Finance: Research, Policy and Anecdotes

Price controls and inflation

Microeconomic theory tells us that price controls, be they price ceiling or price floors, might have the intended effect on pricing, but can lead to adverse reactions in supply and demand, leading to pernicious short- and long-term consequences.  We have also learned, however, that what the simple theory tells us does not necessarily hold in a more complex setting.  Best example are minimum wages, where a large share of economists have moved away from a clear stance that minimum wage reduce employment (especially among less skilled workers) to a more nuanced position, based on theory (e.g., monopsony position of employers) and empirical evidence (here one recent paper on Germany). By now, many (though not all) economists agree that minimum wages can have beneficial effects up to a certain level. Can a similar argument be made about price ceilings? Isabella Weber recently put the case forward for strategic price controls to fight inflation, pointing to an explosion in corporate profits based on windfall gains from supply chain problems. The proposal has met with rather strong if not dismissive opposition.  As so often in economics, the reality is much more complicated!               

 

The question of price controls came also up during the early days of the pandemic, as the supply of toilet paper turned out to be limited. I remember a heated discussion in my April 2020 MBA class on whether a shortage of toilet paper justifies price controls, given the nature of toilet paper as necessity (as it turned out, the shortage was a temporary one, as companies had to switch production from toilet paper rolls used at offices to toilet paper rolls used at home).  There are market arguments for simply allowing the demand and (constrained) supply determine the market price, but given the social importance of toilet paper, also arguments for some rationing and price controls. 

 

The argument put forward by Isabella is obviously a different one: using price controls for strategic goods that drive the current inflation until the supply-chain problems have been sorted. Unlike the classical microeconomic arguments on price caps (nicely illustrated in the well-intentioned recent rent cap in Berlin that might have solved rental problems for some but exacerbated them for others), Isabella’s argument uses a microeconomic tool for macroeconomic purposes.  Even though there might be good arguments and some historical parallels for that, I am sceptical. First, it is not clear that corporate profits drive the high prices (as opposed to being simply a consequence of them) and price controls will therefore simply reduce prices at the same supply or rather might reduce supply even further. Further, price controls might undermine incentives for addressing supply chain problems and prevent new entry into markets.   Second, who decides which prices to cap and which not – a purely technocratic decision or a political one? The problem with ‘strategic’ is that different actors have a very different understanding of it and politics is hard if not impossible to separate from economics. Third, the current situation is characterised not only by pent-up demand but also the need for reallocation of resources and thus relative price changes – as the experience of the transition economies has taught us, this requires higher inflation than usual. There are other arguments, nicely summarised by Noah Smith.

 

Where does this leave us? I would not exclude price controls in extraordinary and very time-limited circumstances, but it seems as economic policy tool it is rather risky if not outright dangerous. If the problem is really monopolistic market structures and supply-chain problem, addressing these would certainly lead to a more sustainable solution, both on the micro- and the macro-level. As already argued above, price controls might actually reduce pressure and incentives to achieve sustainable solutions.