, the Prime Minister directed provincial authorities to ‘stabilise’ the prices of basic items. Together, these decisions betray a gross misunderstanding of economics.

Why are price controls so bad? After all, don’t lower prices mean consumers can stretch their rupees further?

Prices of 50 daily-use items fixed

In normal markets, price fluctuations play a coordination role: they force the millions of individuals and firms spread across the economy to consider whether their use of a resource is valuable enough to make bidding up the price acceptable.

When a potato farmer and an onion farmer reach for the same bag of fertiliser, and the shopkeeper says he will sell to the highest bidder, each grower must then consider how much additional revenue the fertiliser bag will allow him to generate.

For example, if there is an ongoing pest attack on potatoes, the potato farmer realises he can’t benefit from the fertiliser much and stops bidding before the onion farmer does. This means that the fertiliser gets applied to the crop that it can benefit more.

This feature of markets – that disaggregated decision-makers spread across the economy can arrive at a sensible allocation of resources, increasing the economy’s efficiency – is a fundamental argument in favor of leaving prices uncontrolled.

When prices are set by government, they can either exceed or fall short of what the market would have determined. If the price set is too high, suppliers produce more than buyers can absorb, leading to a glut of unsold goods. When the price set is too low, a shortage is created.

The havoc that price controls wreak doesn’t stop here. Price controls damage producers in different ways. First, all producers are impacted by the uncertainty created by controlled prices: instead of tracking and predicting market prices based on sound economic principles (such as, in our example, expecting that prices will rise after a pest attack reduces overall crop yields), they must plan future investments and production decisions based on the expectations of bureaucrats.

This uncertainty is especially damaging for those whose production requires long-term investments.

For example, a timber producer planning to grow poplar trees will want to estimate the price of sale in five to seven years. A car manufacturer setting up an assembly plant will need to project prices and sales for even longer.

The uncertainty created by price controls will increase these producers’ risk, and therefore their willingness to invest in these markets. This is true both for domestic producers, and those considering bringing in foreign direct investment (FDI). Price controls, therefore, are likely to result in under-investment in the economy over time.

What about consumers? Controlled prices create an immediate benefit for consumers, in that they have to pay less to purchase an item. However, they also suffer in a few ways.

First, by definition, a price lower than that determined by the market will lead to a shortage, so some consumers will go unserved. Second, as producers exit, consumers may have to buy from a less preferred supplier, possibly one located further from their home, or perhaps one whose product is differentiated in a way not quite to the buyer’s tastes.

Third, when suppliers are forced to supply at a mandated price below their preferred one, they will start to slide quality down to save costs.

Controlled prices create an immediate benefit for consumers, in that they have to pay less to purchase an item. However, they also suffer in a few ways

To see this, you need look no further than the DC Counter of your local grocery store, where products are sold at a government-mandated price, simply by delivering lower quality. Shorn of control over the price they can charge, high-quality suppliers start vanishing. Price controls thus decrease the average quality of product available in the market.

Not only do consumers sometimes suffer from lower prices, buyers who are provided an item at lower price than efficient will often not take due care in its use.

We have a stark example of this in Pakistan, in the form of the price levied for surface water provided to farmer, the Abiyana. For decades now, agriculturists and irrigation experts have decried the impact of charging too low a price for this water.

Resultantly, we are a water-stressed country in which most farmers manage their water in grossly wasteful ways, because – due to controlled prices – when they decide how to use water, they don’t ever come face to face with how precious the water is.

Now let’s suspend disbelief – and logic - for a moment, and consider a world in which, somehow, price controls are considered warranted. How would bureaucrats know what price to set?

First, consider that nearly all prices capture intangibles, in the form of including a contribution towards reimbursing the entrepreneur for the investment that was necessary to enable production: why is the price of a cup of tea at a five-star hotel more expensive than the price at a dhaba, and why are customers willing to pay?

The hotel isn’t necessarily setting an unfair price, but is instead incorporating a small sliver of its significantly higher fixed costs (or overhead costs, such as the price of maintaining the fountain outside, or of cleaning the chandelier under which you are sat while sipping your cup).

If a government regulator now walks in and orders the hotel to bring prices down to those of the Dhaba, you will soon find it impossible to get a cup of tea at the hotel. This point bears emphasising: a higher-end provider of a simple commodity may legitimately charge a higher price for it without earning unjustifiable profits.

This is not all. For price controls to work, government officials would additionally need to tailor prices by quality and location.

A few years ago, my co-authors and I piloted a study to investigate Lahore’s milk market. We figured that milk was a relatively simple product, and we would study fraud in the market by measuring milk samples’ densities by using lactometers.

We quickly came to realise that judging milk quality was far more complicated than we had expected: milk density varied depending on the time of year and the type and health of the animal milked; suppliers added ice to preserve, not just dilute milk; and the prices charged depended as much on the milkman’s trustworthiness and timeliness of delivery as on the quality of the milk.

If the government is going to have a hard time determining the ‘correct’ price of a product as seemingly simple as milk, what hope does it have elsewhere?

So the bureaucrat attempting to set ‘fair’ prices for all suppliers will either have to swim through a deluge of relevant information about each supplier’s costs, or accept that the controlled price he or she sets will be too high in some cases and too low in others.

Here, I have argued that price controls hurt producers, and often consumers, and that determining the ‘right’ prices is quite impossible. In my next column, I will try to demonstrate that price controls can open the doors of corruption and misgovernance.

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