On Prices and Price Control

In a free market economy like our own, few things as underappreciated as the prices of the products we buy. Very few people in our society understand how complex and subtle prices are. The price of a product is not just a number on a sticker attached to the cover of an item we want to buy, but rather a number that sums up a whole lot of information about that product, where it comes from, what it is made of, who made it, who wants to buy it and among a host of other information how much of it is left. Without a proper appreciation of the importance of prices, people in society tend to ask for policies that, on the surface seem legitimate, but upon closer inspection are deeply flawed.

The strength of prices lies in their ability to signal to both producers and consumers about the relative scarcity of a product. Since both parties (consumer and producers) are sensitive to price, price changes will affect their purchase (supply) of a product. Each morning we wake up and go to the shop to buy any number of items, bread, sugar, milk, gas to name just a few. And each time we go to the shop, we find those items there, waiting for us. We do not need to make a special order nor do we have to wait in an hour long queue. All we need is money and desire for the product and it is ours. Have you asked yourself how the rice farmer in Thailand knew you would want a 50 Kg bag of rice, or how the baker knew you would need a loaf of bread at 7 am every morning, when neither of them knows you? The answer to these and similar questions is that they do not need to know you or your need for rice and bread. Both of these producers are responding to price (and profit). For producers, a rise in the price of their product, along with constant production costs, means that their profit per unit increases. This increase in profits spurs producers to produce more and in some cases other producers to enter the market and start producing the good. The price rise could be due to any number of factors, but the outcome in this case should be an increase in supply by producers. The increase in supply should now reduce the scarcity of the product. On the other hand, rising price of goods leads to people cutting back on how much of it they buy, the law of demand. By cutting back on their purchase of an item, the scarcity of the product falls.

When a society does not understand the role prices play in their economy, then the society tends to demand certain policies from its government. With regards to prices, people demand their governments to control the price of goods, in essence to shackle the free market. It is not at all time that people demand price controls from their governments, but rather at times they perceive to be difficult for them. When prices start to rise (for most products) people start to feel poorer, for good reason since their incomes can now buy less than it used to. Price rises can happen for a number of reasons and the solution to the problem lies in the cause of the price rise. Price control is never a solution to rising prices but rather a cause for more serious problems.

When there is a general rise in the price level, those most vulnerable in society (the poor) ask for help from their government. They ask to be protected from “greedy” businessmen who are “out to exploit the common man”. If the pressure from this group is strong enough, a government usually bows to its demands and institutes price controls for a particular product(s). Price controls are of two types, price ceilings and price floors. In this post I will focus on price ceilings since it is the more common form of price control in our country.

Price ceilings

A price ceiling is a type of price control for a product wherein the government sets a maximum price, above which the product cannot be sold. We usually see this in the food market, for example rice, flour, meat etc. When the ceiling is set by the government, no one in the country can sell above that price. Doing so would lead to that person or the people engaged in that transaction to be jailed. The problem with price ceilings is that the ceiling is set at a price which is below the equilibrium market price. At the equilibrium market price, demand for and supply of the product are equal. If the price is set below the market equilibrium, then what ensues is a shortage. A shortage occurs due to the relationship between price and quantity (supplied and demanded). As mentioned earlier, a rise in price leads to producers having higher profits and supplying more of that product whilst consumers demand less due to their being able to afford less from their income. When a ceiling is introduced, the price of the product falls. The fall in the price leads to lower profits for suppliers which in turn lead to a reduction in the supply of the product by suppliers. On the other hand, consumers, now ecstatic due to the lower prices increase their purchase of the product. The simultaneous effect of falling supply and rising demand leads to there being a shortage at the new price.

The problem does not end with the shortage; rather this is only the first stage. After a shortage takes place, it occurs to people that there isn’t enough of the product to go around, but since price cannot adjust. It can no longer signal to producers that “people want more of your product, so produce more”. Therefore something else has to adjust to serve as a form of rationing. Along with providing us with information about a product, a price also serves as a form of ration where only those who can afford to buy the product at the market price get it. With our price control now on, sellers now have to find a way to sell the limited product they have among so many people. The most common form of rationing is first come first served. This type of rationing by sellers would lead to long queues around the country. Another way seller could ration is to sell to only their relatives, friends and neighbours. Yet another form could be their selling only to those in their ethnic group.

Following a shortage and the long queues, a black market for the product grows catering to those able to afford buying the product at above the government controlled price. Black markets are illegal and therefore anyone caught in that transaction would be arrested and imprisoned.

From the outcomes explained above, we can see that a policy once instituted to help the poor and vulnerable in society only ends up hurting these people more. With price controls, two markets would develop, the first a regular market which has little of the product and therefore very few will get it, and the second a black market where the product is sold at price above even the initial equilibrium market price. In both markets, poor people will find it extremely difficult to obtain the product. The irony is by setting a price ceiling to help the poor, society is in fact making it harder for poor people to buy the product.