Wednesday, March 2, 2011

Governments try to suspend the laws of supply and demand by imposing Price Controls---Even Dictators cannot dictate that...

As inflation rears its ugly head in many parts of the world, governments are responding in ways that are proven to hurt economies in the medium to long run.  One measure is Price Controls. When market prices rise quickly they impose economic pain, especially in lower income countries.  A populist "fix" is for governments to not allow prices to rise at the retail level. Price Ceilings are imposed. That is to say, prices are fixed and are not allowed to rise above the government set price.

Inflation Prompts a Flurry of Subsidies:  Moves to Soften Blow Could Backfire On Asian Countries, Economists Argue.

""As prices for food and energy climb, a growing number of governments—most recently in Asia—are expanding subsidies, imposing price controls or embracing other short-term fixes to protect consumers that many economists fear will prove counterproductive and lead to higher inflation in the end.""

""But over the long haul, economists warn, the programs may help drive prices higher by encouraging consumers to spend. Price controls, meanwhile, discourage farmers and manufacturers from producing more food and other goods—which is needed to help bring prices down—and can create other distortions.""

Graphically, it looks like this:

The market equilibrium price wants to be at "Pe" and where market quantity demanded equals quantity supplied at "Qe", but the government impose a ceiling at "Pceiling". This is below the market price/quantity at Point "A".  At "Pceiling" the quantity supplied is  "Qs" and the quantity demanded is at "Qd". Both conform to the laws of supply and demand and move along their respective demand and supply curves. We now have a dis-equilibrium where the quantity demanded is greater than the quantity supplied---there will soon be a shortage of this good in the marketplace. 

What policy makers choose to ignore, is inflation hits the producer as well. As input prices increase, so does the total cost of producing a good. If they are not allowed to pass this cost on to the consumer, they will not stay in business.  Producers hold back and decrease their collective quantity supplied.

Policy makers also ignore consumer behavior. People know the price control sets the price below what it should be.  They don't know how long the price control will last AND they also know how their neighbor will react.  At the lower price, the collective quantity demanded will increase.

With a simultaneous decrease in quantity supplied and an increase in quantity demanded, a shortage will soon arise and people will get even MORE angry.  The only saving grace for the government is that the shortage will not immediately appear. As inventories are worked through, the shortages will start to show up in the re-ordering of the good to re-stock the shelves---there won't be any, or there will be much less.  This will encourage black market activity and trade of the good will become less transparent. 

Suspend the laws of supply and demand at your own peril, Mr/Mrs. Policy-maker.
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