The Case against Price Control in Slovakia (1992), by Sean Gabb
The Case Against Price Control
by Sean Gabb
Being the English Text of a Lecture
Given in the Research Department
of the Slovak Christian Democratic Movement,
Note: Here is the English text of a lecture given in January 1992, all about the folly of price control. This time, I carried the audience with me. perhaps it was because I made my case without shocking their most cherished prejudices.
In the January of 1991, most price controls throughout the Czech and Slovak Federal Republic were abolished. This has been so far the most noticeable part of the economic reform programme. It has also been the most unpopular.
Compared with the previous month, prices rose during the January of 1991 by an average of 25.8 per cent. During the next three months, the prices of bread, butter and beef fell slightly. But, by the June of 1991, the average of all prices had risen by 49.2 per cent compared with the end of 1990.
It is not surprising, therefore, that the end of price control has been unpopular throughout the Federation - and especially so in Slovakia, where unemployment has risen far higher, and foreign investment to date has been far lower, than in the Czech lands.
Even so, the policy is a necessary one; and it is the purpose of this document to explain why.
How Prices are Set in a Free Market
The price mechanism is essential to the smooth functioning of a free market economy. Prices are the means by which the forces of supply and demand are brought into balance. They are the signals that tell consumers how much of any good they can afford to buy. They tell producers what to make, in what quantities, and by what methods.
Let me illustrate this definition with an hypothetical case.
Suppose that I own a fish pond, and decide to raise carp for sale to the public. Suppose also for the sake of argument that I am the only person in the district who has set up in this line of business.
Now, I have certain costs. I borrowed money to buy the pond and equipment, and I must pay interest on the loan. I must pay wages and gas and electricity bills and other expenses. I must pay taxes. There is also my own salary. I set this by assessing how much I could earn by working as the manager of a similar business owned by someone else.
Taking all these costs into account, I find that I spend Kcs70 on every kilogramme of carp that I bring to market.
Having brought my fish to market, I have decided to ask Kcs100 per kg. This allows me a profit of 43 per cent. Let us suppose two results.
First, I cannot sell all my stock at this price. At the end of the day, I am left with boxes of unsold carp.
Second, I find that I have sold out long before I expected to close my stall and go home.
In a free market, these different results will produce the following further results.
In the first case, it is shown at least that I have made an unwise pricing decision. There are people who will pay Kcs100 per kg of carp. But they will not buy all that I have brought to market. Perhaps I can sell all my stock if I lower the price to Kcs90, or Kcs80, or Kcs70 - at which point I make no profit, but do recover my costs.
Perhaps, however, I cannot sell all my stock, even at Kcs70 per kg - but only at Kcs60. I must now choose one of two decisions. I can cut my costs of production to Kcs60 or less, by reducing the average quality of what I bring to market. I might do this by not throwing away those carp that are too small for sale, or have gone bad. This will allow me to bring more to market without raising my costs, so reducing my costs per kg. Otherwise, I must cut my production to the point where the price I can get per kg covers my costs of production per kg.
If I cannot do either of these, it will be shown that I have made an unwise investment. Either I must turn my capital to some more profitable use, or I must go out of business and let someone else take over my capital.
In the second case, it is shown that I have underpriced my carp. When I next come to market, I can ask a higher price - perhaps as much as Kcs120 per kg, or a profit of 71 per cent. I can ask whatever price keeps me from selling out of carp before I choose to go home.
It may be said that 71 per cent is a very high profit, and that I am exploiting my customers. But this profit is my reward for the risk I have taken. I have invested my time and money in an enterprise that I did not know for certain would succeed. If it had failed, I should have wasted my time and lost my money. But it has succeeded, and people now have something that they want and did not have before. I deserve my profit.
However, it will not continue indefinitely in a free market. Because I am making so much money from fish farming, others will set up in the business, hoping to earn the same large profits. But this will expand the supply of carp, with the following results.
First, the price will fall. Because more carp are being offered for sale, I and my competitors must deal with people who will not - or who will no longer - buy at Kcs120 per kg. So, to sell all that we produce, we must lower the price.
Second, in response to falling prices I will try to maintain my former total profit by producing more carp. Suppose my initial profit of Kcs50 per kg brought me a total profit of Kcs1 million. If competition reduces my profit per kg to Kcs20, I may have to double, or even treble, my production to maintain my total profit.
But this will cause a further fall in price. It will also tend to increase my costs of production per kg of carp. I shall need to buy more ponds, and take on more workers, and so forth. After a certain point, it is certain that I shall find that to produce each extra kg of carp costs progressively more than Kcs70.
I and my competitors will continue to expand production to the point where increasing costs and falling price meet - where, for example, it costs me Kcs90 to produce an extra kg of carp, and I get Kcs90 for it at market. At this point, supply and demand will be in balance, and no one will now be making a profit, but only breaking even.
The Costs of Interference
To interfere in either of these cases - by fixing a price without regard to supply and demand - is both unwise and unjust.
Let us suppose that the Government decides that my 71 per cent profit is unjust, and sets a price for carp of Kcs70 per kg. At this point, I am covering my costs, but am making no profit. I am in fact being robbed. We have earlier established that I can sell all my carp when I am the only producer at Kcs120 per kg. This is my reward for having noticed an unsatisfied want, and for having invested my time and money in satisfying it. That reward has been taken from me. On every kg of carp that I sell, I am being robbed of Kcs50.
But, while I am losing, consumers are not as a whole really gaining. At Kcs70 per kg, there must be many more people wanting carp than I can satisfy. Every day, I come to market with my boxes of carp. Every day, I close my stall and there are still hundreds of people queuing.
Naturally, they are angry and disappointed. They have seen carp offered for sale at Kcs70 per kg, and decided to buy at that price - only to queue all morning and go away with empty baskets.
I can only hope to solve this problem in two ways. I can expand production, but keep my costs from rising above Kcs70 per kg by lowering the quality of what I produce. Or I can start a rationing scheme - selling only so much to each customer, so that each get less than he wanted, but gets at least something. Otherwise, I can combine the two.
The general consequences are:
First, that the material resources available to society are being misused. Land, capital and labour that ought to be used for fish farming are either being used for some less valuable purpose, or are not being used at all.
Second, that no incentive is now being given to increase the resources available to society. Wealth is created by the efforts of individuals. Unless they have the chance of being rewarded by a high profit in the event of their succeeding, they will not risk their capital in new ventures.
This, of course, assumes that I am an honest man who always obeys the law. In reality, I or someone else will withdraw carp from the official market and start selling them on the black market - perhaps for Kcs150 per kg. This will have certain benefits. For a black market is still a market, and people will be able to buy all the carp that they want and can afford. But the great disadvantage is that black markets are inseparable from real crime. They are usually run by mafias - people with the money to organise production and bribe the authorities to look the other way. Even if not, the example of one broken law encourages people to break others that may not be so unwise or unjust. For example, a man who breaks the law when he sells a kg of carp for Kcs150 may not feel so reluctant as he otherwise ought when he pours battery acid into a competitor's fish pond.
Let us now suppose on the other hand that the Government decides to set not a maximum but a minimum price for carp. It desires now to protect not the consumer but the producer. It says that carp shall not be sold for less than Kcs200 per kg.
There may be a few people willing to buy a small amount of carp at this price - but not to buy all that I and my competitors will now be encouraged to produce. Either the Government must give up its attempt to set a price far above what the market will bear, or it must guarantee to buy every kg of carp that cannot be sold at market for Kcs200.
This is obviously unjust to consumers. If they still want carp, they must buy it at a much higher price than free market conditions justify. It is also unjust to taxpayers, who have to fund this policy.
It is unwise in that it encourages more resources into fish farming than ought to be there - so preventing their use in some more genuinely profitable enterprise.
Examples from the Real World
But this has been a purely hypothetical example, given for the sake of simplicity and clarity. There are thousands of real examples. History as far back as we can trace it is filled with examples of price control and its failure. Consider a few of these:
In 1770, the rice harvest failed in Bengal. In a free market, the natural consequence of an actual or expected shortage is for prices to rise. This will ration supplies, so causing hardship, but also ensuring a continuity of supply until the next harvest. But the authorities responded by fixing prices at their old level, and commanding the merchants to sell all that they had at those prices.
As a result, people continued to buy and eat rice as if there were no shortage - but only for a few weeks. Then the supply ran out, and a third of the Bengal population starved to death.
In 1936, the National Socialist Government in Germany responded to an inflation that it had created by imposing the most rigid and comprehensive scheme of price control ever devised. This was enforced with all the efficiency for which the Germans are famous, and where that failed with all the brutality for which the National Socialists are notorious.
This attempt, like every other, was a failure. Between 1936 and 1944, prices on the official market rose by an average of 300 per cent. Even so, there were quality reductions and an extensive black market.
Prices in Russia are set far below their market rate. In consequence, the shops are empty and people are beginning to starve. Consumers in St Petersburg are lucky: they can go into the Baltic Republics where price control has been ended, and food though expensive is available. I do not know how long it will be before President Yeltsin's abolition of price control in Russia ends the shortages. But there is no alternative to his policy of price liberalisation.
Turning to a minimum prices policy, the European Community operates the Common Agricultural Policy. Each year, it sets a minimum price for each foodstuff, and maintains this though buying all that cannot be sold at market. The result is massive surpluses. There are lakes of wine and milk and mountains of beef and butter. When these surpluses cannot be sold outside the Community, or even given away, they are destroyed.
In 1989, 50,000 tonnes of oranges were thrown into the Mediterranean. That is enough oranges laid in a line to stretch six times round the world. 100 million litres of milk were poured down mine shafts.
The total cost of the Common Agricultural Policy was $25 billion - enough money to feed every poor person in India for a year.
From these examples, it can be seen that price control is most commonly imposed in two situations. The first is when the Government is trying to conceal the effects of an inflation that it has created. The second is when it is trying to pretend that a scarcity does not exist. In either situation, the policy is mistaken, and, as was the case in Bengal, can be disastrous.
Inflation is far better fought by taking firm control of the money supply. It is caused by printing too much money. It is cured by printing no more.
Shortages must be overcome in the long term by encouraging the development of better sources of supply. In the short term, high prices are a better effect than famine.
None of this is to say that the Government should do nothing when high prices threaten to cause hardship. It says only that help should not - because it cannot - be given by interfering with the natural laws of the market.
If help is to be given, it must be given directly to those most likely to suffer hardship. Instead of controlling prices - which is to rob producers and subsidise those lucky enough to be at the front of the queue regardless of their income - money should be given to the poorest members of society, so that they can afford to buy what they need.
The British economist John Stuart Mill made this point as long ago as 1848. When wealth has been produced, it can within certain limits be redistributed by the Government so that everyone can enjoy a decent standard of life. This kind of welfare policy is perfectly compatible with a high rate of economic growth. But there must be no interference in the production of wealth. Here, the natural laws of supply and demand must be allowed to operate without any check.
To see what happens when these natural laws are interfered with we need only look to modern Russia. Is that what we want for Slovakia?